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The ABCs of apartment lending.

The first 18 months of the 1990s have given real estate lenders a sobering new perspective on the underwriting rules that prevailed in the 1980s. Many are discovering that no apartment loan is a sure thing and that even the glittering gold of the "A-grade" properties in their portfolios may be merely fool's gold.

Those who think A-grade properties make the best loan collateral should think again. In some markets, "As" face the most competition and pose the highest lender risk. Quality loans can be structured for "A," "B" and "C" properties. Each grade of property, however, poses distinct risks that must be considered.

To underwrite apartment loans in the 1990s one really needs to know the "ABCs"--or, in other words, the basic fundamentals of each property. The underwriting of any income property mortgage is not merely a matter of running numbers; it is understanding and addressing the strengths and weaknesses of properties and structuring the appropriate financing.

All transactions require the usual review of the building and checking the integrity of systems such as heating, electricity, security, and so forth, as well as examining the location, the borrower's credit and the management's expertise. Different property types, however, generate a variety of underwriting concerns.

This article deals with the various non-numeric concerns of multifamily underwriting by classifying properties into three investment grades: "A," "B" and "C." Admittedly, that is a bit clumsy, but it is a very common system. Lenders use the "ABCs" when speaking among themselves, but they may not all be speaking the same language. Therefore, before examining the risks and concerns of each grade of property, it is necessary first to arrive at some common definitions.

While these definitions were developed from a national perspective, keep in mind that all real estate is local. There may be a local factor that clearly distinguishes grades. As an example, in Austin, Texas the local market considers any property without a washer/dryer hook-up to be a B-grade or lower. The following definitions are a starting point from which to add local factors. To define "As," "Bs" and "Cs," one must look at tangible and intangible characteristics. The main factor may not be physical plant, but rather the market's perceptions. Table 1 summarizes the characteristics of each investment-grade property

Grade A

In the 1980s, an A-grade apartment was defined as a property where "yuppies" would be proud to park their BMWs. In the 1980s, however, underwriters have been forced to become more sober-minded and need to take a closer look at the specific defining qualities of these properties.

Certain factors are obvious. An A-grade property must be in an "A" location where affluent people wish to live. Occasionally, a developer will pioneer a new "A" location, selecting a site away from other "As," surrounded by quality employment, shopping and services. Until the location is proven, lenders should be careful. A-grade developments in "B" locations are actually "Bs," because they struggle against the market and have difficulty sustaining a top market position as they age.

Not all A-grade properties are new. A-grade, suburban, garden apartments must generally be new, but infill urban-elevator buildings, (multi-story buildings with elevators that are constructed on empty lots in fully developed areas) may preserve their "A" status by maintaining a youthful, effective


age. This is only possible when the unit mix and design are not dated or the property enjoys a special cache.

A-grade properties compete among themselves on amenity packages and location. The resident is looking for a specific style. Tenants is looking for security and commuting ease will not trade off for an indoor pool and vice versa. Residents are generally tenants by choice, meaning that they could purchase housing, or they have purchased housing in the past. A-grade properties attract persons of the highest income and employment status.

Suburban, A-grade properties provide a full package of amenities: pool, tennis, weight rooms, clubhouses and so on. Urban-elevator "As" are more service-oriented, offering valet, security and other amenities, depending upon the size and location, and they may or may not have physical amenities. Obviously, a full amenity package requires a large number of units to absorb the expenses.

Grade B

Sears, Roebuck and Company sells three grades of appliances and tools: 'good," "better" and "best." Borrowing from their lexicon, B-grade properties are of the "better" variety. They may be dated properties in superior locations or newer, full-amenity properties in less-desirable locations. This tradeoff between location and age may actually create distinct B markets.

The location-oriented B-grade property provides clean, comfortable housing in a very desirable location. The interior amenities of the location-oriented B-grade apartment are generally equivalent to a property considered an "A," but the "B" may be a bit older and may offer fewer common amenities and services.

The B-grade apartment with the emphasis on amenities, on the other hand, offers the full range of such features and in many cases was originally built as an "A," but time may have robbed the place of some of its luster. There are new B-grade properties in quality, suburban locations but not the best neighborhoods. While it is impossible to have an older, suburban "A," it is equally impossible to have an older, suburban "B" without amenities. Generally, only new B-grade properties can survive without amenities.

The residents of B-grade properties include both tenants by choice and tenants by necessity. Tenants by choice may be living slightly under their income in order to save money to purchase a home, while tenants by necessity are living for today. A broad cross section of the population can be found in G-grade properties. White, gray and blue collar persons are all included in this group.

Grade C

To many, "C" means clean. A C-grade property offers clean, generic housing. It is rare to find a C-grade property in a prime location, but if you do, it is by default. That "C" could be a "B" if the utility systems and fixtures were brought up-to-date. Rehabilitating C-grade properties to B-grade for the added value is commonly done in tight markets. Updating the HVAC (heat, ventilation and air conditioning) system where central air is important because of weather patterns, or replacing the kitchen and bath fixtures may move an otherwise sound C-grade property up one grade.

