Running of the Multi-Family Bulls
December 17th, 2009 | 
Author: 
Despite 22 year record high national vacancy rate of 7.8%, the multi-family sector has performed well compared to other asset classes. Several multifamily properties have recently traded at 6.5% cap rates, demonstrating investor confidence in this market sector. I am bullish on the multifamily sector for several reasons.
The U.S. homeownership rate has clearly peaked, decreasing to 67.8% in 2008 from 68.1% in 2007. When the government mortgage spending spree (FHA) slows down, underwriting standards are going to become more stringent. Future loans will probably either require a larger down payment or higher mortgage insurance, making the purchase of a home more difficult. American’s credit has been hurt by the economic downturn; a foreclosure lasts for 7 years on a person’s credit score and makes it difficult for them to get another mortgage. Lastly, folk’s attitudes have changed; I’ve heard several of my classmates at Cornell quip that “renting is the new American dream”. Taken together, these make a strong case for investing in multifamily housing.
So why are vacancy rates currently at record highs? I think that there is a lag effect while transitioning from homeowner to renter. People whom have walked away from their homes are typically in a tough financial position and may not be able to post the security deposit, or have the credit to immediately rent an apartment. Many of the people making this transition have chosen to move in with friends and family until some of the uncertainty about the future plays itself out, rather than commit to a lease. Also, with unemployment hovering around 10%, many renters are switching from renting to living with friends and family. When you don’t have a job it’s hard to pay the rent. As the economy recovers and U.S. homeownership rates continue to decline, there will be an increase in demand for apartments.
Now is a good time to invest in multifamily housing, especially considering the Fannie-Mae loan programs. There are several programs right now, but the bread and butter loan is the Standard DUS Mortgage, suitable for single asset properties with more than 5 units. There are no minimum or maximum loan amounts, terms range from 5-30 years, provide up to a 30 year amortization schedule, a fixed or variable rate, and allow an 80% LTV with a 1.25 DSCR. Additionally, the loan DSCR ratios can be calculated against a 5% vacancy and collection loss.
I know of a 110 unit garden apartment complex that was recently quoted a 5.7% 10 year fixed rate loan with a 30 year amortization. With the likelihood of steep increases in inflation and interest rates approaching certainty, having a 10 year loan fixed at 5.7% may turn out to be a huge asset. In addition to the Standard DUS loan, there are loans specifically oriented toward affordable housing, senior housing and student housing investments. Try getting a loan with terms like this for an office building!
Richard Weidel, a graduate student at the Cornell University Program in Real Estate, can be reached at richard.weidel@gmail.com
Posted in Multi-Family | 
Tags: apartments, Cornell, dscr, DUS, Fannie Mae, FHA, homeowner, mortgage, Multi-Family, vacancy
Rich – In one paragraph you say that FHA will tighten normal SFR mortgage standards, and then provide exapmples of loose underwriting for multifamily from the same GSE’s. How can you be bullish on MF when everyone knows the GSE’s 1. can not continue financing MF with the same terms forever, and 2. most of the stability of cap rates has been driven by the attractive financing and not occupancy or the ability to drive rents (not fundamentals). Basically investors are receiving a subsidy, which when the carpet gets yanked, “could” be left high and dry for a number of years, waiting for job growth? I personally am a bit weary of the risk adjusted return given the way the goernment has unilaterly acted in the recent past in changing the rules of the game. Looks like the local banks aren’t the only ones “extending and pretending”. The GSE’s are as well.
Brad, thanks for keeping me on my toes. The GSEs are ‘kicking the can down the road’ along with the local banks. You point out that “most of the stability of cap rates has been driven by the attractive financing and not occupancy or the ability to drive rents (not fundamentals).” I agree. However, I think that the fundamentals, i.e. rents and occupancy, will be strong in the near term because of the reasons I listed. If you invest in a multi-family property based on a cap rate applied to current NOI or trailing 12 months NOI, and it cash flows with the current vacancy rates, I would bet that it will be a good investment.
What does scare me most is a total resetting of rental rates like we have seen in the office and hotel sectors. As Class A apartment owners lower rents to raise occupancy, the rates will have to be lowered in each subsequent class level. Within the next 6 months I expect that occupancy will settle, but overall rental rates will fall by about 20% nationally. If rental rates fall 20%, property values fall as well.
As to being left ‘high and dry’ if the GSEs tighten the lending standards to multi-family investors, I disagree, if you are willing to hold onto the asset. Demand for rental units is going to increase, regardless of whether investors can obtain loans for multi-family properties. I think that now is a good time to buy sound multi-family investments based on REALISTIC rental assumptions specifically because the lending environment is advantageous. I’m also at the beginning of my real estate career, and don’t mind having to hold onto an asset for 15 or 20 years- if it has a positive cash flow. Sure, it might be difficult to sell a multi-family property if the GSE’s pull out the carpet, but it will also be difficult to buy unless you have the requisite cash to do so. Now is an opportunity for someone without a lot of cash to purchase a property that they may not be able to purchase once the GSEs turn down the music. Do I think that you can purchase a large multifamily property now and flip it in a few years and make a large return? No. I do think that if you adopt a longer term holding period, and focus on paying down the debt, it is a great way to build wealth over time with lower risk than investing in an office building right now. While one can buy office buildings at a 50% discount to what they were trading at, there is too much uncertainty in that sector right now for me. Apartments might have a low return, but I also think that they have a low comparable risk.
You make some good points, I’ll be thinking about them for a while.
Rich, thanks for this post. I’m also bullish on the multi-family sector for a number of reasons beyond those that you mentioned. Looking from a macro perspective, population continues to increase while no new development has taken place over the past 18 months and it’s likely that nothing will happen over the next few years.
Furthermore, historically as the economy recovers, the multi-famiy sector is the first to rebound. Undoubtedly, this will be the case in this recession as well.
Basically, it all comes down to consumer confidence, which will only stem from recouping the nearly 7.2 million jobs we’ve lost. Until people can be confident that their job is safe, we won’t see an increase in consumer confidence.
OK, I love the pop growth statements, which a certain Dr. from the Wharton School is always focused on. However, given some of Rich’s statements regarding declining rents, isn’t anyone concerned of a race to the bottom? Banks have not marked down their investments to a market clearning price. If the FDIC continues to control the market, and sap up distress buyer demand, how can a bank sell a forclosed asset? and if you buy today, and find yourself competing against a buyer who bought lower, you better realize that new owner is going to undercut you to drive occupancy. You can’t only underwrite the subject asset, you also need to understand the closest competing assets and dig into their capital structure (somehow) to understand how (much) a new owner could significantly undercut your baseline rent/comcession assumptions.All good points.
Brad, that Dr. to whom you refer is one very smart guy.
You make some very good points. Basically, the nation has to decide whether we’re going to recognize the losses or continue to let banks extend and pretend. If you extend and pretend and delay the point where you re-value these assets, transaction volume will remain low, price discovery is going to be impaired, and as long as price discovery remains impaired, we’re not going to be able to get back on a long-term growth path.
However, if the banks had to mark-to-market, a significant percentage would be insolvent. This is something the government doesn’t want to deal with (right now).