So, when, if ever, will things get back to normal in this sector? Long-term demographic trends point to the return of multifamily assets as a stable performing asset class, perhaps as early as 2005. But in the meantime, challenges linger as the outlook continues to be negative.

It will be some time before we will begin to observe improvement in profit margins, cash flows and credit profiles. To date, most multifamily REITs have preserved ratings by carefully managing their balance sheets and being prudent with cash flow planning even as they safeguard franchise value, but the available cushion is being eroded as the industry awaits a full recovery.

A Fragmented Sector

There are inconsistent trends in the multifamily sector—an extraordinarily competitive acquisition environment even as fundamentals deteriorate; and increased supply without any evidence of near-term demand growth. These are some of the factors that will dampen the recovery of the multifamily sector even when the economy improves and job growth resumes.

The multifamily sector is more fragmented than the other property sectors, which has resulted in a somewhat unique reaction in this real estate cycle. The multifamily sector continues to be faced with increasing supply, even as demand retrenches. The good news is that with a drop in demand, in most sectors, the capital available for additional supply growth was quickly and substantially limited; unfortunately that was not the case for the multifamily sector.

As the public real estate markets have emerged, capital and pricing have also become more efficient, responding to the wealth of information that is now available in the marketplace. This has typically served to restrain capital to property sectors experiencing supply/demand imbalance and dampened the volatility of market cycles. This has not been the case for the multifamily sector where a substantial portion of investment quality assets continue to be held by private firms and entrepreneurs who have different investment objectives and return hurdles than institutional investors or public real estate firms. Low interest rates and additional sources of cost-effective financing, provided by the GSEs (Fannie Mae and Freddie Mac) and municipal and other governmental programs seeking to enhance housing objectives, continue to be available.

Single-Family Competition

The robust single-family housing market has had a disproportionately negative impact on REITs because of their concentration in higher end Class-A assets, which differentiate their product and enhance their competitive position. During more stabilized periods, these projects were able to command some of the highest rents in their respective markets, attracting not only higher credit quality renters, but in many cases tenants who were renters by choice.

With historically low mortgage rates, the rate of growth in housing prices, and disappointing returns for alternative investment options, single-family housing demand has been soaring. Many of the recent entrants into home ownership were once renters in Class-A properties. In some cases, the growth in first-time homebuyers has impacted demand for Class-B assets. With the combination of low interest rates and the GSEs’ aggressive pursuit of their housing goals, the expansion of home ownership is likely to continue.

Rising house prices and concerns about increased single-family delinquencies will likely temper housing sales somewhat, but not enough to return to historically robust multi-family rental demand levels in the near term.

The drop in demand could also have impacted the credit quality standard accepted for the available renter universe leading to possible delinquencies and future problems, making the monitoring of tenant credit quality of even greater importance. As a result, the portfolio of apartment firms, particularly those with luxury Class-A assets concentrated in markets with reasonable home ownership affordability (including Denver, Atlanta, Dallas and Austin) should be slow to recover.

Stressed Profitability and Cash Flows

Declining rental rates and increasing concessions have reduced top-line growth for multifamily REITs, but the pressure on margins and cash flows have been made worse by increasing expense levels and the need to protect long-term franchise and asset value. As market fundamentals began to deteriorate, multifamily REITs were not only faced with reduced pricing power but also the resulting impact of other macro factors which served to materially increase the cost of property insurance and taxes in just about every market.

REITs have been diligent in being cost effective on the timing and level of capital expenditures, but it is critical that companies maintain asset value as it ultimately affects long-term prospects. Furthermore, expense management strategies can be limiting as many higher-end assets or branding strategies that differentiate a REIT’s product have higher servicing and fixed-cost components, such as doorman or concierge-type services and higher-end maintenance of common areas.

Residential
# of REITs	25
Market Cap.*	$33,538,930
Industry Market Cap.*	$194,767,531
% of Industry	17.2%
Yield	6.6%
YTD Total Return	16.4%
One-Year Return	13.2%
Three-Year Return	8.1%
Five-Year Return	11.6%
Average Daily Trading Volume (shares)	4,336,941
Weighted FFO Growth (First Quarter 2002–2003)	-12.24%
*These figures represented in thousands. Data as of July 31, 2003. Source: NAREIT.

Having gone into the downturn with solid credit profiles and good capital access, most REIT management teams have been attentive to sustaining the balance sheet, even as they endeavored to maintain credibility with the equity market with stable dividend payments. But credit profiles are deteriorating, reflecting the stress of operating fundamentals, and cash flow needs. Effective leverage (debt and preferred stock as a percentage of gross assets) has been increasing. Despite paying off more expensive preferred stock and increasing variable rate exposure, fixed charge coverages have been weakening. More recently, to conserve retained cash flow and eliminate the likelihood of borrowing to pay dividends, some REITs—including Associated Estates Realty Corporation (NYSE: AEC), Post Properties, Inc. (NYSE: PPS), and Summit Properties Inc. (NYSE: SMT)—have taken steps to reduce dividend payments.

However, a meaningful recovery for multifamily REITs will not occur in the near term, and for some REITs it will be difficult to retain their existing ratings should there be additional shortfalls in cash flows or deterioration in credit profiles.

Despite current conditions and short-term concerns, Moody’s continues to favor multifamily as a stable asset class over the medium to long-term. Medium-term demographic trends are more encouraging due to the entrance of a large population of renters between the ages of 19–25 over the next several years. These numbers further support demand growth of Class-B apartments, which should buoy the sector overall in time. Class-A properties will be slower to react to demographic trends.

Top 15 Multifamily REITs (Ranked by Equity Market Capitalization)
Company Name	Ticker	Market Cap ($ Millions)
Equity Residential	EQR	$7,072.4
Archstone-Smith	ASN	$4,371.4
Apartment Investment and Management Company	AIV	$3,246.6
AvalonBay Communities Inc.	AVB	$2,875.0
United Dominion Realty Trust, Inc.	UDR	$1,934.2
BRE Properties, Inc.	BRE	$1,528.2
Camden Property Trust	CPT	$1,373.0
Essex Property Trust	ESS	$1,203.2
Post Properties, Inc.	PPS	$989.8
Home Properties of New York, Inc.	HME	$981.4
Gables Residential Trust	GBP	$743.0
Summit Properties, Inc.	SMT	$557.7
Mid-America Apartment Communities, Inc.	MAA	$483.4
Cornerstone Realty Income Trust	TCR	$399.3
AMLI Residential Properties Trust	AML	$396.4
Source: NAREIT. Data as of June 30, 2003.

Arlene Isaacs-Lowe, CPA, CFA is a senior vice president in the Real Estate Finance Team of Moody’s Investors Service.