“What’s going to happen to billions of dollars of loans and properties as high interest rates continue to wreak economic havoc?” is among the biggest question marks for the multifamily industry—especially in Texas, which has become one of the hottest markets in the country.
Multifamily has been considered the darling of commercial real estate since the end of the Global Financial Crisis and is often thought to be a lower-risk investment among real estate asset types. Investors in hot markets like Texas have bid up prices for years: I’ve seen the same properties go from selling at 7 caps to 3 caps within a five-year stretch. Covid pushed prices even higher. Floating-rate debt allowed buyers to compete, with higher leverage and historically low interest rates.
In March 2022, secured overnight financing rate data (the most common benchmark used for bridge debt) was 0.5 percent with spreads between 150 and 250 basis points, meaning the all-in rate was around 3 percent. SOFR is now over 5 percent with spreads between 250 and 350 basis points, meaning borrowers are potentially paying upwards of 9 percent.
Luckily, lenders often require borrowers to take out rate caps on these types of loans, essentially acting as an interest rate hedge. But since these rate caps typically last for two to three years, many of them are now expiring. The cost of a rate cap is tied to the benchmark federal funds rate, which means that the cost of these caps has gone up drastically.
Borrowers must now decide how to handle heavier unforeseen monthly debt service payments, higher priced rate caps, and bridge the capital stack between a potential new loan, now constrained due to higher interest rates and DSCR constraints, and paying off the maturing bridge debt.
Here are some of the different approaches they can take:
Extend and Pretend
“Extend and pretend” has become the most popular phrase used in these types of market conditions. Since many multifamily loans have extension options, the thought is that if the borrower can extend for another year, rates will be lower by then. Unfortunately, no one knows for sure where rates will be in the future, and lenders often require new rate caps to exercise extension options. In many cases, this means borrowers will need to find additional capital.
Refinance
With loan maturities approaching, borrowers are looking for the most competitive financing options to take their place. Unfortunately, higher interest rates and lower property values—multifamily values are down 15 to 20 percent from their peak—mean that longer-term fixed rate debt isn’t covering the maturing bridge debt. New bridge debt will still have high rates, requiring new and costly rate caps. In other words, refinancing will also often require borrowers to find more capital.
Loan Workout and Restructuring
Many lenders are willing to negotiate a loan workout and restructuring. Lenders may be open to modifying loan terms, extending maturities, or temporarily reducing interest rates to help owners navigate challenging periods. And if the property has good sponsorship and is performing well, they’re more likely to provide much-needed breathing room until there’s a more favorable rate environment.
Equity Partnerships
In almost all of these cases, borrowers are going to need additional capital, meaning they’ll have to go back to their investors or find it elsewhere. Private equity investors are therefore providing “rescue capital” or preferred equity, structured as a loan with its own high interest rates: preferred equity is currently in the mid-teens. But properties can only support so much debt and preferred equity payments, and often it’s the common equity shareholders who will be left empty-handed as the last in line after the lender and preferred equity holders. In other situations, we’re starting to see some sponsors sell their general partner position at a loss to new equity, relinquishing any potential fees or or carried interest they’d normally be eligible for.
Sale or Partial Disposition
Last, but not least, many sponsors are going to need a broker. For borrowers facing insurmountable challenges with underwater properties and impending maturities, selling, even at a loss, is going to be the best option.
Jack Stone is managing director, investment sales based out of multifamily investment sales and capital markets firm Greysteel’s Dallas office.
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