Marcus & Millichap
Both private and institutional investors wait on the sidelines to acquire distressed loans and properties within the student housing sector.
Dorothy Jackman, Travis Prince & Peter Katz
Marcus & Millichap
Both private and institutional investors continue to eagerly wait on the sidelines to acquire distressed loans and properties within the student housing sector. Opportunity funds specifically targeting distressed assets have modified investment parameters to seek solid cash-on-cash returns and institutional rates of return (IRRs) in the high teens to low 20s, while becoming increasingly convinced that the market will deliver similar transactional velocity as in the Resolution Trust (RTC) days. However, due to securitization over the past 5 to 7 years, the volume of distressed assets to reach the marketplace will be delayed because of the “extend and pretend” methods employed by lenders and servicers hoping for a pricing rebound. As capital continues to wait for investment opportunities that meet their acquisition criteria, each REO asset, short sale or loan sale offering is met with unprecedented buyer demand and offer activity.
During the recent asset pricing bubble, one of the most striking trends was ownership shifting from traditional operators to speculative investors seeking opportunistic returns based not on fundamentals, but on asset-price appreciation and fee generation. Since debt and equity has become significantly more difficult to secure, transactions are now based on fundamental underwriting with seasoned operators. Buyers who purchased at the height of the market may have a more difficult time sustaining solid operating performance through this down cycle. As softness in certain markets becomes more prevalent, the quality of the operator becomes increasingly critical to a property’s success.
Student housing has largely avoided the levels of distress seen in other property classes, including retail and hospitality assets. One of the sector’s greatest benefits was the defined leasing season enjoyed during the last cycle. Leasing for the academic year of 2008-2009 ended in August 2008, just ahead of the Lehman collapse and the financial calamity that ensued. As a result, student housing owners were largely unaffected on a current cash-flow basis. In addition, only 3.8 percent of the student housing assets sold from 2005 through 2008 were considered distressed, compared to 6.7 percent of the total multifamily market, further demonstrating the strength of student housing.
Special servicers are primarily concerned with the 2009-2010 academic leasing season because cash-flow problems for challenged assets have begun to emerge and could be remain problematic through 2011. Since many of these properties were barely covering debt service in 2009, even a slight drop in rents and/or occupancies could push debt coverage ratios well below 1.0. In many markets, these drops are dramatic, especially for poorly located assets.
Provided this comes to fruition, there may be more transactions similar to the 2008 Marcus & Millichap closing of a $36 million student housing portfolio sale – one of the year’s largest. Located throughout the Midwest, the four properties have 800 units and approximately 3,000 beds. The assets were constructed between 1998 and 2002.
The wholesale drop in prices at the exit of an asset-pricing bubble is a condition for returning to a normally functioning market. Today’s capital stacks demonstrate that lenders are effectively in control of most assets that traded in 2004 through 2008. Even if the government is able to provide stimuli resulting in increased asset values it is unlikely that financing proceeds will reach the levels necessary to satisfy existing debt loads in the foreseeable future. With the use of pro forma rents and occupancies a thing of the past, LTVs, cap rates, rents and occupancies could return to more normalized levels and adequate financing proceeds may still not be realized.
Unless forced to sell or absent other motivating factors, owners have elected to hold while buyers believe that market dynamics will support lower prices. The resulting bid/ask disparity has caused transactional velocity within the student housing market to drop more than 50 percent in 2009. Until there is clearer evidence of recovery and stabilization, the expectation of lower prices will persist. The bid ask gap will narrow and velocity will return as distressed assets clear the market, creating pricing transparency and a new equilibrium from which to build, while yield expectations moderate due to a lack of investment alternatives.
Amid all the challenges, student housing remains a viable long-term investment alternative due to the shortage of on-campus housing provided by U.S. universities and the demand of the echo boomer generation driving college enrollment. Well located assets with strong performance history continue to draw attention from the investment community and the number of seasoned, well capitalized investors interested in student housing has grown as other asset classes provide less attractive alternatives. While the sector is not immune from softening, it offers a growing niche of recession resilient, risk-adjusted returns for investors and savvy operators.
— Dorothy Jackman, is vice president, investments and Travis Prince, is a senior associate in the Tampa office of Marcus & Millichap Real Estate Investment Services. Peter Katz is a senior vice president in the firm’s Phoenix office. All three collaborated on this article.