WE’RE HEARING that a rising tide of new construction doesn’t have lenders worrying about a bubble in apartment building values...yet.
One of the few silver linings in the Great Recession was the performance of commercial real estate loans. Yes, delinquencies and defaults rose—sometimes sharply—but the market did not fall as dramatically as many had feared. In part, this reflected a shrewd decision by lenders not to foreclose when commercial mortgage balloon payments came due. Because of falling property values, many owners technically could not have met underwriting requirements to refinance their loans.
But lenders chose to ignore the lower property values and refinance the loans anyway. These “extend and pretend” loans helped avert a potential commercial real estate foreclosure crisis.
Fast forward to 2013. CMBS delinquencies are falling across the board, and no sector seems to be doing better than multifamily housing, once the hardest hit asset class at the height of the Great Recession. According to Trepp, 11.27% of multifamily loans packaged into CMBS were at least 30 days past due in July of this year, down from 15.69% 12 months earlier.
Lodging, office and retail CMBS loans also improved year-over-year. Industrial properties saw a slight uptick in their delinquency rate.
And commercial mortgages held outside of CMBS are doing even better, according to the Mortgage Bankers Association. The MBA said loans held by life insurance companies and the GSEs also declined in the second quarter, even though those delinquency rates were much lower than the CMBS delinquency rate to begin with.
Manus Clancy, senior managing director at Trepp, a provider of CMBS research and technology, told me that multifamily mortgage loan performance has been improving for quite some time.
However, he pointed out that the multifamily loans packaged into CMBS were the worst performing asset class in the CMBS world, so there was a lot of room for improvement. He noted that multifamily loans held by commercial banks had much lower delinquency rates than CMBS apartment loans during the Great Recession. The sector was dragged down in part by a couple of gigantic apartment complex loans in New York that went bad because the buyers failed to anticipate how difficult it would be to convert rent-stabilized apartments to market-rate units. (New Yorkers will remember the $5.4 billion purchase of the Stuyvesant Town and Peter Cooper Village in 2006, which resulted in one of the largest multifamily mortgage defaults in history.)
“That just crushed the delinquency rate for those types of properties,” Clancy said.
In general, the 2006 and 2007 vintages of apartment complex loans packaged into CMBS were “highly speculative” and didn’t have the more disciplined underwriting used by commercial banks. Banks remained more focused on financing low leverage deals on stable properties, Clancy noted.
In many markets today, multifamily values and rents are getting a boost from low vacancy rates. But that has also sparked an apartment building boom in many cities. Could that building boom pave the way for a glut in the market?
Clancy said there is some concern about the volume of new apartments coming into the market, along with the effect that investors who’ve bought foreclosed homes in bulk with the intention of renting them may have on the market. But a larger concern for CMBS investors is the impact that rising interest rates will have on the cost of financing apartment deals.
The 10-year Treasury rate has risen by 120 basis points since May, he noted. The spread between that benchmark and the rate on new multifamily loans has also risen. That means buyers are seeing higher capitalization rates and could put a damper on the refinancing prospects for “marginal” multifamily properties.
“That will have an effect of putting a cap on valuation growth,” Clancy said. “I think the whole market is concerned right now about what happens to the 10-year when the Fed begins to taper.”
The slow pace of job creation also could put a damper on the apartment sector recovery, he said.
Peter Muoio, chief economist at Auction.com, agreed that overbuilding isn’t yet a concern in the multifamily sector. Vacancy rates nationally have come down from their recession peak of 8% to 4%, and vacancies are even lower in many hot urban markets. The overall vacancy rate is lower than it has been since 2000, and rents are at all-time nominal highs, Muoio said.
The decline in the homeownership rate is a key reason why apartment delinquencies are so low, he told me. Each one percentage point decline in the homeownership rate creates more than a million new renter households.
The current boom in construction activity follows a fallow period during the Great Recession, when few new units were being added to the apartment inventory.
“If you look at the national level of multifamily development, it has increased dramatically from where it was. But it was increasing from an abnormally low level. Not surprisingly, much of the development is in markets where vacancies are very, very low and rents are rising dramatically.”
Does he think overbuilding could occur? He noted that some markets increased their apartment supply by more than 1% in the first half of this year, but just as many markets added nothing. In a few hot markets, the level of development may lead to higher vacancy rates, but again that is in the context of coming off of historically low vacancies.
“I don’t think we’re at the point where we have to be concerned about that at this point.”
He predicts that the low point for apartment vacancies will occur in 2014 or 2015. By 2016, supply might start outpacing demand again, he said.
Ted Cornwell has covered the mortgage markets since 1990. He is a former editor of both Mortgage Servicing News and Mortgage Technology.