BID® Daily Newsletter
Jun 22, 2012

BID® Daily Newsletter

Jun 22, 2012

MULTIFAMILY RISK


During the mid 1970's, the hottest thing in the underground weapons market was something called "Red Mercury." The Soviets had developed this highly radioactive isotope that was so powerful, a bomb capable of wiping out all of NY or LA could be reduced to the size of a small watermelon. The stuff sold on the black market for $1mm a kilogram and supposedly buyers were coming out of the woodwork. Rumor has it that more than 25 sales took place and we are not sure who the joke was on, but apparently Red Mercury was nothing more explosive than paprika. By 2004, the Int'l Atomic Energy Agency put out a statement that ‘Red Mercury doesn't exist…the whole thing is a bunch of malarkey." ...those funny Russians. Speaking of knowing what you are buying, we want to highlight multifamily lending risk, as it is currently one of the hottest products around for community banks. It is not uncommon to see spreads that are as low as +175bp over Libor. At those levels, you have to be sure of what you are getting. The other day, we saw a bank turn down a $2mm loan that was fixed for 10Ys, had 25Y amortization, a 1.3x DSCR, a 75% LTV and a coupon of 4.50%. The bank's concern was that the loan was below the 5% margin target. That's too bad, as this 65% LTD bank passed up on an opportunity to get a 19.6% risk-adjusted ROE (RAROE). To add more color, national vacancy rates are now down to about 4.9% (the lowest since Nov. 2001), while capitalization rates have declined to Mar. 2006 levels (the top of the market). Multifamily lending has an average delinquency rate of 2.1% (compared to 3.1% for CRE, 1.0% for C&I and 0.2% for consumer) on a national bank basis. In the case above, because of the location and other details, the probability of default (expected delinquency) was 1.95%. On average, the loss given default on multifamily is around 29%, given an expected loss of about 0.6% (analogous to an economic reserve). All this is attractive, except there is a word of caution when you look ahead. For starters, after analyzing more than 2,400 loans in our database, the greatest risk in multifamily lending is in years 3 and 4 of a loan. This is an area where NOI growth slows and debt service coverage starts to get reduced. Property owners usually build a new building, or purchase a building and make improvements, or refinance and use additional loan proceeds to make improvements to a building. Usually improvements in the property or additional marketing wear off by year 3 or 4. Rent increases then slow and vacancies tend to rise. By year 5 and 6, loan paydowns, rent growth and other factors tend to stabilize, producing positive credit economics. Looking ahead, the current attractive economics of the housing crisis and huge surge in rental demand has prompted an increase in future multifamily supply. Apartment construction in 2012 has more than doubled from 2011 and more than tripled from 2010. The bulk of this supply hits the market in 2013, which could serve to reduce or eliminate rent growth. This could impact banks that refinanced apartment loans back in 2010. This could boost loan performance risk. All this said; we still see strong enough demand for rental units to keep major credit problems at bay for now. However, if you keep rolling our econometric model forward, if new construction continues at its current pace, delinquencies are predicted to increase in 2016. Banks that are making floating rate loans on this product could also be in for trouble, as that adds pressure at the start of the next projected upward rate cycle. By market, lending risk is high in those with a projected demand/supply imbalance such as Seattle, Austin, Suburban Maryland and D.C. Multifamily lending is a classic example of a quality lending sector that could burn banks due to pricing vs. credit. Having a pricing model (such as our BIGProfit) allows you to manage risk-adjusted return. In addition, using or BLP program to lock in fixed rates for your borrower (while you receive a floating rate to match your funding structure) helps manage interest rate risk. Finally, using our Credit Stress model helps ensure your entire balance sheet is supported by enough reserves and capital. Hopefully, this information and these tools, will keep your multifamily lending portfolio from turning into its version of Red Mercury.
Subscribe to the BID Daily Newsletter to have it delivered by email daily.