Wednesday, October 15, 2008

Multifamily Occupancy Rates: Four Things to Think About

(Note: If you make it all the way through this post, you'll probably end up thinking I've beaten a relatively simple concept to death, and you'll be right. However, the individual components discussed below tie into other issues, and I think having all this laid out exhaustively in one post will facilitate future posts).

Loan underwriters tend to think of occupancy rates as static. At any given time, you can divide the number of occupied units by the total number of units and get the physical occupancy rate. For any month, you can divide actual rental income collections by gross potential rents and get the economic occupancy rate. It's about as simple a calculation as it gets in real estate finance. However, what's actually going on is more complex, and understanding the four constituent components of occupancy rates is important in evaluating the risk associated with a project.

The first component is the Turnover Rate. If no tenant ever leaves a project, occupancy would always be 100%. However, all projects have turnover. Leading turnover causes are:

  • House purchase
  • Job relocation
  • Household changes (divorce, marriage, births, roommate changes). Such changes can affect both what tenants can afford to pay and how much space they need.
  • Changed economic circumstances (e.g., job loss, salary increase or reduction) necessitate/enable a move to lower cost or nicer housing
  • Death, illness
  • Dissatisfaction with current residence

As is apparent from the list, no project is immune from tenants leaving; in fact, the last item is the only one the project owner has any control over. Many people are surprised by how much turnover there is in a typical apartment project – in my experience 50%-60% of tenants leave a typical project every year. If you want to check this, it's relatively easy to get a rough idea of a project's turnover rate if you have a rent roll with move-in dates. Simply count the number of tenants who have moved in during the last 12 months and divide by the total number of units (this approach will understate the rate to the extent tenants have moved out during their first year of occupancy, but to get an exact count you would need to look at each month's rent roll).

The other components to the occupancy rate relate to the process of replacing these tenants. The second component is Traffic, which I define as the number of potential tenants who visit a project to determine whether or not they want to rent an apartment. A project's traffic is the subset of some progressively smaller sets:

  • Everyone in the market who is interested in renting an apartment in the project's submarket at a point in time (we'll call this group Potential Tenants)
  • The subset of Potential Tenants who are aware of the project (we'll call this group Aware Potential Tenants). A Potential Tenant could become aware of the project through advertising, a referral, or driving by the project. Let's define the Awareness Factor as the number of Aware Potential Tenants divided by Potential Tenants.
  • The subset of Aware Potential Tenants who actually visit the project and inquire about renting (we'll call these Prospects). An Aware Potential Tenant may never become a prospect; for instance, he or she finds an apartment at a competing project before visiting our project, or may drive by our project and conclude it's not for them based on design, maintenance, or location. Let's define the Inquiry Rate as the number of Prospects divided by the number of Aware Potential Tenants.

Like turnover, important elements of traffic are largely outside an owner's control. An owner can attempt to increase the number of aware tenants through advertising and referral programs, and can increase the number of prospects by enhancing a project's curb appeal. However, in an economic downturn fewer people are interested in renting apartments, so there are fewer potential tenants, and there's not much an owner can do about a project's design or location.

The third component of the occupancy rate is the Capture Rate, which is the number of prospects who lease a unit divided by the total number of prospects. If a prospect is not captured, it's generally because they didn't like the leasing agent, the specific features of the project or units as revealed by the tenant's inspection, or the price. These are all things the owner can control.

Here's an example to show how these components work together:

A 120 unit project has a 50% annual turnover rate (i.e., 60 tenants a year or 5 tenants a month leave). In this particular month there are 160 Potential Tenants looking for an apartment in the project's submarket. 25% of the Potential Tenants are aware of the project, 50% of these tenants come to the project and talk to the leasing agent, and 25% of these tenants like the leasing agent, the project, and the price and sign a lease:

160 Potential Tenants * 25% Awareness Factor * 50% Inquiry Rate * 25% Capture Rate = 5 New Tenants

So, for this month the project is full again.

