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CMBS Risk Even Fannie And Freddie Would Not Underwrite: What Does Largest Real Estate Default In US History Mean For Investors?

September 15, 2010 - The Wall Street Transcript has just published REITs Report offering a timely review of the REIT sector. This Special Report contains expert industry commentary through in-depth interviews with public company CEOs, Equity Analysts and Money Managers. Please find an excerpt below.

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Michael Levy was, until recently, an Analyst covering real estate investment trusts for Macquarie Research Equities. Previously, he served as Sector Head Analyst, Financial Services & REITs, at Quattro Global Capital, LLC, and as a Senior Analyst at Lehman Brothers.

TWST: Does the relatively short-term nature of apartment leases set multifamily REITs apart from those focused on other property types, in that they're able to more quickly take advantage of an improving market?

Mr. Levy: Yes, what you've seen in the last 30 years is that apartments have much more volatile streams of NOI, net operating income. The apartment REITs tend to outperform the rest of the REIT sector from a same-store NOI growth perspective during the peaks, and they tend to have below-average declines in same-store NOI during periods of market weakness.

The same, to some degree, holds true for other shorter-duration-type properties, like hotels, which you have a lease effectively for one day, or self storage, which is typically a month, versus apartments, which are obviously usually a year. And the retail, industrial warehouses and office tend to be five years or longer.

The other thing that sets apart multifamily, which helped them a lot all through the credit crisis, was their access to agency capital through Fannie (FNMA.OB) and Freddie (FMCC.OB). Whereas there was a lot of concern that perhaps some of the REITs outside the multifamily space would have trouble refinancing maturing debt or raising equity, the debt concern did not exist for the multifamily operators because there was a belief in the market that multifamily operators would always be able to refinance through Fannie and Freddie.

The sales market, the acquisition or disposition market of real estate assets, which largely ground to a halt during the peak of the recession, didn't grind to a halt to the same degree for the apartment market because even at the worst part of the credit crisis, presuming they had proper equity financing, people where able to take out a loan from the agencies.

TWST: What do the agencies' status mean for the market now?

Mr. Levy: It's interesting - Fannie and Freddie have had all sorts of single-family delinquency issues, but their multifamily books have actually performed quite well. I'd point to Freddie Mac; they recently disclosed their last month's delinquency ratios. For single family, it's well above 4%; for multifamily it's something like 30 basis points. But to the extent that the agencies do have issues and the agencies will restructure, their issues aren't multifamily issues. They aren't losing a lot of money with their multifamily lending portfolios, they're losing money because of delinquencies in the single-family portfolios.

The agencies have a mandate to provide housing for Americans and, in a nutshell, that's what lending to multifamily does. So I'm concerned that the agencies may restructure themselves in a certain way, and they may curtail lending as they shrink their balance sheets to some degree, but it shouldn't really come at the expense of the multifamily sector because it's been a relatively conservative underwriting strategy for the agencies relative to their single-family lending.

Just to follow that, today in the CMBS market, of the four major property types, apartment CMBS suffers from one of the higher delinquency rates. And I think part of the reason for that is that if you were a borrower and you were borrowing responsibly, you didn't need to go to the CMBS market to get a low-rate loan because Fannie and Freddie were providing it so long as you had proper equity and the debt service coverage ratio was conservative enough. If you didn't have that, then you couldn't get a loan from the agencies and you went to the CMBS market.

The results are noticeably weaker for the apartment CMBS, accordingly. A good example of that would be Peter Cooper Village and Stuyvesant Town - that was something that the agencies wouldn't issue a traditional mortgage for because it was underwritten with very little equity and at a relatively low debt service coverage ratio. That's really the prime example of where an apartment operator wouldn't go to Fannie and Freddie to get a mortgage at the peak of the market because they couldn't, because it didn't meet Fannie and Freddie underwriting standards. So they went to the CMBS market, and that's why, in my opinion, to some degree apartment CMBS has had weaker performance than non-apartment CMBS debt. If there is one thing that I am concerned about, it's that there may be, in a repositioning of the agencies, a focus more on affordable housing lending and less so on providing debt to an apartment landlord that's building apartments where rents are 50% above the local market average. That's how I view the realistic worst-case scenario for apartments.

The worst-case scenario is obviously that they stop lending altogether; I just don't put a high probability on that. I think it's more likely that if there is some reform done, it's that they curtail lending to some degree and, in so doing, they stop lending to operators that are building more expensive units, which could hurt the top end of the market.

TWST: What are your favorite apartment REIT names right now and why?

The remainder of this 56 page REITs Report can be immediately viewed by purchasing online.

The Wall Street Transcript is a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs and research analysts. This special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

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