Think There’s Safety In Apartments?

Take A Closer Look At The Metro Areas Nationwide multifamily measurements are strong, but a closer examination of metro areas reveals pitfalls.

BY DAVID BURT AND SUSAN HUDSON-WILSON

In an increasingly uncertain market environment, with large tech and manufacturing layoff announcements every day and the equities market veering into bear territory, investors are looking to markets that can weather tough times.

Attractive investments are those that have exhibited low historical volatility and have proven their ability to stand up to less than favorable market conditions. When examined in this light, the apartment sector really shines. So, “Go apartment”... or is there more to the story?

Exhibits one and two illustrate the apartment market’s relative merits in terms of historical risk and stability during a recession. During 1982 to 2000, the apartment sector’s total returns were the least volatile of the four sectors.

While current market fundamentals are far removed from the conditions that wreaked havoc on the real estate market in the early 1990s, it is still worth noting the relative strengths of a property type in the face of adversity by examining performance during that troubled period.

In Exhibit Two, we see that the apartment market was the least affected of the four property types in value growth and second-least affected behind retail in net operating income (NOI) growth in a very stressed economic environment.

Strong performance
Currently, the apartment market is at its tightest since the early 1980s, with an estimated average vacancy for 54 metros of 5% for the fourth quarter of 2000. At the national level, the amount of new apartment product has not quite kept up with recent absorption levels and continues to come on line at a reasonable pace.

Demographic trends support a forecast for continued strong demand and solid performance in coming years. As capital continues to move out of riskier property types and into apartments, cap rates have been pushed lower.

In summary, good news abounds for investors in apartment assets! However, to address the specific concerns of the commercial lender and to account for the influence of non-homogeneous real estate market fundamentals across the metros (important!), we must delve deeper.

Debt investors are exposed only to the downside risk of an investment, with little or no benefit from the upside. At best, the lender receives only the coupon payment on the loan and the final repayment of the outstanding principal balance.

Because a loan can run into trouble in the presence of a shortfall in income or a sharp decline in the value of the underlying asset, it is important to look at the components of total return when assessing overall risk. Conventional wisdom would assert, therefore, that in looking to minimize downside risk, lenders should exclusively prefer markets with lower income and value volatility.

Volatility alone, however, does not go far enough in the assessment of total downside risk - it ignores current conditions and expected performance. We need a way of measuring all of the market and loan-specific variables that contribute to the relative safety of each loan underwritten.

The loan structure
The most immediate comparison to be made between two loans’ prospects is the specific mortgage structure that will be applied to each loan.

While most lenders will note the initial LTV and DCR ratios in an attempt to quantify a loan’s “cushion” of safety, it is more interesting to observe how these ratios will behave over time.

Given the payment and principal balance schedules and assumptions on value and NOI growth (taking into account market fundamentals and economic conditions), a time series of these ratios can be developed. These dynamic loan ratios offer a measure of just how thin the original protective cushion might become. The question now becomes how “comfortable” are we with that cushion?

A DSCR of 1.2 in one market does not describe a risk identical to that of a 1.2 coverage loan in another market. An assessment of market risk is necessary to complete the picture.

Our comfort level is determined by volatility - it is the market-specific volatility of NOIs and/or values that describes the likelihood that a given level of deleterious movement in NOI and/or value will occur. The larger the required movement relative to its standard deviation, the lower the likelihood of reaching a default situation.

So, our risk measure at each point in time is measured as the DSCR, and/or LTV, cushion (the numerator), divided by the market-specific volatility of the NOI or value (the denominator). We have coined this measure the “Z-distance to default.”

Using the Z-distance
If we combine the component measures by weighting the Z-distance derived for value with the NOI Z-distance, the result is a single measure that incorporates the three key factors affecting risk:

• market volatility,
• expected growth, and
• the loan structure.

With this tool in hand, we can compare the ultimate downside risk of any two mortgages by finding the lowest Z-distance that occurs during the life of each loan. Now we can take a closer look at the apartment market - directly from the viewpoint of a commercial lender!

