Multifamily Lenders, Investors Face Rockier Road

After two years in which the Federal Reserve expanded the US money supply by an astounding 410 percent and kept interest rates at near zero to prop up the economy, the US central bank is striving to battle inflation that has hit a 40-year high. That raises a pivotal question: Will those inflation-fighting efforts help or harm multifamily lending, investment and development?

In mid-June, the Fed instituted its third rate hike of the year, a 75-basis point increase that was the biggest since 1994. That followed the June 1 start of the Fed’s plan to reduce its $ 9 trillion balance sheet, which had grown from $ 4.2 trillion over the past two years.

Ryan Cos. is developing the Avalyn, a 480-unit multifamily project in Chula Vista, Calif., that will include 16,000 square feet of commercial space. When completed in early 2023, the community will offer such amenities as a Prohibition-style speakeasy, coworking spaces, pool and spa, music studio and fitness center.

The Fed’s cleanup operation failed to slow investment sales in the red-hot multifamily sector during the first quarter, when buyers sunk $ 63 billion into apartments, a 56 percent year-over-year increase and the strongest first quarter on record, according to CBRE. But since then, lenders have become more cautious. (maybe move this up closer to the top?)

In anticipation of the Fed’s actions, the benchmark 10-Year Treasury yield spiked from 1.6 percent at the beginning of 2022 to around 3.1 percent in less than three months. The sudden rise jolted the market, said Hessam Nadji, CEO of Marcus & Millichap.

“To go back to a 10-Year Treasury yield of 3.5 percent or 4 percent should not be problematic for the economy or real estate business,” he said. “But when you’re going to from near zero to those levels in two or three months, it’s going to create shockwaves and a lot of uncertainty.

“Is it going to get worse before it gets better? Probably. But the point is we’ve got to clean up what was a highly unusual response to a highly unusual shock. ”

Volatility as the Norm

In previous periods of rising interest rates, lenders typically kept the cost of capital relatively stable by narrowing the spread above whatever benchmark rate was being used, noted Eddy O’Brien, co-founder of Blaze Capital Partners in Charleston, SC Today, however, lenders have either moved to the sidelines or are pricing more risk into deals.

Sources: CBRE Research, Real Capital Analytics

“The magnitude of interest rate increases, the threat of a potential stagflation scenario and general stock market jitters are causing a little bit of a different reaction this time,” said O’Brien, whose Southeast-focused firm has a $ 400 million pipeline of acquisition and development deals. “There is a good bit of volatility in the loan pricing environment right now.”

That volatility has also been felt in the collateralized loan obligation (CLO) market, from which many bridge lenders draw their capital, said Shlomi Ronen, founder of Dekel Capital, a Los Angeles-based real estate merchant bank. The Secured Overnight Financing Rate (SOFR) ballooned from 0.05 percent to around 0.80 percent between mid-March and early May, and CLO spreads widened as buyers of the securities demand higher yields.

“In conjunction with the rate index increases, the volatility in the CLO market caught some investors off guard,” he added. “Everybody in the multifamily space has been running on what feels like full tilt for the last 12 to 18 months, and it appears that there’s a healthy revaluation happening to determine whether assumptions going forward are still relevant or need to be adjusted.”

Rent Growth Hopes

At midyear, cap rates had yet to materially adjust to the rise in interest rates, and as a result, buyers have become more cautious. Seller-friendly contract terms are disappearing as buyers reject demands for truncated due diligence periods and hard money the day a contract is signed, O’Brien said.

Still, transactions in which a borrower’s mortgage interest rate is higher than the capitalization rate of the asset being purchased – are now occurring, observers say. The only way those negative leverage deals work out, they add, is if rent growth continues on an upward trajectory.

US multifamily rental rates grew at a year-over-year clip of about 18 percent, Nadji said. While that pace of growth is unsustainable, rental housing demand should remain strong considering demographic trends and the fact that would-be home buyers are facing higher mortgage rates and median home prices, added Nadji, whose firm is forecasting cooler but still sturdy rent growth of 10 percent this year.

“I think there are reasons to be optimistic about apartment rent growth, especially when homes are becoming less affordable,” he stated. “Even if the Fed causes a recession, apartment demand and rent growth should stay very strong.”

After a period of selling properties before the end of its typical hold period, DB Capital Management is now opting for a standard three- to five-year hold. Recently the firm paid $ 38 million for Cleo Apartments, a 142-unit multifamily community in Denver’s Lowry neighborhood. Planned improvements range from rebranding and common-area upgrades to renovating about 40 percent of the units. Image courtesy of DB Capital Management

Altering the Approach

In many cases, multifamily investors have changed strategies to account for the hiccup in the capital markets. Before this year, DB Capital Management, which owns a $ 500 million portfolio of primarily value-add assets in infill markets in Texas and the West, was selling properties well before the end of its average hold period to take advantage of a rapid rise in values .

But in acclimating to market uncertainty, CEO & Co-Founder Brennen Degner now anticipates keeping the assets for a more typical three- to five-year hold period. Additionally, instead of seeking bridge loans for 70 percent to 75 percent of cost, the investor is looking for leverage of around 60 percent and using SOFR swaps to reduce interest rate risk. And because bridge loan spreads offered by debt funds have increased at least 50 basis points to about 365 basis points early this year, he’s also tapping bank financing.

“I’m still very bullish on all of our markets — people are always going to need an affordable place to live,” Degner said. “But we wanted to shift our debt strategies. For us, it has been a flight to quality in terms of debt structure. ”

Developers looking for construction financing are adapting to changes, too. Design-build firm Ryan Cos. has seen financing increase from around 2.5 percent to 3.3 percent as SOFR has risen, reported Christa Chambers, senior vice president of capital markets for the firm. The company typically adds interest reserves to its financing packages to counter further rate increases, and it is keeping an eye on older loans to see if SOFR increase will cause a shortfall.

Read the July 2022 issue of MHN.

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