Rising interest rates and decelerating rents have brought a rapid change to the multifamily investment landscape. Debt suddenly looks more attractive than equity and high-yield investors are licking their chops at the opportunities for distress.
Though broad economic measures such as employment and consumer spending remain healthy, the Federal Reserve is trying to slow down inflation via rapid interest rate increases that are intended to slow demand and increase the number of jobless.
The Fed’s aggressive moves to contain inflation have led commercial real estate investors to downgrade the economic outlook, increasing the likelihood of a recession and the expected depth of that downturn. Some such as Barry Sternlicht, chief executive at Starwood Capital, worry that policymakers are moving too fast and should slow down the pace of rate increases. The Fed has raised short-term rates by 300 basis points this year and is expected to increase them another 150-200 basis points by early next year.
Sternlicht, speaking last week at the Pension Real Estate Association’s Annual Investor Conference in Washington, D.C., noted that inflationary segments such as housing costs are rapidly decelerating. Referencing the saying that “rising tides lift all boats,” he noted: “No one will survive if all the water is drained from the ocean.”
The impact on multifamily prices and deal flow is significant. Deal flow is set to wane because market players are unsure how to value properties. Multifamily had reached record-high prices and capitalization rates in the spring amid chart-topping rent growth over the last 18 months. Transaction activity reached a historical high of $220 billion in 2021, per Yardi Matrix, with the average acquisition yield dropping to about 4.5%. Now multifamily values are being hit with a double whammy: After falling to the 3% range, and lower in some cases, mortgage rates have risen to 6-7%. Meanwhile, rent growth is decelerating, with the U.S. average asking rent flat at $1,718 for three straight months through September, per Matrix.
Buying properties at an initial yield lower than the mortgage rate is a risky proposition when rent growth is strong, but in an environment in which rent growth is likely to turn flat or grow only moderately, such a strategy is a recipe for disaster. Cap rates are rising, and prices have fallen 20-25% from their peaks, with more to come if rates keep accelerating. Sellers are unlikely to complete transactions in such an environment unless they have little or no choice.
Debt, High-Yield Opportunities
So where is the opportunity for multifamily investors in a market in which mortgage rates remain persistently high, as is likely? One is in originating debt as traditional lenders move to the sidelines. Commercial banks are well-capitalized but exercising extreme caution on commercial real estate, while weak demand for bonds is hindering lenders that rely on securitization as an execution. CMBS and private equity funds that issue collateralized loan obligations are almost entirely out of the market. Even the government-sponsored enterprises have limited capital available.
Investors with a balance sheet to hold mortgages can originate loans with 6% coupons in the senior part of the capital stack, which is a solid return compared to the recent market conditions that produced lower yields for equity, a riskier position in the capital stack.
Another lending opportunity is construction loans. Large banks are cutting back on construction lending as they face scrutiny from regulators. Private equity lenders, which have increased market share in this segment in recent years, will only be able to lend on balance sheet now that the CLO market is closed. That means investors that can write construction loans will find plenty of demand.
For investors that are not equipped for senior or construction debt, there is a brewing opportunity for mezzanine debt and preferred equity—“gap capital”—from owners squeezed by the increase in mortgage rates. This involves properties that find themselves short of capital due to higher interest rates.
Refinancing will be difficult for properties that took out low-coupon floating-rate mortgages over the last two years but will be unable to get the same amount of proceeds when the loans mature. For example, a property valued at $10 million backed by a 70% loan-to-value ($7 million) mortgage with a 3% interest rate and 30-year repayment schedule has a $29,500 a month payment. That monthly payment would net a borrower $4.9 million (on the same repayment schedule) with a 6% mortgage. Put another way, if all else is the same, the borrower needs to come up with an extra $2.1 million of equity or debt at refinancing.
Some investors are already raising funds to provide gap capital to property owners that find themselves in a bind. Gap capital – typically in the 50-80% slice of the capital stack – is currently priced in the 12-15% range, which is a substantially higher return than mezzanine lenders were getting on deals in the highly liquid market in recent years. The same capital shortfall has played out in past downturns and often results in a spate of delinquencies and foreclosures.
While multifamily delinquencies and foreclosures are certain to rise in the next few years from current extraordinarily low levels, it’s not clear yet how bad the problem will turn out to be. Unless there is a “hard landing” recession, multifamily occupancies and rents should remain relatively strong, and most borrowers should be able to make payments unless property performance weakens dramatically. Rent growth is forecast to be slow in coming years, but given the long-term housing shortage and demand projections, net income is not likely to fall to distressed levels.
What’s more, banks probably will liberally employ the “extend and pretend” strategy that they used during the recovery from the global financial crisis. That means instead of taking action to foreclose on borrowers who are current on payments but can’t refinance at maturity, many banks will extend the old terms or negotiate terms more favorable to the borrower until the borrower has the means to refinance or sell the property.
Capital Demands Evolving
While it’s too soon to have a great deal of clarity about the direction of interest rates and the economy, it’s a good bet that rates will remain significantly higher in coming quarters and that the investment landscape will reflect this change. Investors with the means and expertise to originate debt and preferred equity will be in demand in the next phase of the commercial real estate cycle.