We start by originating an 85% LTV, 1.2 DSCR loan in 216 markets (four major property types in 54 metros). Exhibit Three shows the distribution of the Z-distances. The apartment market occurrences are shown separately.

At this point you may be asking yourself, “Why are there so many apartment markets in risky territory? What happened to low volatility and sound fundamentals?”

When we first looked at overall apartment sector volatility, we failed to look at the volatilities of the components of return. While the apartment market has historically shown the least volatility in total return, this is not the case for the components when they are examined separately.

In fact, primarily because of the high turnover generated by short lease terms, NOI volatility at the national level is higher for the apartment market than it is for retail or warehouse, and comes in at a close second to office.

High NOI volatility means uncertain payment streams: a definite concern for lenders. High NOI volatility, however, tells only part of the story. The real reason why so many apartment markets lie in the “risky zone” is that property types look very different at the metro level than at the national level.

The most important lesson to take away from this discussion is that not all markets are created equal! Although apartments shine at the national level, at the metro level, we see apartment markets scattered widely across the risk spectrum.

Different areas, different characteristics
Different metros exhibit vastly different demand characteristics, supply constraints, rent growth patterns and capital market valuations - and, therefore, volatility - even within a property type. So, the answer to the question “What is safe?” depends heavily on the city in question. Institutional lenders must ask both what and where!

To further illustrate the range of risk profiles that exists across apartment markets, let’s consider a couple of extreme examples. The “worst” (lowest Z-distance) apartment market identified in our research is Charlotte, N.C.

The “best” (highest Z-distance) is Miami. Exhibit Four illustrates the flow-through time of the Z-distance scores for these two markets compared with the national market scores over time. The intuitive reasoning behind these results gives us a feel for the vastly different risk profiles a property type can assume across metros.

The first observation is that even at the outset, the Miami score is far more attractive than are either the United States’ or Charlotte’s scores.

Since the loan structures applied to each example are identical, and growth is not a factor at each loans’ starting point, we know that the great gap between Miami and both Charlotte and the U.S. is due to great differences in volatility across these markets.

Why the metros differ
The intuition here lies in Miami’s inherent economic diversity and the ongoing influx of foreign immigrants into the metro. These factors, combined with a history of relatively tame supply growth, reduce the historical volatility of total returns in Miami to about 30% of the U.S. average.

Assuming a Latin American recovery, subdued construction levels and above-average employment growth, values and income streams are expected to increase through the forecast, driving Miami’s Z-distance measure steadily higher.

Although Charlotte’s historical volatility is in line with the national average, shaky fundamentals and a lack of economic diversity signal trouble down the road. Vacancies have been rising in Charlotte over the past five years as additions to inventory have outpaced demand.

The level of construction activity continues to accelerate, with new supply as a percent of inventory measuring 4.4% for 2000, up from 3.6% in 1999. A slowdown in construction activity is not expected, considering a full pipeline along with a slew of new entries by national developers into the market (including JPI, Post, Summit, Hanover, Fairfield and Archstone, to name a few).

Demand diversity is very low, and the importance of First Union and Bank of America on the demand side is worrisome, given the two banks’ recent troubles.

As vacancies rise and concessions abound, income streams and values are expected to steadily decline. These negative influences offset an average level of historical volatility to create a tremendous downside risk, dragging the Z-distance scores into dangerous territory in the later years of the forecast.

Two apartment markets. Vastly different risk profiles. The smart lender looks beyond the broad definitions of property type and sees each property type and metro area combination as unique, with very different stages of evolution and prosperity, each with its own idiosyncratic behaviors.

Is apartment the correct property type for your needs? An initial look at apartments’ historical performance may result in a thumbs-up, but only through a deeper analysis of specific metro fundamentals can the true pitfalls and opportunities be revealed, and a higher level of investment “comfort” attained!

Susan Hudson-Wilson, CFA, is the founder and chief executive officer of Property & Portfolio Research Inc. (PPR), an independent real estate investment research and advisory firm located in Boston. David Burt is a quantitative analysts at PPR. Contact information and further insights can be obtained at www.ppr-research.com.

This article was previously published in the June 2001 Issue of Commercial Mortgage Insight.