May 2016 — Multifamily Properties Quarterly —
Page 31
service is $265,640. The new ROE is
valued at 11.33 percent.
There are a few strategies investors
can use to improve their ROE.
Option 1.
Refinance the asset.With
today’s rates and ease of financing,
many owners can take out equity and
potentially re-leverage that cash into
another investment, therefore put-
ting more equity to work in another
investment.
Option 2.
Trade or 1031 exchange
the equity of the current asset into
a larger asset without paying capital
gains taxes. Owners can use the 1031
exchange law in their favor and take
that equity into a larger real estate
investment that should re-leverage
their equity and, ultimately, give
them a better return on investment
and cash flow. This strategy is sub-
jective to the next step and the new
property the investor is buying.
Option 3.
The final option is an out-
right sale. There are tax consequences
for any outright sale but, depend-
ing on the ownership structure and
situation, sometimes this is the best
choice. This option might yield the
most net worth for the property
owner.
In conclusion, both ROI and ROE
calculations are important to look at
over the course of an investment. The
results an investor wants to achieve
should have the highest impact on
which calculation to place more
weight into. Too often I see investors
overlook ROE and make the delayed
realization that re-leveraging could
have resulted in more cash flow and
a better ROI.
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and affordability. New construction
projects meeting one of many green
building programs and properties
with permanent loan requests that
can become Energy Star certified can
participate in a reduced mortgage
insurance premium obligation of
0.25 percent both initially at closing
and ongoing for the life of the loan.
This is significant in many
respects because the current MIP
rate for a market-rate project is 0.65
percent annually and 1.3 percent at
closing for new construction; and
0.6 percent annually and 1 percent
at closing for the permanent loan.
This 35- to 40-basis point reduction
MIP can make the difference of mil-
lions of dollars in loan proceeds that
are constrained by debt service. The
initial closing savings and first-year
savings, in many cases, can offset the
additional cost incurred to meet these
energy standards. Similarly, projects
meeting one of many affordability
definitions can enjoy a MIP rate of 35
bps both at closing and ongoing.
With construction rates currently
below 4 percent and the energy MIP
rate at 0.25 percent, a borrower can
put in place a 40-year mortgage with
all-in rates below 4.25 percent with
85 percent leverage. The weighted
average cost of capital is consider-
ably lower when compared with a
typical structured finance scenario
that makes use of a 70 percent loan-
to-cost senior construction loan at
3.5 percent and an additional 15 per-
cent mezzanine loan with a rate of
12 percent.
The FHA loan starts to make a lot
of sense for longer-hold borrowers
who have a predevelopment run-
way that can afford a few months
more of processing in exchange for
a nonrecourse, low-interest-rate
construction loan that permanently
removes interest rate risk from the
equation. The same can be said for
borrowers aware of upcoming loan
maturity. Current permanent loan
rates below 3.25 percent and the
energy MIP of 0.25 percent for 35
years are very compelling.
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In addition, the Ballpark area has
seen a disproportionate number
of units, which may be too highly
concentrated to sustain deliveries
at, or even near, recent levels. The
day will come when developers and
banks can’t make the deals pencil
based on reasonable rent growth
projections. It’s the natural progres-
sion of supply and demand. The
amount of the declines in rents and
occupancy in the coming quarters
is directly related to how soon these
trends are spotted and, as a result,
how far supply outstrips the supply
pipeline.
In other words – it can be a hard
landing or a soft one, but deliver-
ing 9,000-plus units annually will
not be supported by demand in the
near future. But, of course, it will be
again at some point in the future.
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to the condo buyer has significant
lender underwriting hurdles that
must be met. Most borrowers prefer
financing provided by government-
sponsored enterprise lenders such as
Department of Housing and Urban
Development, Freddie Mac and Fan-
nie Mae, because they have the most
favorable rates and down-payment
options.
