Has the Outlook Brightened for Multifamily Housing?

Has the strategy worked to increase occupancy? For some properties, yes. But as a whole, apartment property owners are only treading water in terms of occupancy while they watch their rents fall. The net result is that rent collections are down. Exacerbating this situation is that tenant-credit quality is down. Many of the most responsible residents--responsible from the standpoints of paying the rent and the wear and tear on the property--have moved out and into homes. This means more evictions, greater rent loss and increased makeover expenses.

The good news is that in Q2, the US market actually enjoyed low but positive demand for multifamily housing (in contrast to Q!). The second half of the year should continue to produce low levels of positive demand, if for no other reason than the flood of renters to home ownership should dry up (especially if rates continue to move up like we've recently seen). Yet with construction levels hardly abating, the supply-demand imbalance remains. REIS statistics show Q2 '03 occupancy at 93.3%, down slightly from the Q4 '03 rate of 93.7%. In the second half of 2003, occupancy may not drop farther, but no improvement is expected this year either. And 2004 doesn't look much more promising for occupancy, even with the expected return of job growth. (Economy.com currently forecasts +1.2% next year after none in 2003.)

The trouble spot remains rents. As already noted, effective rents are still falling, and they are not likely to stabilize until 2004. Demand needs to rise more substantially than the minimal 28,000 units reported for Q2 '03, and occupancy has to budge off the 93% mark. By 2004, the picture for rents and property cash flows will be brighter for sure, but full rent recovery won't occur until 2005 at the earliest.

Will the cash flow declines translate into higher mortgage delinquencies? Yes. How high? Your guess is as good as mine, but certainly it won't be as bad as Q4 '91, when apartment delinquencies peaked at more than 7%. Delinquencies today are still, fortunately, minimal at or less than 1%. First, properties in trouble have found investors (who can make the financial numbers work with today's rock-bottom mortgage rates). Second, for older loans, the substantial rise in rents during the late '90s and 2000 in many metro markets created a cushion in cash flow. Third, multifamily loans were originally underwritten with some safeguards (e.g., 20% owner equity) and they were conservative--at least compared to the exuberance seen in the 1980s. Fourth, of course, there remain some excellent metro markets where rents are not sliding.

Counting loans 60+ days delinquent and in process of foreclosure, life insurance company multifamily mortgages are only 0.17% delinquent (as of Q1 '03); Fannie Mae only 0.15% (May); and Freddie Mac 0.05% (May). The apartment loans in the CMBS world have a higher delinquency--1.03% (including loans 30 days delinquent and REO as well as 60+ days delinquent and in process of foreclosure as of June according to Morgan Stanley), but even this level is not too bad yet. But, beware: the low delinquency statistics are somewhat misleading. The number of apartment loans on various mortgage-watch lists is growing, and the number of loans being liquidated (and hence taken out of the statistics) has increased substantially this year.

All this said, it's still a great time to be a mortgage lender. Apartment loans unwritten today at current rents are still pretty safe. While there's still some downside in the market this year, it's short-term and fairly quantifiable. Plus with today's interest rates, cash flows don't need to be where they were three years ago. The production challenge for lenders today is threefold: First, they must adequately underwrite expenses (tricky, considering higher tenant turnover, rent loss and higher property taxes. Second, they must allow for some cash flow reduction through the balance of 2003 and remain really conservative in the rental appreciation assumptions in the next two years. Finally, they must manage to not lose the deal to the next three lenders impatiently waiting in line to capture the business.

GlobeSt.com Think Tank member Jeanette I. Rice is principal, Research Lend Lease Real Estate Investments Inc.