By now, many investors have seen a number of headline making commercial real estate (CRE) defaults. Here are a few examples: Applesway Investment Group defaulted on a $229M loan on 3,200 units in Houston. Veritas’ Investment Group defaulted on a $448M CMBS loan on 62 apartment buildings in San Francisco. PIMCO defaulted on $1.7 billion in office loans in San Franciso. Rockstar Capital defaulted on a $51M multifamily loan in Houston.
These defaults are concerning, and have resulted in many investors asking, “What’s Going on in Commercial Real Estate”? This is quickly followed by questions like: Is my money safe in CRE deals in which I am invested? Will we have a capital call? Will we have to pause distributions? Will we lose a property to foreclosure? How can we take advantage of the distress in the market? When will you have another deal? Can we make 20% returns today in CRE? Is real estate, particularly multifamily, a smart place to put our money today?
To answer these questions, it is important for investors to understand what has led to these defaults, and significant losses for lenders, operators, and investors.
Factors contributing to CRE Stress Today
These are a few factors contributing to CRE stress today.
Post Covid, the Federal Reserve kept interest rates at all-time lows and increased the money supply, while federal fiscal programs also put massive amounts of money into the American economy to spark an economic recovery. As US Treasury (UST) yields were historically low, saving was disincentivized, and investing for yield was more attractive.
Both ultra-low rate and high loan to value loans available to CRE investors provided the opportunity to invest in historically low-risk/low-return real assets, with lower debt service payments, thereby boosting cash on cash returns. For Value-Add investors, renovating older assets to bring them to today’s standards for design, functionality, energy efficiency & amenities, and thereby increasing rental demand and income for such properties, there was significant upside. As operators successfully completed value-add projects, and more liquidity flooded the market, demand increased substantially, with most CRE selling in multiple offer situations, well above the asking price.
To keep up with the rise in prices, and to support a value-add strategy, many investors used bridge loans, with either floating rates, or interest only or fully amortizing loans fixed for 2-3 years, and with 2-3 year maturities. This was done due to fixed rate debt not being available on mismanaged or unstable target properties, or to avoid multimillion dollar pre-payment penalties on longer term loans (fixed for 5 to 10 years) better used for buy & hold strategies.
When inflation began to rise rapidly, the Fed claimed it was transitory and said it would not raise interest rates. Just like banks, many CRE investors relied on that commitment to low rates. Those who saw the risk of rising rates purchased properties with variable rate and/or bridge debt, but turned to Rate Cap Insurance to hedge interest rate risk by paying the difference between the loan note rate and any future rate above the cap.
As inflation continued to rise, the Fed began the fastest quantitative tightening program in history, raising the Fed Funds rates from essentially 0% (from Apr 2020-Feb 2022) to 5.33% today. CRE investors who bought properties with rates in the 3-4% range, now have loan rates resetting in the 7-8% range today. The impact of significantly higher rates on the stability, cash flow and value of any operation dependent on low-rate debt cannot be underestimated.
Let’s look at an example:
A CRE building with a value of $20M, with a 75% LTV loan of $15M at 4% interest, has an annual principal & interest debt service payment of $859,344. At a 5 Cap, it produces a net operating income (NOI) of $1M. The cash remaining to distribute to investors after debt service is $140,656. If the interest rate resets to 8%, the new debt service payment is $1,320,780. The cash flow from operations is suddenly insufficient to cover debt payments by $320,780. Even if debt payments were interest only, they would have doubled from $600,000 to $1,200,000. In both scenarios, the doubling of interest rates leaves debt payments exceeding NOI, and nothing left to pay investors.
You can see that even if operations are streamlined, and income and expenses are stable, the level of change in interest rates alone over the last 2 years is enough to turn a profitable operation into one that is bleeding cash.
Additional challenges: Rising Expenses & Tightening Credit
If this were not difficult enough, insurance and taxes have risen 30-50% in 2 years in many markets, employment costs have risen, vacancies and collections have risen, and rents have begun to soften in many markets. Additionally, for those who purchased rate cap insurance, the cost to renew it has risen substantially. For example, a rate cap that cost $40K at purchase, now costs $1M to renew for 1 year! And the lender requires it. All this to say, CRE has been facing numerous, concurrent headwinds that impact both cashflow and the ability to service debt payments.
Unfortunately for CRE investors, loan covenants state that even if debt payments are made, a loan is in default if: the NOI is not at least 20-35% above the debt payment, OR the loan to value (LTV) is not the same or lower than at issue. As you can see in our example, having a debt service payment larger than NOI will put a loan into technical default.
If the operator looks to refinance the property to reduce its debt payments, but has not yet completed its value-add program (raising rents and value), it will not be able to refinance the debt easily. This is because the NOI no longer supports the debt payments, with the existing or new lender, at higher rates.
The operator is left with limited options: (1) ask the lender not to foreclose as long as debt payments are made, (2) issue a Capital Call for investors to fund the debt service payments OR an amount needed to pay down the mortgage or refinance into a smaller mortgage, (3) sell the property, or (4) default on the loan.
To make matters more difficult, as rates are now double what they were less than 2 years ago, if the operator needs to sell the property, it is unlikely a new buyer will pay as much as the property was worth 2 years ago UNLESS the value-add program to raise the NOI and Value has been completed.
