Apartments Lead Default Parade

NEW YORK, NY - The multifamily sector is leading all other types of U.S. commercial real estate in having the highest loan default rate but the others are likely to follow, experts say. Defaulted apartment loans that back commercial mortgage backed securities (CMBS) in May surpassed 5 percent, while retail and lodging broke the 3 percent level and overall delinquencies were 2.77 percent, according to Trepp, which tracks CMBS issues.

Bank loans for apartment buildings defaulted at a rate of 2.45 percent in the second quarter, while those of all other commercial real estate mortgages held by depository institutions reached 2.25 percent, according to research firm Real Estate Econometrics.

Apartment building prices peaked in the fourth quarter 2006, according to research firm Real Capital Analytics. Peak prices for other classes of real estate followed - hotels in the first quarter 2007, offices and retail in the second quarter 2007, and warehouses in the third quarter 2007.

"Because it peaked first, some of the deterioration has come on a little earlier," said Sam Chandan, Real Estate Econometrics president and chief economist said. "You've got these waves of issues that are driving defaults for commercial," Chandan said."

Overly generous and plentiful loans pervaded across the U.S. commercial real estate sectors 2004 through 2007 and pushed up values. Getting a loan today is tough. Falling rents and occupancies along with fewer available and lower loans have pushed down values 35 percent to 40 percent. That has resulted in higher defaults.

The apartment sector usually is early to feel economic changes because of its short one-year leases. The default rate among hotels, which have one-night leases, is lower, but likely to surpass apartments soon, Chandan said. Yet other factors have humbled the apartment sector.

In some markets, prices of many apartment buildings were driven up by investors planning to convert them into condominiums during the housing boom, which ended abruptly in 2006. When the housing market collapsed, condominiums for rent drove down market rents.

In other areas, some of the biggest deals involved pricing based on turning rent stabilized apartments into market rate apartments. That proved more difficult and sent some deals, such as the Riverton, a 12-building apartment complex in New York City's Harlem, into default.

The weak U.S. economy zapped job growth, the key driver of demand for apartments. The U.S. unemployment rate in May reached 9.5 percent. Among 18 to 24 year olds it was 15 percent. About 70 percent are apartment renters who are now doubling up or moving in with their parents.

Higher-end apartments no longer command top prices simply because of amenities. "Most renters are paying for value, in absolute dollars," said Mike Kelly, president and co-founder of Caldera Asset Management. "They're not going to pay an extra 50 bucks because you have a cabinet in granite." Caldera helps multifamily lenders maintain the value of properties in pre-foreclosure or throughout foreclosure.

Buyers of lower-end "C" low-rise apartment complexes were not professional real estate investors and were unable to navigate the economic downturn. "They were thinking they could hire a management company and run a 'C' multi," said Michael Katz, a CMBS veteran and current director of Clark Street Capital, which helps link loan buyers and sellers via an online marketplace. "A 'C' multi is very much like a hotel. You have to know how to handle your clients. There's a lower level of consumer who really doesn't mind being late on their rent."

A large majority of the bank loans financed construction of new apartments and were issued to professional merchant builders, with track records of building new apartments and selling them to investors. Although their default rate is high, many of those floating-rate loans are still performing because they are based on LIBOR, which has tumbled. "They've been able to offset the poor economics and poor property performance by not paying as much interest," Kelly said.