Multifamily Mortgage Market Stable; Fannie, GSE's Share Growing

Delinquencies Remain Low in the Multifamily Sector; Level of Outstanding Debt Grew in the First Quarter

At least one corner of the mortgage market remains healthy: multifamily mortgages, which is good news for those mortgage REITs diversified among the four commerical real estate "food" groups. It is also a huge market, and one that is vitally important to our economy for a number of reasons, so good numbers are just that, good.

Most importantly, The Mortgage Bankers Association says that delinquency rates on commercial/multifamily mortgages remain low - up slightly from the fourth quarter of 2007 but still finishing the first quarter of 2008 near record lows.

These numbers come from figures reported by five of the largest investor-groups: commercial banks and thrifts, commercial mortgage-backed securities (CMBS), life insurance companies, Fannie Mae and Freddie Mac. Together these groups hold more than 80 percent of commercial/multifamily mortgage debt outstanding.

"In contrast to mortgages for single-family residential properties, commercial/multifamily mortgages continue to perform very well," said Jamie Woodwell, MBA's Senior Director of Commercial/Multifamily Research. "Most investor groups saw delinquency rates rise slightly in the first quarter, but they remain at the low end of their historical range."

The 30+ day delinquency rate on loans held in CMBS transactions rose less than one tenth of one percent (to 0.48 percent), while the 60+ day delinquency rate on loans held in life company portfolios remained flat at an incredibly low 0.01 percent. The delinquency rate on multifamily loans held or insured by Fannie Mae and Freddie remain under 1%, while the 90+day delinquency rate on loans held by FDIC-insured banks and thrifts rose 0.21 percentage points to 1.01 percent.

The delinquency figures also illustrate the success of the low leverage model employed by the life insurance companies - they typically underwrite loans with using lower LTV ratios and much better debt coverage. That was a difficult business model in the credit bubble, and their portfolios barely grew, but they stuck to their knitting and widows and orphans cashing those annuity checks can continue to sleep at night: of the 35,192 commercial/multifamily loans in life company portfolios, only 10 loans were 60+ days delinquent at the end of the quarter. These 10 loans had an aggregate unpaid principal balance of just $29 million, a virtual rain drop in the Pacific Ocean in comparison to the over $300 billion in multi-family loans held by insurance companies.

Based on the unpaid principal balance of loans, delinquency rates for each group at the end of the fourth quarter were as follows:

• CMBS: 0.48 percent (30+ days delinquent or in REO);
• Life company portfolios: 0.01 percent (60+days delinquent);
• Fannie Mae: 0.09 percent (60 or more days delinquent)
• Freddie Mac: 0.04 percent (60 or more days delinquent);
• Banks and thrifts: 1.01 percent (90+ days delinquent or in non-accrual).

Meanwhile, despite the contraction in the overall CMBS market, and almost every other credit market including, astonishingly enough, even the municipal bond market, the total level of commercial/multifamily mortgage debt outstanding managed to grow by 1.8 percent in the first quarter, to $3.4 trillion, according to Federal Reserve Board Flow of Funds data.

The $3.4 trillion in commercial/multifamily mortgage debt outstanding recorded by the Federal Reserve was an increase of $60.8 billion from the fourth quarter 2007. Multifamily mortgage debt outstanding grew to $856 billion, an increase of $18.5 billion or 2.2 percent from the fourth quarter.

"Investors continue to increase their holdings of commercial/multifamily mortgages," said the MBA's Woodwell. "The global credit crunch meant a net decline in the balance of mortgages held in CMBS, CDO and other ABS, but banks, thrifts, life insurance companies, Fannie Mae, Freddie Mac and nearly every other investor group increased their holdings of commercial and multifamily mortgages during the quarter."

The Federal Reserve's Flow of Funds data indicate that commercial banks continue to hold the largest share of commercial/multifamily mortgages, $1.43 trillion, or 42 percent of the "total", but many of these loans are actually corporate loans in which a piece of commercial property has been pledged as collateral. However, because the other loans reported are generally income property loans, meaning that the debt service comes only from rent payments, the commercial bank numbers are not strictly comparable.

