Lonestar Limbo

It is also important to note that the spread between the average Dallas cap rate and the average national cap rate of 6.9 percent during the third quarter stood at just 0.3 percentage points. Considering that this spread normally ranges from 0.9 percentage points to as much as 1.6 percentage points, a spread of just 0.3 percentage points is historically very low. This cap rate decline has been pinned on DFW’s significant number of distressed sales, with multifamily properties purchased more on a “per-square-foot” or “per-unit” basis as opposed to a “cap rate” purchase. The buyers of these properties are anticipating significant upside as they improve operating results.

However, a larger chasm exists in pricing expectations. Institutions and private investors are flush with investment capital, but they are still waiting to see “blood in the street.” While there have been significant sales of distressed assets in ’08 and ’09, it has not been at the level that most investors anticipated for the market. There are some who expect a major change in 2010, with lenders foreclosing at a higher level and prices decreasing to a point that satisfies the vulture funds waiting on the sidelines.

In analyzing reports from DFW’s Foreclosure Listing Service, 62 apartment properties in the DFW market went into foreclosure in 2009, with a total assessed valuation of $257 million. But in a declining market, this valuation did not equate to market value. Lenders bid a combined $191 million at foreclosure sales, representing 74 percent of the assessed valuation. Even though vulture funds had ample investment funds to commit to these opportunities, they evidently did not see sufficient promise in said foreclosures. Only four were purchased on the courthouse steps, leaving 58 to revert to lender ownership.

One example of this trend of lenders acquiring foreclosed properties occurred in January 2009 when LaSalle Bank foreclosed on the 160-unit Regal Brook Apartments in the White Rock Lake submarket of Dallas. The property was built in 1978, is located on 6.2 acres, and has 146,142 square feet of improvements. Unfortunately, it is located in a submarket that has seen its share of foreclosures. Area occupancy is at 83 percent and, in the past 24 months alone, rents have declined 6.78 percent. In April 2006, LaSalle financed $4 million for Regal Brook, when the property sold for $5.3 million. At the time, the assessed valuation on the tax roll was $5 million. LaSalle submitted the only bid (totaling $3 million) at the foreclosure sale, then subsequently sold the property to Wind Properties RB in March 2009 for $3.3 million, or $20,625 per unit. The new owner renamed the property Castle Rock and is working on renovations valued at $900,000. For 2009, Castle Rock is assessed on the tax roll at $3.3 million.

George Roddy Sr. of Roddy Information Services and longtime publisher of DFW’s Foreclosure Listing Service expects foreclosure postings in 2010 to increase. “What started as postings of C and D product has changed over the past two-and-a-half years, and evolved to B and sometimes A product,” Roddy says. “The softness in the housing market will provide additional demand for apartments as homeowners continue to lose homes due to foreclosure and as people downsize and double-up.”

Planning for the Future

With the current DFW unemployment rate at 8.2 percent, the expectation of positive job creation and projections of a steadily increasing population, the future for the metro looks guardedly optimistic. But to get to that horizon, the industry will have to wade through 2010.

Developers face competition from plentiful new construction in the face of weak demand, and likely have months of soft occupancy and declining rents ahead. But assuming builders refrain from new project commitments, the Dallas multifamily development market should stabilize by mid-2011.

Investors will look for buying opportunities as the foreclosure trend continues, though they should not expect deep discounts. To avoid a deep recession in commercial values, the FDIC appears to be propping up banks and adopting a policy of “extend and pretend” for commercial notes that are maturing in the near future.

While owners of quality assets might be able to worry less about their position in the fundamentals pecking order—since the majority of foreclosures represent non-institutional-grade product—there are two issues that could continue to stall the investment market for more traditional, non-institutional-grade properties. These are competition from lenders reselling REO properties and buyers who expect a larger discount than most owners are willing to give.

If they are able to do so, owners are best advised to hold off until 2011. That’s when the market in Dallas should be fully recovered and, once again, thinking big.