San Francisco, once considered one of the strongest commercial real estate markets in the country, had one of the largest increases in overall CMBS default rates in the second quarter of 2009, up 444 basis points to 5.15% (and yes, this was even worse than Miami). Detroit was still the worst performing market, with an overall CMBS default rate of 5.62%, up 562 basis points from Q1. However, San Francisco’s multi-family sector now has a CMBS default rate of 21.7%, which is almost double the 12.93% multi-family delinquency rate in Detroit.

The amazingly high default rate in multi-family is being driven by one just one buyer and a lot of brokers in nice suits. Well known for not only paying top dollar (over 20 times gross rents) but also for pursuing, shall we say, aggressive retenanting programs, this buyer actually pocketed 75% of all San Francisco apartment properties that traded in 2007. And who is surprised? At 20 times gross rent, anybody who wasn’t selling was living under a rock. About $1.2 billion was “invested” from 2003 through early 2008, financed primarily with two year, interest-only, cross collateralized debt complete with personal guarantees who’s your daddy now?

The answer is UBS, which has already taken back about 1,500 units, and CIM, which bought the senior debt on 24 properties from Credit Suisse. This is only the tip of the iceberg though, and so far only about 700 units have actually been sold to new buyers. San Francisco apartment brokers, who were only too happy to cheer 20 GRMs on the way up, are now complaining publicly about comps that are “artificially low”. Predictably, the view on that side of the fence is not that this guy overpaid, but that he simply over-levered! That aside, I’ll give you one guess where prices in San Francisco are heading:

Despite the mess in San Francisco now, the S&P/Case-Shiller Index for Bay Area multi-family prices shows a 10.83 percent growth rate from the year of its inception (1995) through 2002. Growth in prices was strongly influenced by the Bay Area’s healthy population growth, and as a result growth in Bay Area multi-family prices far outstripped the S&P/Case-Shiller Index for the top 10 metropolitan areas over the same period.

Unlike some cities in the Lone Star state, for example, where increased supply typically rises to the occasion, Bay Area multi-family prices have been influenced by a fundamental supply and demand imbalance even before the credit/real estate hysteria of 2003 through 2006. Between 1987 and 2002, the Bay Area population increased by 18 percent. The growth was fairly evenly spread over nine Bay Area counties, with Solano County having a growth rate of 28 percent, which was the highest growth rate in the area. The largest population growth in terms of total residents occurred in Santa Clara County, which added 301,000 people, followed by Alameda County and Contra Costa County, both of which added approximately 250,000 people. Combine that with natural and political barriers to unfettered new development, and Northern California doesn’t look so awful even in you’re a Bears fan.

Granted, the current San Francisco foreclosure saga is far more interesting than plodding through Bay Area demographic statistics. But when all those “artificially low” comps get set, is there any place you’d rather be with your money?

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According to RREEF Research (the research unit of Deutsche Bank’s alternative investment management business), the US apartment market faces “one of the most challenging and complex environments in modern history”, but also remarkably strong recovery prospects. RREEF sees a recovery in multi-family real estate starting sometime in 2011, and suggests that the recovery in apartments could be accompanied by “the strongest effective rent gains in history”.

The Shadow Market Media Myth

While the RREEF report did not specifically refer to what I call the “shadow market media myth”, the shadow market being being covered by today’s mainstream media is much less troublesome than the one that existed in anonymity five years ago.

Back then, applicants with bad credit were routinely being turned down for $600 a month apartments only to walk across the street for approval on a $350,000 first mortgages, no questions asked. These liar loans were also being doled just as fast as AIG could write credit default swaps on the underlying bonds. Nobody Carlton Sheets on crack! could resist.

This unprecedented combination of fear and greed propelled the U.S. home ownership rate to record levels:

While briefly pushing nationwide average apartment vacancy rates above 10% in 2004:

** The increase in vacancy rates in the 1980’s is partly due to tax laws which allowed passive loss deductions to offset earned income. The result was a mini-boom in syndications of real estate tax losses to individual investors. The Tax Reform Act of 1986 eliminated these incentives.

Naturally, all of this had a deleterious effect on the performance of apartment investments. RREEF’s 2009 US Real Estate Investment Outlook asserts that the process of unwinding this credit-induced housing distortion in is about to begin, and that it will coincide with several powerfully favorable trends for Apartment REITs:

• Employment growth in 2011 will enable huge pent up demand for apartments by “echo boomers” and residents who doubled up during the recession. RREEF estimates that these two population cohorts are comprised of 75 million people, or approximately 25 percent of the US population;
• Immigration, forecast to continue at an average rate of 1.8 million annually, will be a sustained driver of demand for multi-family rental housing;
• New construction of multi-family rental housing is severely constrained by lack of financing. Deliveries are forecast to drop below 1993-1994 levels, which will facilitate quicker stabilization of occupancies; and
• Reversion to historical rates of home ownership will continue as financing is constrained and job seekers prefer mobility in order to pursue employment.

Apartment REITs Should Outperform

RREEF estimates that the massive government stimuli will take hold by late 2010. As demand snaps back, the short-term nature of apartment leases will allow owners to raise rents quickly, and the recovery in rental rates and occupancy levels may be without parallel. This should position Apartment REITs as the best performing of the four major property-sector REITs.

Look For Apartment REITs With Low Leverage

But don’t look for all Apartment REITs to participate. Higher quality REITs will prevail as lower quality, highly indebted companies will fail or be purchased by stronger entities. REITs with the greatest risk of failure are those that are over-leveraged and exposed to weak markets. Weak metro areas are those with a severe housing imbalance in both for sale and rental product in tandem with the sharpest employment declines. These include Atlanta, Phoenix, Riverside, Jacksonville, Orlando and Tampa.

Look For Apartment REITs in Healthy Markets

Markets with the strongest prospects, in spite of some near-term pain, are Washington DC, Baltimore, San Francisco, Seattle, San Jose, New York, San Diego and Los Angeles. In general, RREEF says these markets were not excessively impacted by housing oversupply, but they will nonetheless experience some weakness due to continued expected job losses. In the longer-term, they should rebound with relative strength.

The Best Apartment REIT for 2009 includes a list of Apartment REITs by leverage level, including a sensitivity for increasing cap rates. Click here for a complete list of Apartment REITs, but avoid REITs paying dividends in stock.

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