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Capital Remains Bullish on Rental Apartment Sector

July 11, 2007

There was a time in the not-too-distant past when condominium conversions were all the rage. Nearly every apartment owner in Florida, it seemed, wanted to “go condo” as a way to tap the booming housing market.

“We’re talking 800-unit and larger apartment complexes,” says David Patten, president and partner at Commercial Mortgage Advisors in Orlando. “Converters bought at cap rates below 7 percent, and the owners selling them were tickled pink.”

Those cap rates decreased to as low as 2% or 3%, says Patten, but the sentiment remained the same: those apartments were going to be converted into condos, and their new owners were going to make a fortune.

The trend lasted about five years, with investors buying more and more apartments - some of which received full overhauls before going on the market, and others getting no more than a “coat of paint,” says Patten. “It depended on the location.”

Behind the scenes, the folks who owned the land under those developments started talking to one another and swapping stories about just “how much per acre” their plots were worth. “Sellers were making a lot more money selling to investors than they would have selling to rental apartment developers,” says Patten, who estimates that the difference ranged from $5,000 to $20,000 land cost per unit.

And while Florida’s condo market has obviously leveled off over the last year, those land costs remain high, according to Patten.

“The land cost per unit is so high that right now it does not make economic sense for a developer to build a rental apartment complex,” he asserts. “Because of the condo boom, landowners are still holding out for what they were getting from the condo developers.”

With so many apartments transformed into condos - and with the housing market in a slump - financiers have set their sights on rental units.

“Virtually every lender wants to finance apartments of every kind right now,” says Patten, who puts Florida in the same group as states like California and Arizona, where in-migration is high due to a large retirement population.

At Madison Capital Group in Miami, Managing Director Timothy E. Martorella says that the markets are “as flush as ever with capital” and that spreads came down over the previous 12 months but did pick back up again recently due to the overall securitization market and faltering subprime sector.

“That’s caused some fallout in terms of a general perception of risk in the securitization markets,” says Martorella.

The apartment sector remains strong, he adds, but the rules have shifted somewhat in recent months.

“We’re actively financing new apartment developments, apartment acquisitions and recapitalizations, but as far as new conversions, we’re very selective,” says Martorella. “We’re seeing some niche conversion projects out there that can still make some sense.”

Lenders are more than happy to hear five-minute elevator pitches for many other rental projects right now.

“There’s plenty of capital to do deals, but they have to be within the scope of reason,” says Martorella. “The challenge for developers is not finding ready capital - it’s finding projects that make sense.”

That means getting to a specific return on cost, he says, or at least 6% to 7% in a market like South Florida, for example. Getting there isn’t easy.

“Rents are moving up nicely, but so are operating costs, taxes, insurance and construction costs,” says Martorella. “The slight reduction in land prices just isn’t enough to get to a point where new construction makes sense in many cases.”

With spreads going down, Del Goforth, executive vice president and partner at St. Petersburg-based Florida Bond and Mortgage, says low-leveraged apartment deals are the deals of choice for financers right now.

“That’s their number-one choice,” says Goforth. “For the right deal and borrower, they are doing some unbelievable spreads, with lower-leveraged projects getting under 85 or fewer basis points.”

Where developers are most challenged, says Goforth, is in making their deals work in the current insurance and property market. At press time, for example, he was working on a small St. Petersburg apartment refinance deal. Once the new property tax rate was figured into the equation, Goforth says, the deal quickly became unattractive.

“If the owner wants to refinance, we need an appraisal, and that’s going to reflect a significant increase in taxes,” says Goforth. “When it comes time to, say, sell the property at a seven percent cap rate, with the new taxes and insurance it winds up being a five percent cap rate.”

Such obstacles aside, Patten expects to see more of the same over the next few months in the apartment finance market. What he doesn’t expect to see is apartment development becoming more affordable until land costs come down to earth - something that’s probably not in the cards.

“It won’t change unless property owners wake up one day and decide to sell their properties for less money,” says Patten, who calls the condo conversion market “virtually dead” at this point, due to an overall housing slump.

On the financing side, Patten says the money will continue to flow into viable multifamily projects.

“There is so much money out there to finance these developments, it’s not even funny,” he says. “And every loan we’ve done here in the last four years has been at less than six percent. That’s great for everyone.”

Martorella sees a continued shakeout in the “for sale” market, and he says that trend will impact the rental market in Florida. Niche projects will continue receiving financing, due to the “strong capital appetite” for such developments. Change could come in 2008.

“Next year will be a transitional one,” says Martorella. “Up until 18 months ago, multifamily sales were much stronger than rentals. Next year, the focus will be on the apartment sector - and on the construction of new apartments.”

Article From Florida Real Estate Journal