The Transaction Roller Coaster – Are We Nearing the Station or Ready for Another Wild Ride?
The past three years have been one of the most volatile periods in history for the multifamily industry. Operating fundamentals have whipsawed dramatically, yet the ups and downs of rent and occupancy pale in comparison to the volatility in the transaction market. Property trades have been on a roller coaster since the industry quickly shut down in the wake of COVID-19. However, highly accommodative monetary policy and ample access to capital led to the most frenzied buying period in recent history between late 2020 and early 2022.
Valuations spiked and deals were trading at record velocity, but when the Fed turned off the money printer and started raising interest rates, multifamily transactions ground to a halt. We are now roughly 12 months into the current quiet period for transactions, but it won’t last forever. Beginning late this year, the first bridge loans that fueled the transaction frenzy in 2020 will mature and a cascade of loan maturities will follow. Transaction activity will have to pick up and given the current state of interest rates, it will almost certainly lead to weaker valuations than sellers are looking for.
The First Wave – Maturing Bridge Loans
Like many industries, COVID-19 forced a pause in multifamily investing, resulting in limited transaction activity in early and mid-2020. However, transactions boomed starting in Q3 2020, and many investors focused on value-add deals. Often this investment type carries bridge loans with an initial term of three years and the interest rate is frequently tied to the Secured Overnight Financing Rate (SOFR). For the better part of two years, SOFR held firm near zero. However, when the Fed embarked on its current monetary tightening cycle, SOFR rose quickly. Many borrowers have purchased rate caps, which serve as an insurance policy against rising interest rates and protect owners in situations like we saw last year. Some owners did not buy rate caps however, and their interest expense is subject to current market rates plus whatever spread their lender initially applied to their loan.
Radix developed a case study to analyze the impact of rising rates on existing debt service coverage ratios as well as the likely impact on cap rates and valuations. The example used a standard loan term of SOFR + 300 basis points with interest only due for the first three years with no rate cap. The loan originated in September 2020. On a $60 million dollar deal with 67% loan to value, a $40 million dollar loan would carry a debt service of $100,000 per month when SOFR was at 0% and the interest rate on the loan was 3%. That same loan now has an interest rate of 8.1%, and an interest expense of roughly $270,000 per month.
We’ve modeled debt service coverage ratios using Radix operating data as well as expense data from across the multifamily industry. According to Radix, the average net effective rent in September 2020 was $1,453 and the average occupancy was 94.0%. Operating expenses were $583 per unit, for a monthly net operating income of $235,020. With an interest expense of $100,000 per month, we were left with a comfortable debt service coverage ratio of 2.35.
Over the past three years both rents and operating expenses have increased. Radix data shows average net effective rents of $1,875 and average occupancy of 94.3%. We estimate operating expenses have increased 15% over the past two and a half years due to inflation. From an operating perspective, the property is currently in better shape, with monthly net operating income of $329,303. However, with SOFR rising from 0% to 4.8%, the monthly debt service jumped to nearly $270,000. The debt service coverage ratio is now 1.23, and below the threshold of 1.25 that many lenders set as the benchmark for default.
We also built a scenario analysis to see which loans are likely in default or in jeopardy of default. Figure 1 shows the debt service coverage ratio (DSCR) of the hypothetical transaction, using a variety of different leverage and price per unit scenarios. In 2020, with SOFR at zero, the debt service coverage ratio was comfortably above lending standards for both conservatively underwritten deals and aggressively underwritten deals.
However, as Figure 2 indicates, the impact of rising rates has pushed many of those aggressively underwritten deals into default indicated by a DSCR beneath 1.25. There are also several deals where the DSCR is at risk falling into default.
Thus far, there have not been a significant number of defaults and foreclosures, but some are starting to emerge. In mid-April a 3,200-unit apartment portfolio in Houston previously owned by Applesway Investment Group went into default and was foreclosed on. But I would attribute the lack of foreclosures thus far to the fact that there has been some limited transaction activity. Owners in default or at high risk of default, have likely taken their properties to market and sold at a steep discount from early 2022 valuations, just to avoid foreclosure.
Any owner who is not forced into a position to sell has likely held on, in hopes of lower rates in the future. But with each passing week, the first wave of maturities is coming closer and closer, and rates are likely to hold firm where they are.
