Based on stress tests of almost 1,600 Q3 2011 and Q4 2011 newly originated apartment mortgages – including agency and balance sheet lending by banks and life companies – a study by Chandan Economics finds that current borrowers’ capacity to internalize higher interest rates at maturity and refinancing has weakened. These risks relate to the impact of interest rates on property values as well as financing costs†

The findings do not reflect a baseline expectation that apartment property income will decline. While underwriting to current cash flow and healthy occupancy and rent trends limit the risk of term defaults, the analysis shows that cash flow gains between origination and maturity may be insufficient to offset fully the impact of higher rates on value and refinancing costs. As a result, Q3 2011 and Q4 2011 mortgage originations show an increased probability of default at maturity.

AGENCY COSTS AND LENDER COMPETITION

Pricing distortions from historically low risk-free interest rates are exacerbated significantly by (i) the competitive effect of quasi-public financing through Fannie Mae, Freddie Mac, and the FHA on lending standards and (ii) the pro-cyclical feedback of improving fundamentals in lending standards. As concerns the former, there is evidence of crowding out of private lenders by agency financing in some segments of the market. This finding is not presented as a broad indictment of the agencies' multifamily programs. Quite the contrary, the study also shows areas of the market, defined both in terms of property quality and geographic location, where access to financing in support of performing loan maturities would be constrained were it not for the agencies.

Refinancing risks are concentrated in segments of the markets where observable lender density is highest and loans are highly contested. Lending spreads exhibit convexity in loan size with the narrowest spreads at an interior minimum point that varies markedly across markets. Some markets which are characterized by a lower density of lenders also present risks as spreads appear somewhat insensitive to differences in property performance and observable (hedonic) characteristics.

TREASURY FORECAST UNCERTAINTY

Qualifying the test results, underlying risk-free rates may tend towards materially lower long-term levels than are reflected in the scenario modeling. Long-dated Treasuries have been declining over a long period and have not risen above 6 percent in over a decade. Reflecting the non-stationary mean, the distribution of ten-year rates in the scenarios' maturity year is centered below 5.0 percent. In comparison, the baseline forecast published by the Congressional Budget Office in January 2012 anticipates long-term yields of 5.0 percent. In the case where risk-free yields reverse some part of their historical decline, as may be the case in the event of higher sustained inflation or persistent weakness in US fiscal policy, valuation and refinancing risks could exceed the findings of the analysis.

† For a discussion of the relationship between leverage, financing cost, and property value, see Chandan, S (2011), Real Estate Loans and Real Estate Debt, in Real Estate Mathematics, PERE Publishing, Edited by David Lynn and Tim Wang.