The government-sponsored enter-
prises have tightened lending require-
ments for borrowers in general and
even more so on condo projects. Proj-
ects have to reach substantial presales
or have a bank willing to hold loans on
their balance sheet while preselling in
order to meet specifications before a
government-sponsored enterprise will
agree to purchase condo loans.These
financing constraints are additional
barriers to growth in the condo market.
Condo Conversion
Much of the apartment supply
being developed today will be ideal
for condo conversions tomorrow. In
every real estate cycle there is a point
at which demand for entry-level hous-
ing exceeds supply and the govern-
ment steps in to help increase liquidity.
While condo conversions would face
some of the same challenges that a
new condo development would face,
there will be a tipping point at which
the regulations loosen or the economic
opportunity outweighs the perceived
risks.
With an existing building and in-
place revenue, a bank might be more
willing to finance such a project, allow-
ing more flexibility to hit presales to
achieve benchmarks acceptable to a
GSE lender. A lender might perceive
less risk with existing building versus
new development, and liquidity might
find its way to apartment condo con-
version sooner than later.
In respect to the construction defect
litigation environment, converting
an existing apartment community to
condos has the potential to mitigate
much of the new development risk.
Apartment buildings that have been in
existence for several years would have
given the owner/developer the oppor-
tunity to correct construction defects
prior to selling individual units. Addi-
tionally, depending on when the prop-
erty was built, converting these units
into condos might be outside of the
time frame in which a homeowner or
an homeowner association can bring
forward a suit for some defects.
An existing community also elimi-
nates the development risk associated
with ground-up development. Skip the
land planning, zoning hearings, archi-
tectural review boards, and on and on.
In Colorado, converting an apart-
ment community to condos can be a
fairly straightforward task and done
reasonably quickly.This gives a condo
converter a big head start – existing
sellable units, in-place income from
existing rents and, potentially, some
captive buyers already living on site.
Converting existing apartment stock
to condos could be beneficial to apart-
ment owners. Conversions would
shrink the overall rental pool and stock
of residents that would prefer owner-
ship to renting. It would help keep the
apartment market supply and demand
in balance.
Further, in the last few cycles, buy-
ers intent on converting apartments to
condos often drove pricing higher for
investment sales and helped support
values of apartment building sellers.
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ing.
Unfortunately, the great return
recently enjoyed by apartment devel-
opers and buyers has created a sense
of complacency. Capital is abundant
and it is likely to drive more serious
overbuilding. The future still remains
in our hands. That is, if developers
stop building, the negative downturn
is likely to be modest. Unfortunately
– given the nature of developers –
this is possible, but not likely.
The larger the oversupply, the
worse the subsequent correction.
What these graphs do not take
into account is a recession. It is our
estimate that there will probably be
a recession in 2019 – give or take one
or two years. While this recession
likely will be a garden-variety reces-
sion, it will have devastating conse-
quences on apartments because it is
likely to appear precisely at the time
of peak overbuilding of apartments.
Vacancies will spike, rents will plum-
met and values will decline.
We are calling this unfortunate
confluence a “negative trifecta” for
apartments based on:
1. Multiyear overbuilding above
population demand.
2. Millennials finally converting
from renters to homeowners.
3. A future recession.
In real estate, timing is everything.
We believe that apartments currently
are enjoying an Indian Summer. But
Denver is getting close to the end
of good times for apartments as the
Real Capital Solutions’ investment
clock illustrates.
Based on our track record of call-
ing real estate cycles, some have
credited us with an “experienced
gut feeling” for where the markets
are heading. We are, in fact, guided
by defined metrics, allowing us to
predict with considerable accuracy
the coming cycle downturn. The
combination of higher vacancy and
lower rents stresses apartment cash
flows breaching construction loan
covenants. It is the appearance of
distressed sales that causes a severe
downturn in apartment values. We
are not sure that such a downturn
will occur in Denver, but we are
watching the metrics carefully.
We are continuing to build selec-
tively. We still like the transit-orient-
ed and the senior-oriented apartment
market niches. Otherwise, in Colo-
rado, we have taken the precaution
to sell our three other apartment
ROE
Lending
Decades
Condos
Trifecta