Of course, it's pretty rare for the equilibrium to be perfect. Think of an apartment project as a leaky bucket with tenants dripping out the bottom. To keep the bucket full you have a hose, but the hose is too short so you have to spray the water in from some distance away. As long as you have enough water coming through the hose (potential tenants) and good enough aim you can keep the bucket full, but if the combination of water coming though the hose and your accuracy doesn't put enough water in the bucket to exceed the volume of the leak, the level of water in the bucket will go down.

The final component, Time to Turn, relates to economic occupancy. When a tenant gives notice they're going to move, a good onsite manager starts looking for a new tenant for that unit before the physical vacancy actually occurs. In an ideal world the first tenant moves out on the last day of the month, the new tenant moves in the next day, and no rent is lost. However, it's not an ideal world; units need to be cleaned, units aren't always leased before they become vacant, and tenants don't always move in immediately. As a result, turnover almost always results in economic loss, even if on a monthly basis you are 100% occupied. As a result, economic occupancy is always going to be lower than physical occupancy.

Let's see how these components work together. Let's say we underwrote a loan based on an economic occupancy of 95%, which is well supported by the project's history. The next year the project is on the watch list and the economic occupancy is 80%. What might have happened?


  • An increase in the Turnover Rate. Pronounced changes are usually related to the local economy or a change in resident management, but there are other interesting possibilities. For example, during the early 1990's in Southern California I was involved in a number of workouts on small projects which experienced 90%+ of the tenants moving out in one month. The pattern was the owner leasing a unit to someone fronting for a gang member, the gang moves in, and all the other tenants move out the next month.
  • Decrease in Potential Tenants. This is usually related to the local economy.
  • Decrease in the number of Aware Potential Tenants. This is usually related to a change in the owner's advertising.
  • Decline in the number of Prospects. This is usually the result of more competition in the neighborhood and/or a decline in the project's curb appeal.
  • A lower Capture Rate. This is usually related to as change in the pricing environment and/or a change in resident management.
  • Longer Time to Turn. This is a function of all of the above, plus maintenance staff capability, the condition the vacant units are left in, and management willingness to wait for a tenant to move in vs. gambling they can find a tenant who will take occupancy sooner.

Usually there is more than one factor at work. I think you will agree that it is not implausible that these events could happen to almost any project. Now, look through the list again and think about how an underwriter could anticipate such events. The answers fall into two groups:

  • Forecasting economic downturns. This is usually possible to some extent over the short term. The difficulty is that, while you may know the market is weakening, it's impossible to know if the downturn will be sharp enough to warrant rejecting the loan.
  • Owner decisions. You can't know that an owner won't make a future mistake, but you can mitigate the risk if you lend to experienced owners.

    Monday, October 6, 2008

    Does Recourse Matter on Income Property Loans?

    One of the ideas that occasionally pops up in discussions about the mortgage crisis is that mortgage loan losses are exacerbated by the fact that most mortgage loans are non-recourse (see, for example, The Hidden Put via Over the Counter). Is there any truth to this idea? I don't think so.

    Actually, the best answer is, we don't know. To prove the argument we would need to match a pool of non-recourse loans to a similar pool of recourse loans and see how they perform. If anyone has done that for income property loans I'm not aware of it, and if it has I seriously doubt if the pools were matched correctly (for reasons discussed below). Absent actual data, we're left with theories. The theory that recourse matters is compelling, but in my experience does not conform to actual borrower behavior.

    To start at the beginning - a nonrecourse loan is a loan secured by collateral under which the lender's ability to collect is limited to the collateral. For example; a lender makes a loan for $1,000,000, the borrower defaults, the lender forecloses on the property and sells it for $800,000. If the loan is nonrecourse, the borrower has no further obligation to the lender. If the loan is recourse, the borrower is still liable to the lender for the deficiency. Typically, the lender obtains a judgment for the deficiency and executes it against the borrower's other assets.

    The theory that recourse matters is straightforward. With a nonrecourse mortgage, the borrower has a simple put to the lender; any time the property value drops below the mortgage amount the borrower can walk away. With a recourse loan there is no put, and the borrower has an incentive to pay the whole debt. What's there to argue about?

