Leverage in M-F World of Business
- Mar 19, 2014
In spite of what you may have read in the paper, debt is not a four-letter word. In fact, structured prudently, it can be viewed more as an asset instead of a liability. This is particularly true in the world of multi-family REITs. This space has historically tolerated higher leverage than other commercial real estate product types for several good reasons. As a result, leveraged apartments have traditionally delivered above-average returns to investors. In fact, as measured by NCREIF over the last several decades, even on an unlevered basis, multi-family properties have generated the highest returns followed by industrial, retail and office. Consistently higher returns is indicative of a product that can handle higher leverage.
So, what is it about apartments that generates these strong risk-adjusted returns? First, housing is a basic human need. You may choose to telecommute, you may buy your goods online, and you may not stay in hotels—but there is no such thing as a “virtual home”. Historically, one out of every three Americans picks apartment living for their housing choice, and demographic shifts, economic challenges, and changing consumer preferences continue to support and grow that choice. The Millennials and the Baby Boomers are the two largest renting cohorts and will continue to fuel this demand. Plus, there is incredible pent-up demand since the Great Recession derailed the creation of approximately 2.3 million households. As the job market recovers, and these people leave home or move out of a roommate situation, there will be hyper demand for apartments. So while apartments are not immune to declines during recessionary times, the elasticity of demand is not nearly as significant as other product types. And the moderate income price range for apartments in high job growth, non-coastal markets are great examples of this demand.
Second, apartments are viewed by the capital markets as lower risk. They have shown lower volatility during economic cycles. One of those reasons is the diversification of lease risk. Unlike retail and office that rely heavily upon the ability of a few tenants to make the lease payments, an apartment community can have hundreds of leases and the lack of payment of one resident does not jeopardize the ability to make debt service. Adding to that picture is the fact that average apartment occupancy over the last two decades has averaged 95 percent. Typically, an occupancy level below 65 percent is the critical threshold for debt service risk.
Third, apartments have a unique access to capital with government sponsored enterprises. Although there is news that a bill will be moving through Congress with regard to these groups, it is firmly believed that financing to the apartment industry will remain an attractive way to support any financing for single-family residential business. The financial crisis of Fannie and Freddie related directly to single- family residential lending and in fact, the GSEs national multi-family default rate is approximately one third of 1 percent. So any solution to save financing for long-term home mortgages (which is critical to the health of the single-family home business) will depend upon the continuity of capital available to multi-family properties.
So in closing, it is always important to recognize that successful companies can use both the right side and the left side of the balance sheet to deliver predictable, consistent value to REIT shareholders.