Thus, the CMBS, CDO and other ABS issues are the largest holders of "pure" income producing commercial/multifamily mortgages, with $777 billion outstanding, according the the Fed (everybody reports this number differently, but it is a huge market no matter how it's measured). Life insurance companies hold $309 billion, and savings institutions hold $226 billion.

Government Sponsored Enterprises (GSEs) and GSE-backed mortgage pools, including Fannie Mae, Freddie Mac and Ginnie Mae, hold the largest share of multifamily mortgages, with $143 billion in securitized multifamily loans and an additional $158 billion "whole" loans in their own portfolios, or 35% of the total. (N.B., for you number fact freaks - I am one - many life insurance companies, banks and the GSEs also purchase and hold a large number of CMBS, CDO and other ABS issues. These loans are covered in the CMBS, CDO and other ABS category.)

MULTIFAMILY MORTGAGE DEBT OUTSTANDING

In this "new" credit environment, The GSEs (Fannie Mae, Freddie Mac, etc.,) and Ginnie Mae are now an even bigger factor in supporting our nation's housing stock. Not only do they hold the largest share of multi-family debt outstanding, but Fannie Mae is now almost the only game in town when it comes to financing multi-family property. Fannie Mae is there, and I can tell you they are writing checks.

This has been incredibly important in relieving at least some pressure on the demand for new commercial real estate credit, and probably for reducing overall default rates in CMBS pools, which still remain at historic lows. As I wrote in another post, High Yield Mortgage REITs, the Perfect Storm?, the low levels of CMBS debt scheduled to mature in 2008/2009 is also a big factor. Combined, these two supply inputs undoubtedly contributed to that fact that, according to Fitch Ratings, 99% of all maturing CMBS loans since August 2007 have been successfully refinanced.

Consequently, GSE's share of multi-family debt will only increase in the coming quarters, since credit officers at commercial banks, which hold $173 billion, or 20 percent of total outstanding multi-family debt, are spending more time calculating portfolio write downs than assessing new risk. And of course, the CMBS, CDO and ABS markets, which had been approaching $250 billion a year in new origination volume, now look unlikey to match even half that in 2008.

Indeed, of $18 billion increase in multifamily mortgage debt outstanding between the fourth quarter 2007 and first quarter 2008, Government Sponsored Enterprises underwrote $10 billion, or 54 percent of the total increase. Agency and GSE-backed mortgage pools increased their holdings by $3.4 billion and commercial banks increased their holdings by $4 billion. Nobody would be surprised to learn that the CMBS, CDO and ABS categories saw the biggest drop in their holdings of multifamily mortgage debt: a decrease of $9 billion.

In spite of the implosion in the CMBS,CDO and ABS markets, these figures show that at least one segment of the commercial real estate mortgage market is holding up well, possibly even thriving, and they are demonstrative of one of the underlying, basic truths of commercial real estate: Assets that produce reliably monthly income will survive, and so will the mortgages that support them.

Disclosure: None

Conservative Investors: Apartment REITs Offer Safety Amid Market Turmoil

Despite the industry wide turmoil in REITs and real estate, the Multifamily Executive News Service reports that Apartment REITs seem to be faring well, according to a recent study from Standard & Poor's Ratings Services.

Things might not look as good as 2006 and 2007, but they still aren't bad, according to George Skoufis, S&P's primary apartment REIT analyst. "In 2008, we expect continued moderation but positive rent growth," he says. "From a fundamentals standpoint, we've seen moderation in rent growth and NOI growth."

Green Street Advisors, based in Newport Beach, Calif., also studies the REIT market and sees positive growth potential. The firm projected that revenue growth would hit 3.8 percent coming into the year, but those projections have since fallen back to the 3.5 percent mark.

"Apartment REITs overall this year should still achieve positive revenue growth, even in the face of a mild recession," says Haendel St. Juste, an analyst with Green Street. "Despite a slowing economy and an increased supply of single-family and condo "shadow rentals" in certain markets, the supply/demand picture is still in pretty good balance."

Skoufis sees the for-sale market troubles as one of the biggest boosts to the supply/demand equation. "Homeownership is coming down," he says. "That will benefit the multifamily sector."

