Softening Markets and The K
Factor
 Softening markets and declining rents are of major concern
to multifamily lenders. I'm sure you're aware that this phenomenon
has been occurring in many apartment markets across the country.
Softening markets and declining rents are found in the form of
increased vacancies, rent concessions, and/or lower effective base
rents. Softening markets usually begin with increased vacancies, and
rent concessions resulting in lower effective base rents. Finally,
lower asking prices and property values ensue. While higher
vacancies, rent concessions, and declining effective base rents are
found in some markets, paradoxically, the asking prices and property
values maintained a status quo. With low interest rates and few
investment alternatives, multifamily remains a very popular
instrument to market participants.
Our view, with overabundant capital chasing too few deals is that LTV's
might currently be maintained, but DCR's are declining. The concern is
that other investment types improve, capital flowing into multifamily will
slow down causing the prices and values to destabilize (potentially
decline), thereby increasing LTV's. It is precisely these conditions
lenders strive to anticipate, and quantify, and in the process minimize
the risk of over lending at the point of origination.
Lenders first thought was
to reduce LTV's to 65% when declining rent conditions were found in a
given market, but after further study, some applied a more sophisticated
approach to the underwriting in cases where the appraisal did not
adequately address declining rents. The K factor (1),
a mathematical formula, is used to stabilize a stream of changing income
(converting it to its stable equivalent) where income is expected to
change on an exponential curve, or at a constant ratio. This formula
adjusts the OAR to reflect upward, thereby reducing market value.
Interestingly, the application of the K factor has generally resulted in
an LTV greater than 70%. We should point out that while our lending
guidelines have taken this approach, lenders in some of our markets have
simply adopted the 65% mentality.
With the forgoing in mind
we ask that borrowers be positioned to expect lower loan amounts where
declining rent conditions exist. During this time of uncertainty and since
the inception of the use of the K factor, loan amounts have been adjusted
anywhere from 2% to 10% downward, depending on the conditions specific to
the market in question. With these adjustments, lenders utilization of the
K factor, effectively, is very similar to the multifamily lending
community as a whole, as a past report in Mortgage Banking, August 2002
suggests. This report indicates that lenders have dropped loan amounts 4%
to 8%. This puts the lending community, on purchases at 70% - 78% LTV's.
Going forward, in markets
where declining rent conditions exist, lenders and investors will continue
to make underwriting adjustments deemed necessary to minimize risk
inherent to a loan. We appreciate your business, and hope we have conveyed
to our borrowers, the advantages of using the K factor in the underwriting
decision. Referral Mortgage remains very competitive in declining
markets. We are a long term player in the small apartment lending market
and will continue to respond to adjustments as they occur. Interestingly,
on the other side of the coin, using forecasted rents in some of our markets put
purchase LTV's above 85%.
(1) Source:
The Dictionary of Real Estate Appraisal, Third Edition by the Appraisal
Institute, 1993. The K Factor is defined as an income adjustment or
stabilization factor used to convert a stream of income changing at a
constant ratio into its stable or level equivalent.
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