Lost Leverage
Live by leverage. Die by leverage. During the past few years, low interest rates allowed private buyers to stretch their dollars even further and buy properties that they may not have been able to afford in the past. Then interest rates went up, and things started changing.
“If I’m a leverage buyer and I go in today, when the 10-year Treasury [note, which is a benchmark for lending rates] is 5.22 percent, spreads have widened,” Kaplan says. “The average spread is 100 [basis points] over. So I’m at 6.22 percent. Even if I’m [going for an] interest-only [loan], the spread between where my cap rate is and where my interest rates are is 200 basis points negative. I’ve got negative leverage.”
And this is starting to keep leverage buyers away. “It’s definitely happening,” says Tim Naughton, president of AvalonBay Communities. “With leverage buyers, it’s cash out of their pocket for a year or two. They tend to shy away from those opportunities.”
Others see this as well. “There’s definitely less guys showing up at the dance on any one auction than there used to be,” says Keith Harris, executive vice president of Investments for The Laramar Group, a Chicago-based apartment owner and operator. “That has to be a symptom of the debt and private guys not doing stupid things.”
With the increase in rates, high-leverage deals are starting to fall through, which may be a blessing in disguise for the leverage buyer.
“We’ve seen a couple of deals come back to us,” says Mark Wallis, senior executive vice president of United Dominion Realty Trust, a REIT headquartered in Richmond, Va. “We’ve got a feeling that there’s going to be a lot more of that. There’s the perception that if a guy has to secure debt, it may take longer and his numbers may be a little tighter.”
Filling the Gap
So now that the leverage buyers are fading from the picture, it opens the door for the formerly beaten-up REITs and institutions. Earlier this year, people were talking about the competitive demise of these powerhouses in terms of their ability to buy properties and portfolios. That isn’t the case anymore.
“The all-cash buyers can swoop in and get the deals because the leverage buyers can’t make sense of the return right now,” Kaplan says.
This is especially true in certain product types. “Especially on well-located B properties or Class A properties, purchasers less reliant on maximum loan proceeds will have a distinct advantage,” says Blake Okland, principal at the Charlotte office of Apartment Realty Advisors, an apartment broker.
And which purchasers are least dependent on leverage to make deals? The very well-heeled private and institutional buyers are two of the biggest beneficiaries, but REITs may be at the top of the list. “If I’m a large REIT or a pension fund advisor and I’m taking yield within a fund, I can buy all-cash, finance it, and not have the negative leverage,” Kaplan says.
“The leverage buyer, including condo converters and private individuals, have been replaced by pension funds and REITs, who are more cash and equity buyers,” Naughton agrees.
The disappearance of condo converters cannot be overstated. “REITs are now becoming more active in the investment market because they don’t have to compete with the condo converters,” says David Baird, national director of multifamily for Sperry Van Ness, a broker based in Irvine, Calif.
Still, not everyone sees REITs taking control of the market. “Our return thresholds are different,” says John Smith, senior vice president and chief investment officer for HOME Properties, a REIT based in Rochester, N.Y. “We want some kind of return from day one. Some of the leverage buyers are not looking for cash-on-cash [returns] for the first couple of years. Their overall yield for the five years may be based on the belief that they can still sell for higher price in five years. We may not be as optimistic because we have to hedge our bets for the shareholders to reduce risk.”
