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NEW YORK CITY-Though it’s under pressure from a growing shadow market and the return of former homeowners has been less significant than anticipated, the multifamily REIT market is holding up well. That’s what analysts from Fitch Ratings reported during the locally based firm’s 2008 Annual Housing Conference held here last week.The company also examined the single-family housing market, which experts said is exhibiting few positive signs. The most pressing problem for the US economy today is excess supply, said Robert P. Curran, Fitch’s managing director of corporate finance, homebuilders and building materials companies. He added that it looks likely that the housing contraction will extend through 2008.

“A modest recession, declining home prices, tighter mortgage standards, poor buyer psychology and near-record levels of new and existing homes for sale, define the current environment for housing,” he stated. “Should mortgage rates rise or credit terms tighten further, then our housing forecast could turn even more pessimistic.”On the multifamily front, however, the outlook for public companies is stable. That, says Steven Marks, managing director and head of Fitch’s REIT group, is “based on strong trends that have begun to moderate.”

The expectation that the decline in single-family homeownership will significantly benefit multifamily owners, he said, “has thus far been exaggerated. The effects of a slowing economy are weighing more heavily on multifamily fundamentals” than expected.

For one, vacancy has gone up over the past 12 months and Fitch expects it will continue to increase over the coming year. The rise, Marks explained, has been, and will likely be, driven by a supply-demand imbalance, resulting in positive yet slowing rental income and NOI growth.

The key demographic trends that drive multifamily demand, he said, are supply and demand, employment growth, household formation and the affordability of single-family housing in given markets. “While there is a below-average construction pipeline expected to come on line in 2008 and 2009, there has been an increase in the shadow supply in the form of vacant for-rent single-family homes and reversion of condos to the rental pool,” said Marks. While the single-family slowdown has pushed households back into renting, “the movement of this population back into the rental pool has only a measured impact on multifamily occupancy. These supply-demand dynamics will likely result in increased vacancies through late 2008 and into 2009, and vacancy will likely near 7% by the end of 2009.”

The growth in employment–or lack of–will also be a factor, he said. Unemployment has gone from 4.5% a year ago, to 5% as of April 2008 and is projected to be about 5.5% by the end of 2009. In the current economic environment, this increase in unemployment and the corresponding slowdown in employment growth will weigh heavily on apartment demand.

Meanwhile, household formation tells a slightly different story. The population of singles and married couples without children–those who are more likely to rent–is projected to grow more than married households with children, who tend to reside in single-family homes.

In terms of geographic markets, the executive pegged mainly coastal areas as prime locations in which to own apartments. Included among these are San Francisco, where rents grew 4.8% between 2007 and 2008, Honolulu (4.3%), San Jose and the East Bay-Oakland, CA area (3.3% each), Orange County-Santa Ana (2.5%) and Los Angeles (2.2%)—compared to the 1.6% average year-over-year rental growth for the 54 markets tracked by Property and Portfolio Research.

In these markets, said Marks, “Apartment owners continue to have pricing power and will generate above-average rental rate growth relative to the US average.” He added that places like Miami and San Diego, which made the list of top markets, will suffer in the near term due to a significant supply of units, but should improve over a longer time frame.

Regarding REIT credit profiles, Fitch has a stable outlook for multifamily and stable ratings on all rated companies within the sector. According to Marks, “that rating is based on demonstrated above-average portfolio performance combined with the fact that on average, rated multifamily REITs own assets in more defensible destination markets with above-average product quality.” Further, rated entities within the sector have acceptable, though slightly increasing, leverage and solid coverage metrics that are appropriate for their respective rating categories.

Discussing multifamily housing in commercial mortgage-backed securities was Adam Fox, senior director for CMBS for Fitch. He noted that historically, loans backed by apartments has comprised about 18.6% of the debt in the universe of all CMBS transactions the firm rates, totaling some $550 billion. In recent years, that figure has declined, to 13.2% in 2006 and 17% in 2007. Today, apartments account for $99.2 billion of all loans Fitch monitors.

Multifamily has typically received “favorable treatment” in Fitch’s CMBS model, said Fox, because it’s a less volatile property type with a low historical probability of default than other property types and lower-than-average loss severity. However, that’s not necessarily the case today. As of April 2008, multifamily loans represented 63.8% of all CMBS loan delinquencies of 60 days or more–though the overall CMBS delinquency rate is low at 0.35%. The reasons behind the higher delinquencies in multifamily, said Fox, are that demand has gone down due to lower interest rates; overbuilding, especially in Texas, which accounts for 43.2% of all delinquencies; recent defaults by one borrower principal who accounts for 23.7% of all current multifamily delinquencies; and some spillover from markets that were hit hard by the economic downturn. Indeed, just five states–Texas, Florida, Tennessee, Michigan and Ohio–accounted for 70% of al delinquencies, reported Fitch.

Looking ahead, Fox pointed out that while multifamily has some factors bolstering its prospects, the sector is also facing some headwinds. Vacancy was 6.1% as of the first quarter, but rent growth is expected to slow from 5.2% over the past two years to 1.6% by the fourth quarter of this year. And while demand is slated to go up, due to former homeowners and those who decide to remain in the rental pool due to the weakened market, supply should rise as well. Some 120,000 new units are anticipated to hit the market in 2008. That figure is the same as last year, but represents a 900% increase over the 12,600 units that were delivered in 2006. Shadow supply from failed condo projects and single-family assets offered for sale will apply further pressure.

It is this growth of supply, combined with the rise in commodities prices and unemployment, said Fox, that will probably slow rent growth and cause occupancies to dip slightly. The analyst said to expect values to decline and cap rates to rise along with interest rates rise.

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