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Apartment Loan Quality Worsens as Prices Outpace Growth in Rents

The quality of new loans on U.S. apartment buildings dropped in the second quarter, putting multifamily properties at greater risk of price declines should rent growth stall, according to a study by Chandan Economics.

The ratio of rental income to loan balances on high-rise apartments fell to 8.7 percent from 9.7 percent a year earlier, Chandan Economics said. So-called debt yield for securitized loans on all types of commercial properties, including apartments, rarely fell to less than 12 percent during the four decades through early 2006, before plunging as the market peaked, according to Toronto-based debt-rating company DBRS.

Apartments and central business district office buildings in large coastal cities have led the early stages of a recovery in U.S. commercial real estate as investors seek stable, income-producing properties. Debt yield has declined because property values have risen faster than rents, Chandan Economics said.

“In effect, apartment and office borrowers are encumbered with more debt for every dollar of cash flow their properties produce, heightening downside risks should property values adjust or cash flow decline,” Sam Chandan, founder of the New York-based real estate research firm, wrote in today’s report.

In New York, Washington and San Francisco, where property prices have rallied the most, apartment debt yields fell to 7.5 percent in the second quarter from 8.6 percent a year earlier.

Office buildings had a similar increase in prices and drop in yields. Their debt yields fell to 9.7 percent from 9.8 percent in the first quarter and 12.1 percent a year earlier, Chandan’s research shows. In New York, Washington and San Francisco, they dropped to 7.8 percent from 8.1 percent in the prior quarter and 10.3 percent a year earlier.

Beginnings of Recovery

The rebound in values has encouraged more lending, Chandan said. Signs of a slippage in loan standards contributed to upheaval during the past month in the $600 billion market for commercial mortgage-backed securities as investors demanded greater collateral protection in a $1.5 billion sale of property bonds by Citigroup Inc. and Goldman Sachs Group Inc. The underwriters were forced to cancel the sale, adding to concerns that sent borrowing costs to their highest in more than a year.

With apartments, values are rising higher than the cost to build as many Americans sour on homeownership and lease instead, pushing rents higher. Apartment-mortgage purchases by the government-owned finance companies Fannie Mae and Freddie Mac also help keep apartment-borrowing costs low, Chandan said.

‘A Bubble?’

“A lot of people bought into the premise that multifamily is the place to be, that fundamentals are going to be strong,” said Chuck Burd, who oversees about $8 billion of assets as chief investment officer of the U.S. unit of Bentall Kennedy, a Toronto-based real estate investment company. “Is it a bubble? I think if it were another property type, I’d say yes.”

Bentall Kennedy has been among those betting that demand for rental housing will remain robust for the foreseeable future as echo boomers, the children of baby boomers, favor urban lifestyles and shun homeownership after witnessing the plunge in housing prices. The company turned to building rental units in cities including Seattle as prices for existing apartment buildings surpassed replacement costs.

“In the current cycle, this is probably the most interesting investment opportunity,” Burd said. At the same time, “cap rates in many markets may have reached their low point,” he said.

Capitalization rates fall as property prices rise. Cap rates, which measure the yield on an investment, are calculated by dividing net operating income by purchase price.

Mortgages Studied

Chandan examined $89.4 billion of loans made between the first quarter of 2010 and the second quarter of 2011, including loans made by banks, life insurers and lenders whose mortgages were pooled into securities. New mortgages backed by U.S. office, apartment, industrial and retail properties with original principal balances of $3.5 million or greater were used for the study.

Before founding Chandan Economics in June, Sam Chandan was global chief economist at Real Capital Analytics Inc., a property research firm in New York. He also has been chief economist at Reis Inc. He teaches real estate finance and managerial economics at the University of Pennsylvania’s Wharton School.

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