By: Andy Bratt
As seen in Commercial Property Executive
“This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
— Winston Churchill
Legendary words from a leader navigating through the depths of turbulent times. We can take heart in the work ahead to rectify a multifamily marketplace adjusting to the realities of a higher rate climate, a steep rise in operating costs and softening rent growth. Take heart. Conditions are poised for improvement, which should set a tone for the second half of 2024.
While the Fed raised fund rates hyper-aggressively in 2022/2023, policy has since held steady for the past year at what most now agree will be the peak of this shift. The Fed is now consistently messaging lowering rates as a next step. However, expected rate reductions will be marginal before material, tentative this year and hopefully picking up some sort of pace in 2025—a state of affairs we can now call the proverbial end of the beginning.
Most of the approaches to prolong accepting this reality are coming to an end. More maturities will require action in the months ahead, as extensions run out, rate caps reset, and the reality of pretend and extend comes to roost. The lenders who would prefer to keep assets off their balance sheets are expected to see more pressure to move towards longer-term resolutions. There will be pain for some, haircuts for others, and opportunities for fresh capital waiting to transact with mark-to-market price discovery. A market at standstill is poised to come back to life.
The current logjam dragging on a more active multifamily marketplace is that sellers have generally yet to capitulate to current market pricing. The staying power of higher rates is beginning to force their hand. Refinancing has gotten more expensive. Cash-in deals are a reality impacting syndicators, high net worth investors, developers and institutions alike.
In this market reality, groups that have the financial stability to do cash-in and cover debt service or with room for a preferred equity or mezzanine component to recapitalize and retain properties are setting themselves up for long-term success. There will be a lack of new development, construction starts planned, and fewer deliveries over the next several years. So those who can hold on for the next 12-18 months or complete delayed projects still in motion should be well-positioned by 2026.
Healthier Performance Ahead
Long-term multifamily fundamentals remain promising. Lenders understand this, and that’s why multifamily remains one of the most attractive targets for their portfolio allocations. It is estimated to cost approximately 37 percent more to own a home than to rent in current market realities. That is changing the dynamics of the sector long term. While rents are softening after a period of substantial post-COVID growth, they are not dramatically coming down from those new highs, and we are not seeing a wave of enduring vacancies. Conditions exist for a near-term return to healthier performance.
For vulnerable borrowers, such as many who financed with high leverage during the last three to five years and pulled significant cash out, new equity will be necessary, or a sale forced to capitulate to this cycle’s price discovery and capital costs. Some of the most vulnerable borrowers are in the value-add space, where lofty rent growth projections have not materialized, project costs have exceeded budgets, and units yet to come online remain in limbo with expensive bridge debt coming due. A sale might become the best course of action, but not before a deeper dig into the current loan options available for specific assets and investment goals.
Quality debt options exist to transact, albeit from fewer sources. Sponsors will need to adjust their investment approach accordingly. Banks, once a primary lender for many multifamily developers, are still navigating liquidity challenges, processing their existing loans, and purposely slowing down new origination. Luckily, non-bank institutional and private capital sources remain a consistent source and are in the market with well-structured programs for current conditions. These alternative lenders include life companies, agencies, conduits, and debt funds. Ample liquidity exists to support market needs in the current cycle although with tighter underwriting and higher rates.
Rates to Recalibrate
There is consensus that over the next 12-18 months we should expect interest rates to improve. For many borrowers, the fear of locking into a higher rate and missing out on a healthier climate down the road has kept them sidelined. Lenders have responded with shorter-term loans offering prepayment flexibility. Life company programs for five-year loans, with the last two years featuring prepay flexibility, are available as are seven- and 10-year loans with prepayment flex after five and other variations that have become an expanded offering from a range of top-tier life company lenders.
For borrowers struggling to make debt service coverage work at desired leverage points, some Agency loans will offer a 35-year amortization. For projects that meet their affordability criteria, Agencies are willing to increase leverage at lower debt service coverage ratios. CMBS lenders are willing to go higher on leverage for improved returns, and both capital sources have interest-only offerings to make every dollar of debt service count towards proceeds. Life insurance companies have capital allocated towards higher proceeds and lower debt service coverage ratios in order to get additional yield.
Perhaps the greatest challenges in this market face syndicators missing the mark after an aggressive value-add acquisition. The bridge-to-bridge options available will come at a higher cost, but will reset a timeline if a viable exit can be demonstrated. There are solutions available, but they are going to diminish returns. Those not able to afford a rate cap and secure a capital infusion will likely become forced sellers.
So, the end of the beginning. We are at a new point in the cycle requiring a necessary shift in sentiment. Rates increased, and now they are sticking. In a historical context, we are not at a level where business can’t get done. That’s the start of the middle act. We are not on the other side yet. That will take time to process as apartment investors address their challenges, act on solutions, and adjust with growing confidence in more predictable, less volatile conditions.