By: David A. Smith

… is affordability?

Am I up when you’re down?

When the homeownership rate drops, what happens to apartment occupancy?  As illustrated by this Wall Street Journal article, the answer depends on two factors:

1. Why homeownership rates are dropping

2. How long it has been since the homeownership drop began

Start with a fact. 

Start with just the facts, ma’am

Apartment vacancies hit their highest point since 1986, surging in cities from Raleigh, NC, to Tacoma, WA –

While the Journal leaves its choice of cities unremarked, neither of these are primary cities, nor are they at the epicenter of foreclosures – Miami, Phoenix, Las Vegas, or California’s Inland Empire.

During the third quarter, vacancies increased in 42 markets, improved in 26 markets and remained unchanged in 11 markets. Omaha, Neb., saw the largest rise in vacancies, with the rate rising 1.1 percentage points to 7.4%. Other big rises were seen in Memphis, Tenn., Indianapolis, Raleigh and Tacoma.

Here’s a hint: dark red is bad

If apartment vacancies are high in such normal-America cities as Raleigh and Tacoma, the cause is not a glut of supply, but a withering of demand:

– as rising unemployment continued to chip away at demand during the traditionally strong summer rental months.

People tend to forget that housing demand is elastic.

The muscles in my mighty arms

Are as strong as rubber bands

When housing is cheap, people consume more – they move out of the house, lose the roommates, buy a larger home with a media room, a home office, or a game room.  Going the other way, when housing becomes expensive: the total number of households shrinks.

Driving the change is the troubled employment market, which is closely tied to rentals. With unemployment at 9.8% –  a 26-year high – 

“Hey, aren’t you as big as you think?”

Young singles double and triple up in larger roommate combinations.

And with the money we save not washing, we can be solvent!

– more would-be renters are doubling up or moving in with family and friends during periods of job loss.

Young adults move back home (’boomerang kids”).

Even if you charge him rent, household consumption has shrunk

Landlords have been particularly battered because unemployment has been higher among workers under 35 years old, who are more likely to rent.

Families put young children two to a bedroom.

Most of us grew up with bunk beds at one time or another

The result is fewer households, and higher structural vacancy:

The U.S. vacancy rate reached 7.8%, a 23-year high, according to Reis Inc., a New York real-estate research firm that tracks vacancies and rents in the top 79 U.S. markets.

When that happens, some landlords, usually of weaker properties, cut their rents as they seek to prop up occupancy, at least in the short term:

Meanwhile, the air leaving the market is driving rents down, most sharply in markets that had been chugging along until a year ago, when unemployment accelerated, including Tacoma; San Jose, Calif.; and Orange County, Calif.

From the WSJ: higher vacancy squeeze rents down

Nationally, effective rents have fallen by 2.7% over the past year, to around $972.

Only 2.7%.  Could be a lot worse.  Still, with structural weakness embedded in the rental sector, as long as the economy continues to shed jobs, we can expect to see apartment occupancies wobbling, even though new construction has largely dwindled to a stop.

Not so flashy any more

For the next six months, occupancy will also drop cyclically, because housing demand expands in the late spring, when people tend to move house and when we graduate a new crop of collegians.

The [vacancy] rate is expected to climb further in the fall and winter, when rental demand is weaker, pushing vacancies to the highest levels since Reis began its count in 1980.

The weakness has even hit that least-American of marketplaces: Manhattan.

Manhattan has all the drivers of structural rental tightness: pernicious and stubborn rent control, severe land restrictions and barriers to development, and a strong employment base.  Even so, New York City landlords are confronting market forces, some for the first time.

In New York, Jennifer Hyman rented a one-bedroom apartment in July at a monthly rate of $1,950 — down from $2,450 for the previous tenant — when she returned to the city after graduating from Harvard Business School. Her first month’s rent was free — and her landlord painted the apartment, scrubbed the floors and added window coverings.

Painting the apartment?  Scrubbing the floors?  Sprucing the window coverings? 

Half of America of ROTFLMAO right now, since in America (the land of the Kleen Rest Room and the free ice tea refill), all those things are de rigueur for landlords upon new rentals.  It’s called “prepping a turnover vacancy.”

“The experience was night-and-day different from before,” said Ms. Hyman, who had rented other Manhattan apartments between 2002 and 2007, each time paying a brokers’ fee –

Another sign of a formerly hyper-inflated apartment; the commodity was so scarce people paid finders’ fees to secure one:

– and feeling pressured to sign a lease the minute she found an apartment.

Third sign: haste in closing, because if you don’t take it, there is someone right behind you.

Now, she says, “Renters are the ones with the power.”

Not all the power, but certainly more than the zero they had before.