Even with a slight recession, St. Juste thinks multifamily will hold up. "Demand will still be driven from household formation, a declining homeownership rate, and Echo Boomer demand," he says. "Even in periods of very weak job growth, new household formations tend to bottom out at around 500,000 per year, a result of an ever-growing population."

All of these factors help the REITs, of course. S&P sees AvalonBay (BBB+/Positive), Equity Residential (A-/Stable), and Camden (BBB+/Stable) as setting the pace for the multifamily sector, though it recently downgraded both AvalonBay (for its large development pipeline) and Equity (for not having debt protection).

Although BRE Properties (BBB/Stable), Essex Property Trust (BBB/Stable), Post Properties (BBB/Credit Watch) and UDR (BBB/Stable) were at the bottom of the REITs list, Skoufis says they're still fairing well compared to other sectors.

"They're solidly investment grade," Skoufis adds.

Amplifying this point, the National Association of Real Estate Investment Trusts (NAREIT) reported that Residential REITS were the second best performing REIT sector in the first quarter of 2008.

Apartment REITS, which comprise most of the Residential REITS (the balance is composed of manufactured housing REITs), were up 12.29 percent year-to-date. Residential REIT returns increased 11.20 percent in the first quarter. These are impressive figures compared with the Dow Jones Industrials which was down 7.55 percent to start the year.

Apartment REITs' total returns compare favorably with the those of the U.S. REIT market, which was nearly flat for the first quarter of 2008. (The FTSE NAREIT All REIT Index was down 0.42 percent, while the FTSE NAREIT Equity REIT Index was up 1.40 percent.)
By contrast, other market benchmarks dove into negative territory to start the year.

Other than the Dow Jones Industrials, the S&P 500 was down by 9.44 percent, the Russell 2000 dropped by 9.90 percent and the NASDAQ Composite was lower by 14.07 percent.
REIT performance accelerated in March, as the FTSE NAREIT All REIT Index was up 3.88 percent in the month.

“The sub prime mortgage crises did not have a direct negative impact on apartments but did in fact have an indirect positive impact,” says Brad Case, VP of research and industry information at NAREIT. “All those people who could not afford to buy homes had to start renting apartments.”

This, Case believes is the reason Apartment REITS are a safe way to play the real estate meltdown.

“Fundamentals in the REIT industry are pretty strong and there is no real sign that they are likely to weaken anytime soon,” Case concludes.

For more, see "Even Ben Stein Likes REITs".

Play Subprime Safely With These Residential REITs

Back in 2005, executives at Camden Property Trust (CPT), a REIT specializing in large apartment complexes, were worried. Why had they been unable to maintain their average occupancies at historical levels? They fanned out across the country to talk with CPT property managers, who complained of having to turn down the credit of applicants for $700 a month apartments when home lenders across the street were providing the same questionable applicants with mortgages worth $350,000.

The CPT executives were suspicious about the mortgage credit checks, but they were unable to confirm their hunch. Numerous observers had been monitoring the record growth in the U.S. homeownership rate, including the Boston Globe which published a 2005 article entitled The Dark Side of Subprime Loans. The article was suspicious about “so-called subprime loans” but until the cracks in that market began to appear last spring, there was no way to know for sure what was happening.

What everyone could see, however, was that the U.S. rate of homeownership had reached historically high levels. It was at about that time that both outgoing Fed Chairman Alan Greenspan and incoming Fed Chairman Ben Bernanke both played down the possibility of a so-called “housing bubble”. As it turned out, there was a bubble, encouraged not only by subprime mortages, but also by numerous government policies that encouraged homeownership.

Not surprisingly, the same census data that showed increasing rates of homeownership also showed increasing levels of vacancies in the nation’s rental unit housing stock. Although still higher than average, the national vacancy rate was far outpaced by above average vacancy rates in the Midwest, where homeownership is more much more affordable and economic dislocations have put pressure on the region generally.

