The State of Multifamily Lending
THE GOOD OLD DAYS
The multifamily sector, along with the industrial sector, had stood out as a primary focus of the pandemic’s impact. Property values surged, and capitalization rates saw a significant decline.
This trend was acceptable because the promise of rising rents suggested a prosperous future, irrespective of the soaring property prices. According to Jon Siegel, Chief Investment Officer and Co-Founder of RailField, two years ago marked the pinnacle of the multifamily market. Markets were intensely active, with properties fetching three-cap rates.
Many individuals opted for variable-rate or bridge financing, with interest rates hovering around 300 to 350 basis points over SOFER, which was only 5 basis points at that time. Additionally, 80% loan-to-value ratios (LTVs) were prevalent. Jahn Brodwin, Co-Head of FTI’s Real Estate Solutions Practice, notes that numerous investors sought properties, securing 75% leverage when interest rates were at 3%, and acquisitions were made at 5 cap rates. The strategy was to borrow more, thereby increasing equity. However, a significant error was the widespread assumption that these favorable conditions were the new norm and the prosperous times would persist indefinitely. Brodwin explains that many believed they could buy at a low return, anticipating future rent hikes that would allow refinancing at a fixed rate or selling at a profit. Essentially, this approach handed over the present value of the interest payment for the entire loan term to the lender.
Even banks participated in accumulating low-interest rate, long-term assets, a strategy that eventually led some of the major players to exit the market. However, as with any parade, it eventually concludes, and people return to their routine lives. In the realm of multifamily finance, the return to normalcy meant that for many, a good night’s sleep was no longer part of the equation.
THE NEW NEW NORMAL
Currently, a more realistic interest rate stands at 7%, leading to a cooling off of real estate valuations. What was once a 5-cap rate has now shifted to 6, and the more funds borrowed, the greater the equity loss, according to Brodwin. Common loan-to-value ratios (LTVs) have now become 50% to 60%. However, predicting specific outcomes in this situation proves challenging.
Michael Margarella, principal from Next Play Investments, notes varying approaches among banks, with some local ones completely halting credit, while others offer aggressive terms based on their balance sheets. Flexibility is diminishing, and smaller banks, although rare, may still provide terms similar to those in 2022, such as a 70% LTV, especially if they have an aggressive board seeking to deploy capital. Nonetheless, such cases are uncommon, and there is less flexibility overall. Previously, banks might have allowed property owners to implement value-add changes, increase rents, and gradually achieve a 1.25 debt service coverage ratio (DSCR). However, Margarella observes a shift in policy, with banks now hesitant to risk not reaching the 1.25 DSCR if rent increases do not continue as expected.
Edward Ring, CEO of New Standard Equities, emphasizes the current challenge in financing. The required debt yields mean operating at around 50% to 55% leverage, missing the mark on assets that faced cash shortfalls during the pandemic eviction moratorium. New Standard typically avoids bank financing for non-bank entities due to the recourse component, favoring non-recourse borrowing.
Banks, often dealing with their own portfolio issues, may pull back from credit. Ring and Margarella both note lenders attempting to accommodate borrowers but introducing terms like interest rate floors to consider their cost of money for variable-rate loans. Matching capital to the business plan and ensuring cost certainty has become crucial. The industry appears caught off guard, not just by the movement in interest rates, but by the speed of the 500-basis point shift, exceeding the anticipated 200 to 300 basis points.
SEEKING NEW PLANS
Given the current landscape of multifamily borrowing, it’s not surprising that many in the sector are contemplating adjustments to their financing strategies.
Jon Siegel from RailField shares an example from 2017, where they acquired a property intending to implement value-add improvements and sell quickly. Despite advising against it, they opted for a fixed-rate loan due to low interest rates at the time. However, circumstances changed, and they ended up holding the property until 2021, incurring over $2 million in yield maintenance costs, significantly impacting their expected return.
RailField transitioned away from variable rate loans in 2021. Siegel notes that an interest rate cap purchased in 2020 for $50,000 would now cost $1 million in the current environment, pushing the effective finance rate to nearly 8%. While still better than rates in the 1980s, the rapid rate of change has posed challenges.