Most "Cs" however, cannot be raised to "Bs" because they usually possess some fatal flaw. The C-grade property may have obsolete floor or site plans. In other words, replacing olive green kitchen appliances will not fix a motel-type layout; small, dark kitchens; or an inferior location.

While there is a wide range of C-grade properties, they compete on price. The residents are primarily tenants by necessity. Renters in these properties may pay a small premium for location or fixtures, but assuming all the properties are safe and clean, they shop for price. C-grade properties are almost always older. Only a limited number of new properties are built as "Cs," given the difficulty in supporting new construction costs with generic rents.

There are D-grade properties and F-grade properties, but these are not generally conventionally financed, and will not be covered by this article.


An A-grade property survives on image and lifestyle. Any condition that impairs that image, or reflects a lower quality lifestyle, is a fatal flaw. An owner who moves a model unit to a less-preferred location in order to lease the model unit with a view, has detracted from the lifestyle presented to new residents. The marketing of A-grade properties should be based on lifestyle, not price. Any price-based marketing indicates a potential weakness in the property or market.

Deferred maintenance tarnishes a property's image. The maintenance staff should be of sufficient size to cope with maintenance problems immediately, and the entire property should be under a regular redecorating plan.

Since A-grade properties compete on amenities, the underwriting process should carefully consider the amenity packages at comparable properties. An A-grade property may survive without a specific amenity during a tight market, but the absence of one critical amenity may be a fatal law during weaker demand periods.

The demand for A-grade rental properties overlaps with the demand for owner-occupant purchases. When interest rates fall, the demand may shift toward ownership if the price difference between owning and renting in the particular submarket is not significant. Therefore, the cost and price stability of condominiums, co-ops and single-family homes in the immediate area is an underwriting concern. A-grade properties are safer in markets where the cost of homeownership is high, or the ability to resell is uncertain.

While the pool of the potential renters for A-grade properties will shrink as interest rates decline, the market also shrinks during recessions. Residents, by choice, may move down to B-grade units as their real or perceived economic conditions decline. The strength and diversity of the market is critical for "As."

The pool of tenants by choice is comparatively thin. Calculating the potential for developing new, competing properties is, therefore, necessary for "As." This issue is generally resolved in urban locations by the shortage of available sites. In developing suburban areas, no such protection exists. Even if there are no A-grade properties in the planning stage, the mere existence of quality, available land presents a threat to potential properties that strive to maintain their current status. More conservative economic assumptions should be used in these cases.

Where the supply of A-grade properties is limited, owners will find that their residents are the least sensitive to upward price pressure. Once again, tenants who have chosen to emphasize quality of lifestyle will pay increasing prices to maintain that lifestyle.

Because slipping into the "B" category impacts the ability to raise rents, and may raise cap rates, the site plan and architectural style of an "A" must have staying power. Many lenders believe that brick units have that staying power and use brick work as a proxy for it.

In many markets, the owners of A-grade properties have developed brand names. The residents perceive a level of quality based on the ownership and management. The perceptions of residents toward developers may differ significantly from the perceptions of lenders toward developers. Lenders are looking for a developer with a strong track record and financial strength, while residents look only at the reputation of the properties in the developer's portfolio. "An A-quality sponsor is required for 'A' properties," according to Brian Stoffers, first vice president of CB Commercial Real Estate Group in La Jolla, California. "The owner must be willing to put money back into the property to maintain its status."

Mark Ebersold, vice president of METMOR Financial, an Overland Park, Kansas-based subsidiary of Metropolitan Life, believes that "A-grade properties can be classified in two ways: new or one- to five-years-old and consisting of luxury high rises and four-story walk-ups with stick construction and brick exteriors. Location is critical for the garden complex to maintain the staying power of an 'A' property. In addition, there are two aspects of sponsorship that are crucial: owner management or reputable free management and owner liquidity. We prefer owner-managers that are proactive on maintenance rather than reactive. In addition, if there are any signs of troubled properties in the owner's portfolio, it will impact the lending parameters and loan dollars."

Nationally, the safest property type for lenders is generally the B-grade. In good times, residents of "Cs" move up, and in bad times the residents of "As" move down. Farris E. Richardson, vice president of the Keenan Companies of South Carolina believes that "many investors that start out looking at 'A' properties end up buying 'B' properties because they pencil-out better. The rents necessary to support the high unit cost of 'As' just may not be possible to obtain over the short run."

B-grade properties can maintain their position as long as the neighborhood stays desirable and the fixtures and systems are kept up-to-date. For these properties, the owner's willingness and capacity to replace shortlived components regularly is vital.

