Multifamily Bubble on the Horizon?

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It's easy to see why multifamily construction is booming: vacancy rates are falling and rents are on the rise, making investments in rental property particularly attractive.

According to the Harvard Joint Center for Housing Studies' "The State of the Nation's Housing 2012" report, multifamily starts surged 54% from 2010 to 11. And in the first quarter of 2012, they were up 36.1%.

Despite the optimism, several risk factors are pointing to a potential multifamily housing bubble. Developers and their lenders should proceed with caution.

Why worry?

There is one major reason to be cautious: low interest rates. It is very easy to let the giddiness of low-cost debt obscure the weak economic conditions that are preventing interest rates from moving to more normalized levels. It is hard to ignore the fact that low interest rates make it possible to not only develop new projects with very little equity support, but also to trade projects at premium prices, sometimes well in excess of replacement cost.

Go to any major city and take note of the record high number of multifamily construction projects that are underway. No doubt, there is pent-up demand for multifamily rentals, but this is where some further scrutiny is warranted.  During the height of the housing boom homeownership rates were driven to peak levels by easy credit terms and low interest rates. Once the housing bubble burst, home prices collapsed and credit terms tightened, making it difficult for the average homebuyer to access mortgage credit.  This shifted the bias for many former and would-be homeowners to favoring a rental option. The very same low interest rates and easy credit terms that ran up the "for sale" housing business are now busily at work running up the multifamily rental business. 

Nonsense, say the demographers! The population cohort driving household formation, thus creating an unprecedented demand for additional rental housing, is going to continue to grow well into 2016 and beyond, creating supply challenges that will prevent a bubble from developing, they say. 

Not so fast. Yes, rents have rebounded from their lows in 2006 to 2008, but can they continue on the same trajectory? One need only look at personal income growth and it becomes clear that we are headed for a rent ceiling that is very close to where we are for most new multifamily development projects.

After factoring in utilities and parking, the rent burden can reach or exceed 35% of a renter's gross income. Since the cost of new development continues to increase, most new multifamily projects exhibit pro forma unlevered returns of 5% to 7% using stabilized net operating income. Assuming that a developer wants to earn a premium for taking the development risk, the stabilized NOI needs to be valued at a rate that provides a spread of 100 to 150 basis points above the unlevered development return. Well, with interest rates of 3% to 4% for debt capital readily available, buyers of multifamily rental projects are happy to acquire properties at capitalization rates (yields) of 5% to 6%.  So life is good for developers and owners.

However, what happens if interest rates rise by 200 to 300 basis points or more?  What if personal incomes remain flat as they have for years? 

What are stakeholders to do?

Once an un-virtuous downward cycle begins, it is very difficult to reverse. Lenders that attempt to recover their principal in loan default situations may sustain losses, and borrowers who attempt to refinance their loans may find their new loan proceeds are inadequate to do so. And borrowers who attempt to raise occupancy will also have to cut rents. Thus, we have the making of a cycle of deflation that will likely catch many lenders by surprise.

Of course, the areas that are the hardest hit will be those with the least population growth and the weakest regional economies. So, to avoid the pitfalls of a potential bubble, lenders should be vigilant about sensitizing debt service coverage ratios to withstand reduced rents, higher interest and/or vacancy rates, and adjust their underwriting to provide a reasonable equity margin at loan maturity in order to minimize refinance risk.

Recognizing that it is not possible to eliminate all risk associated with the movement of key variables in the loan underwriting equation, it is important that all lenders and developers at least approach them with open eyes. 

Chris Terlizzi is a senior vice president and regional manager of commercial real estate finance at First Niagara Bank covering the Northeast Corridor from Boston to Washington.  

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