Jeff Klotz, CEO of The Klotz Group of Companies, who operates both as a borrower and a lender, highlights the abrupt shift in market dynamics. He notes that after a seven-year period of creative lending and favorable conditions, the lending landscape suddenly changed. Klotz emphasizes the frustration on both sides of the table, being a borrower and lender. Interest rates have doubled or more than doubled over several months, impacting the entire multifamily market, especially in the southeast. He anticipates that it will take time for the market to adjust to these changes.
Klotz mentions that government-sponsored enterprises like Fannie Mae and Freddie Mac remain top choices, offering some of the best lending opportunities in the marketplace. Despite the challenges, there’s a resurgence of loan funds, debt funds, and non-bank lenders that can provide larger loan amounts than GSEs, life insurance companies, or CMBS.
WHERE LENDERS ARE
“As a lender, the focus on the quality of the borrower, the strength of the sponsor of the borrower, and their ability to withstand future market deterioration is critical for us,” says Klotz. He highlights an increased emphasis on the asset’s quality, borrower quality, and improved business plans.
Lenders are now dealing with the consequences of past decisions. Klotz notes that the pre-workout stage is lasting longer than in previous cycles, with lenders showing a reluctance to rush into defaults or take back keys. The current conditions, unlike the ease of transactions experienced for many years, make it challenging for few transactions to pencil out.
Forman Capital, a private multifamily lender, primarily operates in Florida, Texas, and Georgia, focusing on residential properties. Managing partner Brett Forman acknowledges the complexity of the current conditions, mentioning the challenges in determining cap rates and NOI due to increased expenses. Rising costs, particularly in insurance, pose a significant impact on cash flow dynamics, influenced by climate change and natural disasters, especially in Florida and Georgia.
John Vavas, a commercial real estate finance attorney at Polsinelli, highlights the challenges in structuring deals, especially in areas like California and Florida, where specific issues make it harder to assess transactions. While it is still possible to structure deals, it often requires more equity from borrowers. The cost of equity becoming cheaper than debt could lead to intriguing conversations, particularly in negatively convexed situations.
Forman anticipates the next 24 months to involve a significant amount of what he terms “rescue capital,” where fresh capital is injected to pay down banks or lenders. However, this places more money senior to equity, complicating the realization of equity value and essentially deferring issues. The uncertainty persists, and the return of favorable interest rates is far from certain.
Merchants Capital, operating in various aspects of multifamily financing, including debt financing, construction lending, and acquisition financing, notes concerns in the construction lending space. Many banks are cautious about engaging in construction lending with higher loan-to-value ratios in specific markets.
THE FUTURE
Given the current macroeconomic landscape, both lenders and borrowers are confronted with intricate and conflicting decisions. Predicting anything by the end of the year seems optimistic, as the Federal Reserve has indicated a potential longer hold on interest rate increases but stands ready to raise rates again if conditions change.
FTI’s Brodwin expresses a belief that interest rates may decrease in the longer term, perhaps over two or three years. However, he cautions that this doesn’t imply a return to the previous era of easy money. A more normalized mortgage interest rate would be around 5% or 6%, and higher interest rates compared to property cap rates could deter many from entering the market.
Brodwin suggests lenders will likely adopt a selective approach, focusing on quality sponsors, properties they are comfortable with, and low leverage levels. Achieving stability will be challenging when buyers and sellers struggle to agree on pricing, making it difficult to buy at a 7% rate when someone is selling at 5%. Brodwin notes that over time, individuals may be compelled to sell, but quick resolutions should not be expected.
Patience is emphasized as a crucial tool in navigating the uncertainties. Jeff Klotz stresses the importance of riding out the challenges, reassessing the capital stack, and either working with the lender or facing the possibility of losing the property. While there is ample capital available to provide assistance, borrowers may resist accepting the new market conditions. However, with time, they may find themselves with no alternative.
Despite the strain on the multifamily lending market, those with experience in previous cycles find parallels in history. Edward Ring notes that while the present situation appears extraordinary, it aligns with past cycles, emphasizing that, despite expectations, things are not entirely different.
Written by Erik Sherman | Source: GlobeSt.com | October 9, 2023
