Realistic Pro-forma Hurdle Rates. When historical new development hurdle rates (150 to 200 basis points over sales cap rates) start making new multifamily development pro-forma’s pencil out, a surge in new projects is expected. In today’s environment with sub 5 percent cap rates in many markets and significant levels of uncertainty, listening to the September 2010 NMHC Apartment Strategies Update raised the question, are those hurdles appropriate? The approval process, construction, lease up, and sale of a new property can take years and are the expectations for the future multifamily market, the associated risks, and the interest rates (a few years from now) going to be better, the same, or worse than past history?Supply and Demand Look Good. Demographics, declining home ownership rates, decoupling, and a dearth of new construction starts are obviously in the multifamily industry’s favor from a simple supply and demand viewpoint. Multifamily vacancy rates have been declining throughout 2010 with RECORD BREAKING net absorptions, concessions burning off and rent increases starting in many markets. These fundamental indicators depict the best conditions in decades are within reach, but is the pace sustainable?
Unemployment’s heavy weight. Consistent GDP growth in excess of 3.3% is necessary to just keep unemployment from growing due to population growth. GDP growth in excess of 3.3% does not look realistic in the near term, so real unemployment will continue to rise. Government spending will not help. The key term is “growth” and unless the amount of money spent grows every quarter, GDP growth does not go up. So, stimulus money is not going to improve the situation (even with the “other half” of the stimulus that has yet to enter the economy). Unemployment data, (as manipulated as it is to hide the true extent of unemployment), is not going to make many people FEEL like progress is being made for some time – even after progress is made. The Fed's stated intentional pursuit of higher inflation to generate job growth is a risky plan which some experts give marginal chances of succeeding (Greg Weldon places the odds at 2:1 against success). Two key questions are how does continued high unemployment (and other factors) effect the notion of job security for those with jobs, and what are the resulting long term implications for consumer spending (the true driver of the economy)? Multifamily cycles are normally closely correlated to employment, but so far in 2010 the unemployment data and industry performance have diverged. The growing population still needs housing.
Negative Consumer Psyche. There are the obvious weights on American consumers that continue to get news coverage. Debt deleveraging and foreclosures get the most press. The anchoring of homeowners in place by not being able or willing to sell their homes is another drag. The situation with home foreclosures got even murkier at the end of September with foreclosures slowing to a crawl from revelations of “robo-signing” foreclosure documents by GMAC (Freddie Mac’s processor), B of A and JP Morgan. Many others are privately scrambling to clean up their processes. The long drawn out process will get worse as class action lawsuits are filed and state attorney generals file their politically motivated lawsuits. Extend and pretend, strategic defaults, and lawsuits can’t last forever, but bad real estate loans and foreclosures are going to continue to be in the news and a drag on lenders books and the American psyche for a long time to come. Strategic defaulters will continue to live rent free, potentially bad news for multifamily.
Politics is Adding to the Problem. The current political environment and election cycle is the source of much uncertainty and divisiveness. In broad terms, pride and confidence (or lack thereof) in the American system is reflected in congressional approval ratings. In terms of regional markets, how cyclical is multifamily going to be in the future as a result? The metropolitan Washington DC area for instance has enjoyed a recent boom, which many are rushing to take advantage of. If the movement to reduce the size of government gains traction, what multifamily market effects will be felt in Washington and other metro areas around the country that are highly dependent on government? How drastic are the swings going to be? What impact will it have on subsidized housing in general? High barrier to entry markets are less susceptible to huge swings over time, but even they are vulnerable in the current market. Set the scare tactics aside - turning back spending is tough, but will the 2010 mid-terms bring more or less uncertainty?
Energy Policy Uncertainty - More Weight The end of September also marked continued PROCLAIMED uncertainty with regard to energy policy. Interior Secretary Salazar actually released the following statement, “over the coming years you can expect a dynamic regulatory environment as we continue to raise the bar for offshore oil and gas development.” In an industry requiring billions of dollars in investment, introducing that uncertainty is mind boggling. Without clarity of what the regulations are and without drilling leases that can be relied on, expect dependence on foreign oil (and energy prices) to rise significantly. On October 1st, the EPA announced it is developing proposed higher fuel standards for cars, but with scant details. They added more uncertainty with estimates of the standards ranging from 35 MPG to 62 MPG by 2025. Is it coincidence that the drilling and fuel standards announcements were within a week of each other? Although cap and tax looks politically unviable, gasoline prices in the range of $4 to $5 per gallon by 2012 (as John Hofmeister predicted this past week) may not be far off. While, there would be clear winners in the multifamily industry with high gasoline prices, the impact on the overall economy and industry would definitely be negative.
Access to Capital Low interest rates and the GSE’s (Fannie and Freddie) have played pivotal roles in multifamily lending (and value), but can developers rely on these factors in their pro-forma’s in years to come? Is uncertain availability of funds the new normal rather than a brief aberration of the financial crisis? Talk continues about unraveling the GSE’s, but that would involve owning up to the true value of all bad loans – a doubtful scenario. Still, there is a lot of questionable multifamily debt that requires refinancing in the coming few years and a slow market rebound will bring troubled times for some.
Let’s Blame Someone American’s love villains, and Congress took time in September to play to that sentiment by pointing a finger at China. Recent commentary regarding the valuation of the Yuan and the notion that manufacturing would somehow come back to the United States (rather than migrate to other developing countries) if the Yuan was “fairly valued” are perplexing. That door shut long ago when Americans’ determined, for good or bad, the benefits of low cost goods trump the benefits of “buying American”. Don’t look for the cost of Chinese products (there are more of them than you think in new construction) to suddenly jump, although expect a gradual appreciation of a few more points. Keep an eye on the Fed's related attempt to make inflation kick in though.
Tax Rates and the Deficit– Do They Matter? Congress left for recess without deciding what the tax rates would be for next year. By the way, the government fiscal year ends in October. Increasing percentages of tax revenue are used to pay interest on the debt. The problem is getting worse now that the Social Security system needs the Federal Government to start paying back all the money it borrowed from the “Trust Fund” (different than just paying interest). Perception is reality, and tax rates matter for their impact on the American Psyche as well as their direct economic impact. As to the impact of government spending, go back to the discussion of GDP growth and think about the word growth. Government spending simply cannot grow every quarter.
A Final Word The 2010 multifamily vacancy and absorption trends are welcome news for the industry. Real Estate has always been about location first and the conditions, perceptions, and psyche are different for each sub-market. Continued cautious optimism appears to be today’s wisest path. Timing will be key. After laying dormant for most of 2009, in select markets we are starting to see a surge in new construction of A product that is expected to gain steam as more pro-forma hurdles are met. Conversely, many renovations continue to be on hold, so when will we see a significant rise in rehabs? As the concessions burn off and rents tick up in the A product, at what point will adequate returns for specific improvements be possible at existing, older stabilized communities? In the “new normal”, are rehabs more or less risky than new construction and what are appropriate rates of return? These are questions we will explore in a future post.