The slide down to a "C" generally begins with deferred maintenance or some other cost-cutting effort. If the owners are primarily managing the expense side of their income statement--watch out. Some signs to look for include removing or downgrading fixtures rather than replacing them with quality units, closing amenities because "the tenants do not use them" or transforming public rooms into storage areas and replacing dated, shortlived components such as appliances or carpets on an as-needed, rather than a scheduled, basis.

The B-grade property that depends on its location for its status has less risk than the B-grade property that depends on its amenity package. Obviously, a "B" surrounded by "As" has a superior position to a "B" surrounded by "Cs." The amenity-based "B" is struggling against, rather than with, the marke.

Even the "B" surrounded by "As" in a suburban location has potential market problems if quality building sites are still available. The market can only absorb so many A-grade units. Excess capacity results in a price reduction among the "As" that crowd out the "Bs."

Mike Fisk, manager of the Washington, D.C. region for General American Life, St. Louis, prefers to make "A-quality loans on B-quality apartments. General American is a lending institution that is more yield-driven and cannot be competitive enough to lend on "A" quality properties. We are looking for good-quality, class 'B' properties that are 10- to 20-years-old, well-maintained, have excellent locations, positive operating histories, excellent sponsorship and we will underwrite using conservative financial forecasts for the future. Because we can get a higher yield for 'B' properties, it is one of the best, low-risk investments today."

The key underwriting criterion for C-grade properties is strong "hands-on" management. The residents who select "Cs" by necessity are looking for clean, comfortable and hassle-free housing. Because there may be little income differential between these residents and those who are less concerned with their housing environment, tenant selection and management is vital.

All rental housing complexes of any size are, in fact, communities. They develop community reputations that are well-known by the potential resident pool. Strong management is required to guide the reputation of "Cs." Strong management includes extensive tenant screening, aggressive rent collection practices and a proactive stance toward tenant relations. On-site staff capable of marketing units and fulfilling these management responsibilities can be difficult to find.

It is easy to fill a "C" for the short run by disregarding tenant screening. However, in the long run, such neglect will degrade the property. Once a property has developed a bad reputation, it is very difficult to bring it back. According to Keenan Companies' Richardson, "Leasing for the sake of leasing will kill you every time. 'C' properties only survive through intensive management: screening of residents, curb appeal and maintenance. This philosophy flow from the owner through the property manager right down to the on-sight staff."

Older utility systems and short-lived components found in older C-grade properties result in highly variable operating expenses that use a significant portion of the collected income. Given the price competition normally associated with C-grade properties, growth in these expenses cannot always be passed through to the residents. This fundamental conditin requires more conservative underwriting

The potential need for replacing broken systems presents a stronger liquidity requirement for the borrower. This need may be limited by fully funding a replacement reserve account. Certain components, such as elevators, boilers and roofing, cost so much to replace that the initial deposit to the replacement reserve or lender holdback will be a significant portion of the mortgage.

Even with these reserves, the expected useful life of the building may be less than 25 years and may require structuring for a shorter amortization or a fully amortizing term.

Older properties also are more prone to contain environmental hazards, such as lead paint, underground storage tanks, radon, lead solder and asbestos. The potential cost of rectifying these problems msut be offset against the value of the property in structuring the loan.

Furthermore, older properties are likely to be out of conformity with current zoning. For instance, in the event of damage due to a fire or hurricane, the current zoning may only allow for partial rebuilding of the property. Thus, the current income stream may not be replaceable in the event of hazard damage.

The underlying strength of a C-grade property is that it generally has the largest available market of a potential residents. Furthermore, this abundant pool of potential renters will remain a constant factor. The possibility of losing a large portion of the tenant base is highly unlikely because, as stated earlier, C-grade properties generally compete on price, and there is little likelihood or incentive to build new C-grade properties.

Although competition from new properties has not traditionally been a concern, in some markets, however, properties financed with low-and-moderate-income tax credits may compete for this C-grade property tenant base. Reasonably priced, multifamily sites in close proximity to the property should be considered as potential competition if tax credit deals are viable in the market.

The one fundamental principle that is apparent throughout the entire underwriting process is that all real estate is local. Each market has its own grading keys. The underwriter must detect the key qualities in a given market that classify each property.

Once a lender has examined the property's physical condition, amenities, marketing methods and location to determine its grade, and then reviewed the underwriting concerns appropriate for that grade, then, and only then, is it time to pull out the calculator and proceed with the loan.

Bruce A. Carlson is vice president of The Patrician Financial Company in Bethesda, Maryland. Kari Diehl has been involved in the acquisition and financing of multifamily properties for 12 years.
COPYRIGHT 1991 Mortgage Bankers Association of America
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:underwriting apartment loans by classifying properties into three investment grades
Author:Carlson, Bruce A.; Diehl, Kari
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
Previous Article:Apartment lending after the boom.
Next Article:Houston has returned.

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