The Second Wave – Permanent Loans from 2016 to 2018
In addition to the short-term bridge loan maturities starting in late 2023, there will be more than $75 billion worth of permanent loans maturing between the end of this year and 2025. Many of these loans originated between 2016 and 2018, as the post Great Financial Crisis recovery continued, and the multifamily industry was growing steadily.
Sellers of assets purchased back in 2016 through 2018 will fare better than those purchased in the last three years for multiple reasons. First, they will reap the benefits of two to four years of additional operating fundamental growth that will offset any operating performance declines in early 2020 with the exception of some coastal gateway markets. They are also likely to have financed using fixed rate loans which has saved them significantly as interest rates rose.
However, sellers of all assets regardless of when they acquired and what type of loans they are holding, will likely need to acquiesce on pricing as cap rate expansion and higher borrowing costs will lead to lower valuations compared to 2020 through 2022. We have not seen significant repricing yet, but that is only because transaction activity has been muted.
Private real estate, unlike publicly traded securities, does not have to be marked to the market daily. However, rising interest rates are having just as much impact on property valuations as they are in public market securities, and while real estate owners can hide from falling valuations in the short term, when forced to sell, the decline in valuations becomes readily apparent. As loan maturities increase in the coming months, buyers will gain leverage at the negotiating table and sellers will be forced to accept lower prices.
As interest rates have increased there has been heightened sensitivity around the CMBS market and the potential for default. Rather than paint the entire CMBS market with a broad brush, it is better to view different sectors and their relative performance when considering the future of many existing CMBS loans.
Most multifamily CMBS will be fine, given the extreme rent growth our industry experienced between 2020 and 2022. Even for some coastal markets that didn’t grow quite as quickly as the sunbelt, rents still increased at or near record paces. The underlying strength of the apartment industry will carry multifamily CMBS through the current challenges, especially when considering most CMBS represent a portfolio of loans rather than just one loan or a concentration of loans in one area. CMBS also makes up a small portion of the multifamily lending pool compared to Fannie Mae, Freddie Mac, private debt funds, banks and insurance companies. While CMBS issuance may falter slightly, I don’t think it will have a large impact on multifamily.
The office market on the other hand has much greater risk, both today and in the future. CMBS tied to office assets are on shaky ground, as office vacancies continue to rise in light of hybrid workforce demands. Companies have been downsizing or completely giving away office space when leases expire, leading to high vacancies and lower lease rates. Rising interest rates and increased operational risk in office make the asset class and the CMBS attached to it even more risky. Blackstone recently sold a Class A office portfolio in Orange County at a 36% loss. I expect to see a major discounting in the office sector as loans mature and properties are forced to sell.
Is There Hope for a Soft Landing?
So, what does this mean for our industry moving forward? There have been numerous analogies made to the Great Financial Crisis and the Savings and Loan Crisis. While there may be some similarities, and some distress in the multifamily industry, the key difference is that both of those crises ended with lower interest rates than when they began. As we move forward from our current situation one thing is for certain, rates have to be higher than they were, and the likelihood that we will ever see a zero percent interest rate environment again is very low. Real estate investors must return to fundamental analysis, asset selection and market selection to find alpha and achieve outsized returns. The rising tide of falling interest rates is over and we cannot rely on cap rate compression as a way of boosting values. Rather, investors should extend their hold periods, modify their return expectations, and view multifamily as it has been historically; a steadily growing long term investment with meaningful tax benefits and inflation protection.
The most aggressive investors who borrowed at high loan to value ratios and low cap rates are either in default or are rapidly nearing default. However, given the conservative approach to lending since the Great Financial Crisis, I expect most properties are not yet in default, but owners are growing increasingly worried, and will be looking to sell.
The loan maturities will not come all at once, instead there will be a steady increase from September 2023 through March 2025. As valuations soften, ownership groups and property managers should look to maximize their current operations, driving rent where they can, stabilizing and growing occupancy, balancing concessions and optimizing their revenue per available unit. While these changes may seem marginal at this point, in the coming months as transaction activity ramps up and valuation transparency emerges, every dollar that can be added to net operating income will have a significant impact on the sales price.
The next few years will serve as a reset in the multifamily transaction market. Valuations will normalize below levels seen in 2021 and early 2022, cap rights will likely expand, and quick flips will be much harder to accomplish. Yet the strong underlying demand for housing and the fundamental tailwinds of the apartment sector will keep the industry growing at its historic and steady pace.