    The first problem with the theory is it does not accurately describe borrower behavior. Many, many borrowers continue to pay their mortgage even when there is no equity in the property. Many, many income property borrowers come out of pocket to pay debt service on properties with no equity and which don't generate enough income to cover expenses. In my experience, the actual norm is, "Borrower's pay their mortgage regardless of property equity and cash flow until it becomes apparent they are going to run out of money (and sometimes longer)."

    Why would a borrower continue to spend money on an investment which has no value?

    • The borrower is not fully rational. There are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). We know these biases exist, and their existence helps explain seemingly irrational borrower behavior.
    • The borrower believes in honoring his or her obligations. That approach may be irrational for an isolated nonrecourse loan, or it might be rational if the borrower is thinking about ability to borrow in the future.
    • The borrower is rational and believes (incorrectly or correctly) that the property still has equity or will have equity in the future. Historically values have always recovered, and it's difficult to predict how long the recovery will take. Anyone who was around during the last significant income property downturn (1990-94) remembers the incredible fortunes that were made by the people who bought distressed real estate at the bottom, and no one wants to be the chump who lost his or her property right before the recovery. Most real estate investors are optimists willing to bet a recovery is just around the corner.

    If a borrower will pay his or her mortgage until he or she runs out of resources (and I believe that's the vast majority of borrowers), it doesn't matter if a loan is recourse or nonrecourse. The time of default is the same (when the borrower runs out of resources), and even if the loan is recourse there are no resources for the lender to go after once the borrower exhausts them.

    Of course, there are some borrowers who will default before they run out of resources; even if 90% pay until their resources are exhausted, 10% of all defaulting borrowers these days is a big number. What about them? For a variety of reasons, it usually does not make a lot of sense for lenders to go after such borrowers:

    • By definition, these borrowers are not "do the right thing" people (those people pay until they can't). Google "asset protection" and you will get 3.1 million hits, most of which seem to be law firms happy to help debtors avoid their creditors. The set of borrowers who are vulnerable to deficiency judgments are those with assets who are too stupid to protect them. This is a very small subset of all income property borrowers.
    • Lenders rarely get a clean shot at assets which are easy to execute upon. Defaulting borrowers tend to have encumbered assets and fractional ownership interests. Sure, you can execute your judgment against that 3% general partnership interest in that mortgaged strip center, but do you really want it?
    • The deficiency judgment process is usually unpleasant. Historically, mortgage foreclosures were time-consuming judicial proceedings that could take a year or more. Mortgage lenders lobbied, and almost all jurisdictions now provide a relatively quick non-judicial foreclosure mechanism for lenders to get their collateral (New York notably excepted, and there are others). However, if you want a deficiency judgment, you usually still need to go the slow judicial route. Often, part of this proceeding is a determination of collateral value. The borrower gets his appraisal, the lender gets theirs, the judge usually sets the value in the middle.
    • An almost guaranteed effect of seriously pursuing a deficiency judgment is a set of counterclaims from the borrower (lender liability, document deficiencies, etc.). On the one hand, these claims rarely have merit; on the other hand, responding takes time and money, and the downside is substantial.

    Back when I was chasing borrowers, our rule of thumb was to subtract our loan amount from what we thought the property was worth, divide by two (on the theory the judge would set the value in the middle), subtract $100K for legal fees, add a year to the process, and weigh that number against the assets the borrower is likely to have which we could execute on. The only times this equation made sense for us was when the loss was severe and the borrower had a non-real estate source of recurring income we could go after (for example, a doctor or dentist). There's some irony there; the default risk for borrowers not fully engaged in real estate is much higher, but they're the best candidates for deficiency judgments.

    To bring this full circle, to definitively answer this question you would need to match a pool of similar non-recourse and recourse mortgages and look at default rates and loss recoveries over the life of the pools. If recourse doesn't matter, the recourse pool will have a similar default rate and similar recoveries compared to the non-recourse pool. Given all the factors outlined above, I think that's what a well-designed study would show. But, I don't expect to see such a study, because income property lenders don't have the data to create similar pools. It would not be difficult to create similar pools based on collateral location, type, initial LTV and DSC, etc. However, if you accept the premise that borrower financial capacity is relevant to this question, there's a problem; income property lenders don't capture that data up front, so someone would need to go back through the original underwriting files for each loan. That's not likely to happen.