While policy makers across the U.S. crowed about delivering the American Dream to ever greater percentages of Americans, the problem for CPT was more immediate: how do we keep our apartments full so we can grow our earnings? CPT, like many apartment owners, had no choice but to reduce their average rents, offer incentives to renew leases, ask for smaller deposits to protect against property damages, and reduce investments in capital improvements. Cumulatively however, these solutions were not much more than a band-aid in the face of a national stampede to homeownership.

Subprime was not the only reason for the increased levels of homeownership. Well-meaning government sponsored loan programs allowed first time home buyers to purchase homes with little or no equity, and tax laws allowed the deduction of home mortgage interest while providing generous shelters for capital gains. At the same time that the subprime market was starting to unravel however, influential law makers were also rethinking the government’s largesse.

In a New York Times article entitled “Mortgage Trouble Clouds Homeownership Dream”, Representative Barney Frank (D) Massachusetts said that United States policies in recent years had promoted the idea of homeownership too hard and at the expense of rental housing. “I wish people could own more homes,” he said in the interview. “But I also wish I could eat and not gain weight.”

Many academicians agreed. In the same article, Joseph E. Gyourko, Professor of Real Estate and Finance at University of Pennsylvania’s Wharton School of Business asserted that "we went too far. It’s not the case that high homeownership is always good.”

These increasing homeownership trends are clearly reversing, and now may be the best time in years to own Apartment REITs. Not only are secular, long-term demographics supporting improved operating fundamentals, but the havoc in the financial markets has discounted all REIT stocks.

REIT stock prices have typically been a good harbinger of property values. When they trade at or below the value of the underlying real estate, as most are now, they have traditionally predicted weakening property values. However, these times are anything but traditional, and commercial property values now are not directly connected to the wider real estate contagion because they produce reliable monthly income.

These income streams determine how commercial property is priced, and the income for apartment buildings looks strong for several reasons. First, commercial development of new-builds in this cycle has been muted by high construction costs. This limited new supply, combined with strong growth in demand from immigration and the “echo-boomers”, should provide a floor under apartment rents. Add in the thousands of households now returning to the rental pool, and apartment fundamentals have never looked more solid.

In addition to these strong operating fundamentals, the Fed has responded to the liquidity crisis by directly intervening in the government agency securities market. I wrote about this unconventional and rarely used Fed operation in a previous article, which was undertaken in an effort to reduce long term borrowing rates. This Fed action, along with its steep reductions in the discount rate, will also help support commercial property prices.

So far, values have held up. The Mortgage Bankers Association reports that in 2007, defaults in Fannie Mae loans for apartment buildings remained flat at .08%, while 2007 defaults among apartment loans sponsored by Freddie Mac declined to .02%. In fact, despite all the bad news in residential real estate, defaults in the broader commercial property sector remain at historical lows. According to the Wall Street Journal, the delinquency rate on the almost $840 billion in outstanding commercial mortgage backed securities is less than .5%. Lenders, particularly Fannie Mae and Freddie Mac, also remain active in the apartment sector, unlike other commercial property markets where liquidity has dried up.

In this market, REITs aren’t for the faint of heart, but I believe the market has it wrong. In addition to CPT, well run, diversified apartment REITs worth considering are Avalon Bay Properties (AVB), which has a large development pipeline in high barrier markets and low leverage, and Essex Property Trust (ESS), which also operates in high barrier markets and just announced an almost 10% increase in its dividend. Avoid AIMCO (AIV) which operates in low barrier markets like the Midwest and has relatively higher leverage, and REITs like Post Properties (PSS) which had been relying on condo conversions to drive operating results.

Caveats? A deep recession will impact rents no matter how strong the fundamentals. The “shadow” rental market of foreclosed homes will also put some pressure on apartments, but rental homes do not compete directly with apartments. Most renters are not interested in mowing lawns and shoveling snow, and apartment living excuses them from these kinds of responsibilities.

Also, REITS enjoy favorable taxation treatment at the corporate level, so most do not allow for the 15% tax treatment on dividend income. Accordingly, if you decide to do any buying, it should be done in your 401k or IRA. Consider REITs for capital gains though, and think of the dividends simply as the icing on your subprime cake. Click here for a complete Apartment REIT list

Disclosure: None