A Changing Market Requires Changing Strategies

The world in terms of acquiring multifamily properties has changed a great deal since last fall. Debt and equity providers have made major adjustments in their expectations and underwriting criteria. But multifamily borrowers are fortunate that Fannie Mae and Freddie Mac, who have picked up the slack in the market that conduits and life insurance companies previously occupied, are still financing deals. But even these active agencies have changed the way they look at deals, which is why multifamily borrowers must change their strategies to secure financing in today’s market.

Shifting Debt and Equity Markets

Debt coverage, which used to underwritten at 1.15, now is underwritten at 1.20 or 1.25. Rates have also increased -- while treasury rates have decreased, spreads have increased about 400 basis points, resulting in higher interest rates. Another change is that the government-sponsored entities used to underwrite to pro forma rents and expense levels. In today’s market, they are using historical data, focusing heavily on the last 90 days of operations. Together these changes have resulted in significantly lower loan proceeds -- and more equity.

Equity providers also are looking at deals differently today. Some institutional equity providers have stepped out of the market altogether, believing that values will continue to fall. Those that are active primarily are looking for distressed opportunities. Their return expectations have gone up 300 to 500 bps. Mid-2008 leveraged internal rate of return expectations for a value-added multifamily acquisition with a light to moderate rehab would have been in the 16 percent to 19 percent range. Now the return on that type of a deal has increased to 20 percent to 25 percent. Equity providers also are being more conservative in their underwriting, using higher exit caps, larger reserves, and lower growth rate assumptions.

New Tactics for Borrowers

The net result of these shifts in the multifamily financing arena is pushing up capitalization  rates and dragging down values, creating a bid-ask gap between buyers and sellers. Sellers are looking at what their properties were worth six months ago and buyers and lenders are looking at what they will be worth six months from now. Understanding today’s debt and equity expectations can help buyers approach potential acquisitions with a much better idea of a realistic capital structure.

In today’s market, it’s wise to structure deals with loan-to-value ratios in the 60 percent to 65 percent range and with more equity up front. Since the leverage is lower and equity return expectations are now higher, there is increased downward pressure on pricing. In the case of deals that have been in progress for the last several months, underwriting and the offer price are moving targets.

For example, borrowers might obtain a debt and equity structure that is acceptable to providers at a certain price, but in the time it takes to reach agreement on price with the seller, the capital markets change again resulting in yet another renegotiation. By making offers at more realistic prices up front (instead of making higher offers and working through negotiations) borrowers can keep up with debt and equity providers’ changing expectations.

As we continue through 2009, it is likely there will be excellent acquisition opportunities created by the turmoil in today’s shifting market. Having a better understanding of the requirements of debt and equity providers will help buyers make better offers and close deals faster.

Herb Tousley, CCIM

Herb Tousley, CCIM, is senior vice president of acquisitions for Griffin Properties in Minneapolis. Contact him at (612) 904-7808 or htousley@cbcgriffin.com.