“When job losses stop, rents will firm and occupancies will firm,” said Richard Campo, chief executive of Camden Property Trust, a Houston-based real-estate company.

“Living inexpensive?”

Well, yes.

The deteriorating rental market comes amid some signs of stabilization in the housing sales market.

Normally, home ownership and rental are countercyclical, so as the demand gradually rises, we can expect apartment occupancy to tick up before home prices do. 

But then there’s our Federal government putting its thumb on the rent-buy scales:

Need rebalancing?

An $8,000 tax credit for first-time home buyers and investor demand helped to boost sales of low- and moderately priced homes this summer.

But some analysts warn demand could fall with the expiration of the tax credit and supply could increase with more foreclosed homes hitting the market.

Both are true: housing will fall again, and supply will probably rise, particularly when one looks at the interest rate resets still before us:

We’re not through the rate resets by any means

While a housing recovery could lead the best quality renters to move out and purchase homes, the move-out rate [into homes – Ed.] isn’t expected to surpass levels seen during the housing boom earlier this decade.

In other words, we have a very long hill to climb.

Mortgage credit standards have tightened considerably since then, which should keep more renters in place.

Can’t support that much, can I?

In the intermediate term, that should be good for rental.

Apartment owners ultimately could gain from the housing bust because the U.S. home-ownership rate has fallen as foreclosures rise. But the housing bust has also flooded some of the most overbuilt housing markets with new apartment inventory as developers have converted unsold condominium developments into rentals.

Reis projects that the vacancy rate will peak at well above 8% in mid-2010.

Folks, this recession is a long way from over.

SIGNS advertise apartments for rent in San Francisco in July. Rents declined during the third quarter, usually a strong period for rentals

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Pay your loans or I’ll foreclose, threatens the lender, believing that to be an effective threat.

Or is it?

As illustrated a The New York Times article from a couple of months, there’s a huge difference between property, loans, and assets:

When the New York developer Harry B. Macklowe acquired the Drake Hotel almost three years ago and began buying up surrounding properties, market specialists expected him to include the site in a mammoth luxury office development.

After the downturn in credit markets, however, Mr. Macklowe defaulted on his loans, and bidders are now vying for the Park Avenue site at fire-sale prices.

A year ago – how things change! – I profiled Mr. Macklowe’s situation, speculating that he would dodge the bullet:

I thought he was nimble enough

What we have here is a complicated game of possible wealth transfer.  Each of Mr. Macklowe’s creditors is entitled to something — but they do not have control over specific assets.  Mr. Macklowe, for his part, has plenty of assets, that he can turn into cash by selling.  What gets sold, and to whom, is his choice.  So if there are bargains to be got, Mr. Macklowe may choose who gets them.

Slightly used trophy properties for sale … cheap

Some of the wiliest players in the real estate business have already been circling Mr. Macklowe.

This past fall, Vornado Realty Trust, of which Steven Roth is chairman, bought a stake in loans collateralized by four of Mr. Macklowe’s buildings on an apparent bet it might snare some great real estate on the cheap, bankers and real estate executives said.

I admit, watching these titans maneuver for leverage is just plain entertaining.  Straight out of Field of Dreams and other melodramas of the prairie, Mr. Roth’s company — which now is probably glad it lost the Equity Office battle to Blackstone — is hoping that by owning a piece of the debt, it can increase its chances of eventually owning the equity.

 “It’s not a real estate crisis but a capital markets crisis,” the younger Mr. Macklowe said. “Our legacy and acquired portfolios are renting at market rates or better. In August, when the world took a 180-degree turn, we and others got caught up in it.”

William Macklowe is 100% right.  Will being right be of any value to him?

Cypher: I know what you’re thinking, ’cause right now I’m thinking the same thing. Actually, I’ve been thinking it ever since I got here: Why oh why didn’t I take the BLUE pill?

Yet even as Mr. Macklowe’s company clings to the control seat its equity gives it –

I can sling the bull with the best of them

– others are jockeying for better position in the Tranche warfare about to break out:

But the Drake site is not for sale directly. What is available is a $200 million mortgage for the swath of land, which covers a third of a city block between Park and Madison Avenues and 56th and 57th Streets. The buyer of this note will own a majority of the most senior piece of the debt, and so will most likely be paid back first should Mr. Macklowe have enough funds. If he defaults, the owner of the note will be in the best position to take ownership of the underlying property through a foreclosure.

My debt’s got position over your debt

This deal highlights a shift in the commercial real estate market, away from brick-and-mortar properties and toward the buying and selling of debt.  “We are expecting a flurry of deals like the Drake Hotel site, where it is the loan that is for sale, not the actual real estate,” said Robert L. Freedman, the executive chairman of Williams Real Estate, a New York firm. The company is now creating a distressed-property group to handle such transactions.

