Lon Horwedel | AnnArbor.com

Ann Arbor’s Hidden Valley Club apartment complex is a local example of a $70 billion national real estate problem: Securitized commercial loans that are in default.

A foreclosure notice on the 324-unit complex near Briarwood was filed in late April, despite months of ongoing conversations initiated by the owner to modify the loan.

The loan itself - which totals $18.1 million - is complicated, since it’s one among billions in real estate investments that were repackaged and sold to Wall Street investors during years of peak real estate prices.

So are the circumstances behind the loan default, said Hidden Valley Club co-owner Jeff Starman.

The most obvious is the drop in the property’s value as rental rates fell below levels to cover loan payments. Other factors include a national real estate climate in which banking consolidations after the lending crisis and the sheer volume of properties in securitized loans - known as Commercial Mortgage Back Securities - is overwhelming the system.

“We believe the lenders are swamped with loan issues,” Starman said, “so the process is long.”

Real estate experts say many commercial real estate owners are facing challenges meeting their lending obligations. Some strategies that traditional lenders have used with their borrowers include modifying loan balances or terms, allowing interest-only payments and allowing contingency funds to dip below contracted levels.

Yet financing through CMBS means that many borrowers, as Starman said, “don’t even know who the actual lender is.”

And that puts Ann Arbor’s Hidden Valley Club into the growing mix of properties affected as national CMBS defaults soar to record levels this year.

The situation - described by some national experts as the next real estate crisis - is likely to be invisible to residents of Hidden Valley, according to local sources.

Starman said he’s hopeful that efforts to work with the lender to retain ownership of the property and modify the loan will pay off. He’s hired CB Richard Ellis to help navigate the process, which he said he initiated in 2009 to stem what he saw as a growing concern.

“I think it will be resolved,” Starman said. “We plan on owning (Hidden Valley) for the long term.”

RENTAL MARKET CHANGES

The property - built in 1974 on 15 treed and rolling acres off of South State Street near Eisenhower - is at 90 percent occupancy, Starman said.

“It’s a great property,” he said. “… It doesn’t have an occupancy problem.”

However, he said, the fundamentals in the Ann Arbor apartment market have changed during the downturn, resulting in lower rental rates that can’t support the loan payments at Hidden Valley.

Starman and partner Francis Clark bought the complex in 2006 from Equity Residential, Chicago-based real estate investor Sam Zell’s apartment division.

The owners, part of the Ann Arbor-based Madison Group and also Arch Realty, financed the purchase with an initial mortgage was $15,190,000, with a second loan financing a $2.9 million investment in the property - bringing the total financed to $18 million. The total purchase price was $19 million, representing a cost of $58,641 per unit.

The owners “put in a ton of money since we bought it,” Starman said. That funded hallway improvements, lighting upgrades and unit updates to include hardwood floors and in-unit laundry equipment.

Now, Starman said, “there’s no extra capital.”

Starman said rental income at Hidden Valley is down about 15 percent a month since 2006, despite its occupancy climbing.

“That equates to a bigger differential than we ever accounted for” when forecasting the property’s financials when purchasing the complex, he said.

“It’s not performing like it was, but it is performing well,” Starman said. “It just has to wait for the economy to re-engage.”

He continued: “When rents go down, it takes a while to go back. I think it’s a couple-year return to get back to where we were.”

Alice Ehn, CEO of the Washtenaw Area Apartment Association, said the average rate for a one-bedroom apartment in the region was $757 as of March 1. That’s dropped to $725 as of May 1. Two-bedrooms fell from $1003 to $973.

Ehn did not have recent occupancy averages for the area, but many other landlords also have reported a market softening over the past several years. Some real estate industry experts estimate the overall occupany at 85 percent.

Ehn described a local situation where some landlords have had to lower pricing “to get people to rent at all.”

However, she added, “some places can’t do that … when the market goes below what costs are.”

Meanwhile, city assessment records show the assessed value of the complex fell 7.5 percent from 2008 to 2010. It’s now valued at $9.49 million.

