Seeing Patterns Where There Are None: Geography

Humans are wired to detect patterns, but sometimes there isn’t one. For example, what distinguishes the best and worst performing submarkets in Orange County?

You might focus on geography first; the real estate mantra is location, location, location. Are the best and worst performing submarkets concentrated in a particular area?

Here’s a map, with the five best performing markets (as measured by combined occupancy and rent change) highlighted in green, and the worst ones in red:

Looking at this, you would have to conclude there’s not a pattern; the best performing and the worst performing markets are pretty will mixed up.

The data is for the first quarter 2009 from RealFacts, as reported by Lansner on Real Estate.  Here’s the chart accompanying the story; can you find a pattern in the occupancy and rent changes?

Occupancy and Rent Change News Can Mislead You

When you see a headline saying rents or occupancy in a market has declined, you need to remember you need to consider both rents and occupancy to understand what’s going on.  Lansner on Real Estate reports multifamily rents and occupancy are declining in Orange County, based on a RealFacts first quarter survey. The chart accompanying the story illustrates my point:

Which is the best performing city? Which is the worst?

A few seconds spent trying to answer this question makes it clear; you need to consider both rent and occupancy trends to arrive at the right answer. Costa Mesa is the best performing city, because even though its rent decline was one of the worst, that decline was more than offset by the improvement in occupancy. Placentia was the worst performing market; even though neither its rent nor occupancy decline was the worst, on a combined basis its performance was substantially worse than the other cities.

You might think that occupancy and rent levels move up and down in tandem, and usually you would be right. However, there are actually four possibilities:

• Your occupancy goes up, but your rents go down (see Newport Beach and Costa Mesa). This can happen if you reduce your rents and attract more tenants.
• Your occupancy goes down, but your rents go up (see Buena Park, Laguna Niguel, Garden Grove, and Cypress). This can happen if you raise rents but drive tenants away.
• Your occupancy goes up and your rents go up (no place in Orange County this quarter). This happens in tight markets which are seeing tenant growth in excess of supply additions.
• Your occupancy and rents both go down (all the other Orange County places in the table). This happens when there are fewer tenants in a market (the case almost everywhere today).

So, when you read about a decline in either rents or occupancy, remember you need to consider both in order to understand what’s going on.

Problems Mounting in Orange County Multifamily

Lansner on Real Estate reports it’s taking twice as long to rent vacant units in Orange County, rents are falling, vacancies are rising, and landlords are looking the other way on tenant credit issues and cutting back on maintenance.

None of this is surprising; all these things go together in a softening market. But, it’s nice to see an article which puts all the symptoms of a soft market in one place. For more on the relationship between rents, vacancy, and turnover time, see Multifamily Occupancy Rates: Four Things to Think About. For a discussion of the nasty feedback loop cutting tenant credit standards and maintenance creates, see The Slippery Slope to Default.

Where Do Tenants Go in a Down Market?

Everyone knows multifamily vacancy rates increase during a recession. Where do these tenants go for housing?

I’ve not seen any studies on this topic, but the obvious explanations are they move back in with families (children back to their parents, parents and grandparents move in with their children), and doubling up (unrelated households combine to share space). And, some drop out of the housing market altogether. Here are some links to stories which explore what’s happening this time around:

Rooms for Rent. From the Seattle Times, In tough times, the rented room is resurgent:

Because most of the arrangements are informal, it's hard to assess just how many people now share their homes with strangers for money. But as the economy plummeted during the past year, mortgage foreclosures soared and layoffs became common, the ads for people seeking roommates increased by more than 70 percent nationwide on craigslist.com.

Homeless Shelters. From TimesOnline:

Joan Burke, director of advocacy for the homeless charity Loaves and Fishes, said: “The folks we deal with typically are the working poor. But right now the economy is in such turmoil that it is affecting a new layer of middle-class earners - construction workers, farm labourers, retail workers, restaurant staff.

Shantytowns. From the New York Times, Cities Deal With a Surge in Shanty Towns:

While encampments and street living have always been a part of the landscape in big cities like Los Angeles and New York, these new tent cities have taken root — or grown from smaller enclaves of the homeless as more people lose jobs and housing — in such disparate places as Nashville, Olympia, Wash., and St. Petersburg, Fla.

Squatting. From Slate, Homesteaders in the HoodSquatters are multiplying in the recession—what should cities do?:

As the current recession picks up speed, we are again confronted with the ingredients for a squatting boom. Unemployment is closing in on double digits nationally, and homelessness is on the rise. Between late 2007 and late 2008, the number of families presenting themselves at homeless shelters in New York City increased by 40 percent. In Massachusetts during the same period, the statewide increase was more than 30 percent. At the same time, housing vacancy rates are at all-time highs. According to the Census Bureau, about 15 percent of housing units in the United States were vacant during the last quarter of 2008. That's 19 million homes sitting idle, largely in the hands of banks. The difference between the 1970s and today is that the crisis last time was focused on the urban centers, while this time around the suburbs are the site of the greatest mismatch between people without homes and homes without occupants.

And so, the squatters are squatting.

Commercial Property Values Down 50%?

The Royal Institute of Property Surveyors says the value of commercial properties in the UK will fall by more than 50% by the end of 2010 (see Guardian article here). Is that forecast plausible? Could it happen here in the US? The answer to both questions is yes.

Income property value is a function of the cash flow it generates. The cash flow has the following components:

• Gross Potential Income (GPI) – This is the total rent the property generates if it is 100% occupied.
• Vacancy/Collection Loss/Concessions – This is a deduction for any unleased space, bad debt, or discounted rent.
• Effective Gross Income (EGI) – GPI less Vacancy/Collection Loss/Concessions
• Operating Expenses – Expenses related to property operations The usual categories are real estate taxes, insurance, utilities, repair and maintenance, management fees, payroll, administrative expenses (advertising, telephone, etc.), and a reserve for capital items.
• Net Operating Income – The EGI less Operating Expenses.

The value of the property is the capitalized value of the NOI, and is determined by dividing the NOI by a capitalization rate (cap rate). The cap rate is the annual rate of return on an all cash purchase of the property. You determine the applicable cap rate for a property by looking at the cap rates of comparable properties which have recently sold in a project’s market (more here if you are not familiar with cap rates).

Here’s an example:

What does it take to produce a 50% decline in the value? Let’s say rents fall 10%, vacancies increase to 15%, operating expenses increase to 55% of EGI, and cap rates increase to 7%. Here is the math:

How plausible is it that such declines and increases will occur? Very plausible – all such changes are well within the shifts which have occurred in previous severe recessions.

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?

Possibilities:

• 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.