Demographics Are Favorable

Demographic trends indicate that there will be some structural changes that should boost rental demand. These bode well for the multifamily sector.

• Parts of two demographic cohorts are expected to have strong effects on the rental market. The younger part of the Echo generation (ages mid to late 20s) and the older part of the Baby Boomers (ages mid 50s to mid 60s) are expected to have the greatest propensity to rent. The Echo generation has fully entered the workforce and is leaving home. Likewise, the largest portion of the Baby Boom cohort is approaching the "empty nest" phase, and many are seeking a more maintenance-free lifestyle, such as luxury rentals.
• The United States population is more transitory as corporate restructurings and new technologies provide incentives for workers to go where there is action.
• Immigration growth will have a distinct impact on the apartment industry. Immigrants account for 10 percent of the U.S. population and immigrants are more likely to rent. Rental apartments are the first housing for many immigrants. In particular, urban markets such as California, Florida, New York, New Jersey and Texas, where immigrants are a significant part of the apartment market, will be affected.

Diverse Capital Sources Help: Government- Supported Funding

We view access to multiple capital sources as a distinct credit positive—particularly under the REIT format, which constrains cash retention. Apartments have an advantage over other property types through their access to low-rate, tax-exempt financing from municipalities and quasi-governmental agencies. A drawback is that these facilities are oftentimes secured, thus tying up assets and decreasing financial flexibility.

REITs can access the public finance capital markets for affordable multifamily housing, or in some cases apartments with mixed market rate and affordable housing components. Affordable housing, which targets residents in low- to moderate-income brackets, is housing with lower rents and is generally funded with creative financing. This may be achieved through the use of tax-exempt bonds, low-income housing tax credits (LIHTC), government grants or subsidies, U.S. Government or Government-Sponsored Enterprise (GSE) insurance and guaranty programs, or some combination of the above.

Affordable multifamily housing bonds can be secured with loans that are either insured or guaranteed, or loans that are uninsured, the latter of which is considered to have more risk. Loans can be insured or enhanced in several ways. GNMA, a wholly owned instrumentality of the United States within the Department of Housing and Urban Development (HUD), and the GSEs—Fannie Mae and Freddie Mac—each offer loan enhancement products which can result in a Aaa rating on the bonds, resulting in lower capital cost for affordable housing investors.

HUD offers a variety of insurance programs as well. The FHA risk-sharing program, issued in conjunction with state and local housing finance authorities (HFAs), generally can achieve a Aaa rating, while traditional FHA insurance, due to timing and process concerns, is likely to be rated Aa2. Finally, an investor can obtain enhancement on the bond itself through a bank letter of credit, bond insurance, or through the general obligation of a sponsoring HFA. These issues will carry the rating of the provider enhancing the debt.

Financing "pure affordable" housing (uninsured or unenhanced) is also an option. We believe that there will be significant growth in this type of housing as a result of the limited availability of rental subsidies, the federal trend towards privatization of the housing market, and the strong demand for affordable housing in the United States.

In response to this trend, Moody's is offering an approach to rating affordable housing bonds, which focuses on the property's historical and projected financial performance, as evidenced by its debt service coverage ratios and sensitivity to various market conditions. In addition, there are other non-financial elements that also factor strongly into Moody's rating process, including the physical condition of the property, the market demand for the product, and the property's ownership and management. Moody's will look to some form of liquidity facility, typically a letter of credit (LOC), to be in place during the construction phase and up through stabilization. We believe that this approach best captures both the financial strengths of these properties as well as the real estate risks associated with uninsured and unsubsidized multifamily rental properties. Ratings for this type of bond are generally in the Baa to A category.

GSEs Credit Facilities Available for Housing

In addition to providing credit enhancement for multifamily tax-exempt bonds and LIHTC transactions, both FannieMae and Freddie Mac provide credit facilities for apartment REITs. These GSEs have ample access to funds and are robust sources for apartment financing—sources other property types do not have. These credit facilities are secured—a drawback for unsecured bondholders.

There is a concern among analysts that apartment REITs may boost overall, and secured, leverage through tax-exempt and GSE financing, weakening long-term financial flexibility for transient gains. This concern is mitigated, however, by the attractive cost of capital from these sources, and their typically long maturities. Nevertheless, Moody's does not believe that many apartment REITs will pursue shortsighted funding strategies.

Liquidity Protects Portfolio and Cash Flow Quality

Owners of institutional-quality apartments have the added advantage of the substantial liquidity of their assets. Multifamily projects typically are small in size, which generally results in a greater universe of potential buyers. Even underperforming assets have appeal to investors who have an interest in converting market-rate properties to affordable housing, using the financing strategies described above.

Technology Wins for Multifamily REITs

Evolving technology bears a relatively modest threat to the multifamily sector, which has a strong necessity factor, and whose physical format has (so far) accommodated technological advances. Multifamily REITs have been successfully embracing technology to enhance operating margins, meet tenants' evolving demands, and to generate ancillary revenue, all of which improve the bottom line. The leading multifamily REITs have been at the forefront of using technology to automate and improve operations such as:

• Online revenue management, lease processing, and credit review systems, which adjust pricing to meet market conditions, standardize leases and accelerate the review and approval processes.
• Automated facilities management, which increases productivity and shortens tenant response time.
• Integrated property management systems, which connect the maintenance, budgeting, tenant receivable and cash management processes.

Highly innovative multifamily REITs are looking at new ways to take advantage of the vast number of tenants who are captive audiences, providing opportunities to generate additional revenues from sponsorships and strategic alliances with utility vendors, broadband companies, and other service providers. Utilizing taxable REIT subsidiaries, joint ventures and other means, Moody's expects apartment REITs to generate material strategic traction through technology.