Lots of people are ‘creating distressed-property groups.’

We’re creating a ‘distressed animal group’

During the real estate boom of recent years, developers increasingly used debt to finance their acquisitions. Now, with the market cooling, some of these borrowers are beginning to default. This is leaving lenders — including banks, private equity firms and hedge funds — in the position of owning the real estate.

To be technically precise, to be able to own the real estate if they wish. 

“Loans don’t typically go into default immediately when there is a downturn in the market,” said Robert Knakal, the chairman of the brokerage firm Massey Knakal. “In the beginning, owners continue to make payments on their loans, hoping things will turn around, or if the loan is relatively new, it may have a significant interest reserve that is still carrying the note. So defaults on mortgages are a lagging indicator of market conditions.”

Knakal’s waiting for the lagging indicators

Some people don’t wish to become owners:

Many lenders are looking to offload these loans because they need to cash out quickly, or because they are not in the business of selling real estate and lack the necessary resources and expertise.

Who sells defaulted or soon-to-be-defaulted loans?

• Entities that need cash now.
• Entities that lack the expertise to make the quick and sharp choices necessary.
• Entities that have some expertise but other fish to fry.
• Entities that have written the loan down below its expected resale trading price, so they can get an earnings bump by disposing of the property.

We Sellers need cash now!

If something needs to be sold, enter the brokers!

This means that commercial brokers, who regularly negotiated the acquisition and sale of properties, are now marketing mortgages and other loans.

“I am being inundated with calls from banks who want to sell their loans,” said David Schechtman, a senior director at the commercial brokerage firm Eastern Consolidated.

Does he look inundated?  Schechtment

Who buys defaulted or soon-to-be-defaulted loans?

• Entities with cash.
• Entities that think they can make fast and smart choices.
• Entities that can transact on or operate the property or assets.
• Entities that think they can improve the property’s underlying performance if they can gain control of it. 

Well, maybe more confidence-inspiring than that

“In just the last few weeks, I have also collected a list of about 30 clients — primarily high-net-worth individuals, long-established real estate families and small opportunity funds — who want to buy up these loans.”

Observe the characteristics implied by that list:

• High net-worth means people with money.
• Long-established real estate families means people with expertise.
• Small opportunity funds means people who can move fast.

That’s the right mix of talents.

Cash-rich developers and wealthy individuals are maneuvering to take advantage of the shift.

We have the right mix to take advantage

Despite this delay, there are early indications of an increase in loan sales. “Clearly, there has been a pickup in sales volume,” said David F. Dorros, a managing director at CB Richard Ellis.

It’s called ‘creating liquidity.’

Some are buying performing loans, where the borrower is continuing to pay interest on the debt. In this case, the buyer acquires the loan at a discount, but continues to receive interest payments. Then, when the loan comes due, the buyer is paid back the full face value.

Markets thrive on asymmetry of information and asymmetry of perception. 

I see things you don’t

You may think the loan will default; I may expect it won’t. 

You may fear that after default, the collateral will plummet in value; I have a plan to recapitalize it.

“The cash bind that many lenders are in is much more acute today than in the early 1990s,” when the previous major downturn in commercial real estate occurred, Mr. Knakal said.

As the binds tighten, more people will want release from the headache.

Wait ’til we tighten this

Anticipating default and anticipating loss given default are the very stuff of secondary-market trades.

Others are snatching up nonperforming loans, where the borrower has defaulted on the payments. In this case, patient buyers, including developers and private equity firms, may acquire the debt at a discount and eventually take ownership of the underlying real estate — usually after court action.

Loans with an above-market interest rate can stay in defaulted-but-not-foreclosed status for months and years, if the parties work out a modus vivendi.

We’ve worked out a modus vivendi

In the current environment, however, the volume and complexity of deals are expected to be much greater than in the past because so many of the loans were grouped together and converted into bonds.

As we’ve seen, if the lenders can’t work together, then they all go over the cliff together. 

We’re sure someone is in charge

Volume, in fact, will overwhelm all. 

We’re hearing a lot of noise like this

Many of the distressed-debt buyers or asset managers will move into the space because they have the combination of capital and broad management expertise to work out the individual assets.  It’ll take both.

As the market grows accustomed to the sale of loans, many eyes will be trained on the Drake Hotel site.

“It will set a floor price, establishing new benchmark metrics for the new economic realities,” Mr. Freedman said. “The Drake is just the tip of the iceberg; stay tuned, there is more to come.”

Robert L. Freedman’s firm in Manhattan is forming a group to handle loan sales.  “We are expecting a flurry of deals,” he said.

Meet the undertaker.

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