Today, Starman said, the more limited pool of renters means that lower rents can’t be counted upon to increase occupancy. And raising rent isn’t realistic.

So despite owning an apartment building with high occupancy in one of the stronger real estate markets in Michigan, Hidden Valley faces a situation that only time - in the form of economic recovery - or the loan modification can cure, Starman said.

Before the economic meltdown, he added, “no one sat in Ann Arbor and thought rents will be going down.”

CMBS LOAN WEAKNESS

Nationally, “CMBS-financed properties have shown the greatest amount of weakness,” said Dave Cardwell, vice president of capital markets and technology for the National Multifamily Housing Council in Washington, D.C.

The most acute among them: Properties that were purchased from 2005-2007, Cardwell said. Many have been pushed into either foreclosure or lender-prompted workouts, while still more are on lender “watch lists.”

“When the market tumbled, there was not the income stream to support the loan amount,” Cardwell said.

Hidden Valley Club’s loan is bundled with over $2.2 billion in loans known to Wall Street as Citigroup Commercial Mortgage Pass-Through Certificates Series 2006-C4.

Citibank Global Markets Realty Corp. packaged the original mortgage. It was assigned to LaSalle Bank in 2007, and by this spring was serviced by Bank of America.

The interest rate on “conduit” loans typically were lower than a traditional mortgage and required less down payment, but the reporting requirements - because the mortgages were converted into securities - were more rigid.

That wasn’t an issue when values and rental rates were stable.

“It was the only way to go,” Starman said.

Multifamily properties in 2006 were yielding peak net operating incomes and rents were increasing at 4-5 percent a year on average, Cardwell said.

As a result, “top-of-market” real estate deals became common at the time, as investment firms chased loans in every commercial real estate sector so they could establish CMBS, said Cardwell.

“In 2006, you had a market that was overheated in all real estate, including … multifamily,” Cardwell said. “Values were being driven by an over-exuberant investor community.

“…People were overpaying for properties and that was fueling value,” he said. “At the same time, you had incredibly cheap capital. So the leveraged returns that you could get on paper were very good.”

Cardwell said many large, older apartments complexes were purchased with the CMBS financing “based on income that was probably not going to be there.”

Gains in operating income and occupancy reversed in the last couple of years, and across the U.S. several apartment deals from 2004-2007 have prompted discounted sales and bankruptcies. Among them: Fairfield Residential, the nation’s 13th largest apartment owner.

Nationally, the delinquency rate for CMBS hit a record 8.02 percent in April, according to a National Real Estate Investor report issued May 3. Multifamily property loans were the only sector to show a decline in the delinquency rate - which was 13.06 percent in April.

However, some forecasts call for multifamily to generate as much as 1/3 of all distressed CMBS loans this year.

RESIDENTS UNAFFECTED

As the nation’s multifamily sector sorts out the myriad financing issues facing it, Starman expressed hope that his company will retain the apartment complex.

“We’ve been talking pretty regularly about restructuring the debt,” Starman said.

Ehn said the residents and potential tenants at Hidden Valley shouldn’t be affected by the situation, since everyone involved in the foreclosure will want the property functioning at a high level.

Many apartment foreclosures result in a receiver - an independent company - to be appointed to take over operations, before the property is sold.

At Hidden Valley, Starman said, he’s had no indication that a receiver is under consideration.

And with financing unavailable for most multifamily deals, finding a better qualified buyer without taking a larger loss could be unrealistic for the lender.

Employees were told recently about the foreclosure filing and the attempts to refinance the loan, Ehn added.

“The management staff that is there is a good group of people,” she said.

Ehn added: “Whoever takes over honors whatever leases are in place … It doesn’t do anyone any good to have renters move out.”

Paula Gardner is Business News Director of AnnArbor.com. Contact her at 734-623-2586 or by email. Sign up for the weekly Business Review newsletter, distributed every Thursday, here.