Challenging Sales Scenario
Let’s look at a sales scenario for our example:
The property bought for $20M produces $1M in NOI. It is listed for sale at a 5 Cap, just enough to pay off the loan and return equity. A buyer wants to use a fixed rate mortgage. The agencies offer a 65% LTV loan, with a 1.2 Debt Service Coverage Ratio requirement, and with principal and interest payments at 7%. For the DSCR to be met on a property, the loan payment cannot be more than $800,000. So, the buyer can only qualify for a $10M loan at 7%. The buyer now must raise $10M from investors plus $3M for reserves, closing costs & improvements.
With a 50% LTV loan limit, based on the DSCR, the distributable cash after debt service is @ $200,000 per year, for an investor COC return of 1.5%. Even with an all-cash purchase, the property would yield only 4.34% COC. Additionally, if taxes, insurance, payroll, and other expenses continue to rise, and rents soften, both the COC return and value of the property may deteriorate further. With the 10-year US Treasury paying 4.33% today, this deal would be a hard sell for any buyer and their equity partners. Thus, many buyers will simply walk away from the transaction once they review their options carefully.
As you can see, the distressed seller will find a very limited buyer pool willing to buy the asset at the same value they paid for it 2 years ago, or even for the loan principal outstanding. This is a hard reality for many sellers who have variable rate loans or short-term bridge loans coming due, and the reason many CRE operators feel they are left with no choice but to default on their loans and turn the keys over to the lender.
This is the reality of what has happened in the CRE space, even to experienced, competent operators. The risks are high for everyone involved. If an operator loses a property, tenants suffer, investors lose their principal. Banks holding these assets must write them down, which can trigger insolvency risk and higher reserve requirements. This leaves fewer banks and lenders willing to issue new debt, and brings sales to a virtual halt.
Now for the Good News!
Now that I have painted a picture of this ugly backdrop, let me point out a few bright spots, ways operators can navigate these waters until safely on the other side, and some good things that can come of all of this for investors.
- It is important to understand that multifamily has very strong fundamentals. It has been, and will continue to be, a relatively low-risk, low-return investment on the investment curve, with average Cap Rates / returns for Class A multifamily being about 2.3% higher than yields on a 10-year UST. So, while multifamily and other CRE are facing challenges in this interest rate environment, many other investment alternatives have greater risks.
- People need a place to live. As housing is the most unaffordable in decades, many households will remain renters. Many areas of the country are still undersupplied relative to demand for housing, and are still experiencing low vacancies and strong rents, though rent growth is slowing. Those investing in apartments in areas with limited supply and strong local economies will continue to draw strong tenants and keep multifamily incomes and values strong.
- With inflation still high in some areas of the economy, corporate profits declining, and unemployment ticking higher, a recession is still likely. Multifamily has proven to be the most recession resilient asset class among CRE. In times of struggle, people generally prioritize paying rent over spending on discretionary goods and services. As a result, Cap Rates on Class A/B Multifamily may fall, even in a recession, while other assets’ cap rates rise to account for recession risk.
- Inflation is falling. Costs for materials, certain utilities, and services are coming down.
- As economic conditions move closer to recessionary, the Fed will complete their hiking cycle and will hold rates steady for some time. This will remove uncertainty in the credit markets, and lead to lower premiums charged in mortgage rates, as well as rate cap premiums. While credit markets will remain tight, loans will still be available for quality assets, in strong markets, with experienced operators. Multifamily loans are some of the best available.
- Additionally, as the economy softens, it is likely that they will lower rates from restrictive levels, and cut again. While we are unlikely to get back to the low loan rates of the last couple of years, many economists believe we will settle in the 2.5 to 3% Fed Funds Rate range. This should put multifamily agency rates back in the 4.5 to 5.5% range.
- As rates fall and cap rates stabilize, buyers will be confident in the fundamentals of CRE, particularly multifamily. Both NOI and exit Cap Rates will be easier to project, to give investors confidence in their investment return projections.
- Those who can get through the next year or so will be rewarded. Operators must continue to maximize rents, cut expenses, and negotiate insurance policies and tax assessments. Operators may need to pause distributions, invoke a capital call, and work out a plan with their lenders to extend their loan, waive DSCR/LTV requirements, or lower payments. The good news is that the Fed is encouraging lenders to work with CRE borrowers to minimize foreclosures. Investors may need to hold properties for longer than projected. They will be rewarded with higher exit prices when rates come down to allow more lending options, so buyers and sellers can create win-win transactions.
- Investors can capitalize on the opportunity to purchase properties at less than replacement cost, with loan assumptions at low rates, and where there is still significant, value-add upside. While returns will not be as high in a contracting economy as they were in the expansion of the last few years, there is still opportunity.
- It is rare to be able to buy stable assets at a significant discount. With most of the stress in CRE related to inflation and artificially high interest rates, this is a short window of opportunity to buy great assets at a significant discount. We look at distressed deals daily. While there are more of these deals coming, the risks are not yet abated, and the cost of capital is still high. When we find quality, discounted opportunities, our investors will be the first to know. This is an exciting time, but also a time that requires wisdom and patience to do only the best deals.
We are committed, first and foremost, to quality asset management, and to stewarding our assets through these challenging times to both preserve and grow our properties’ incomes and values for our investors. We are also committed to bringing strong opportunities to our investors to help preserve and grow their wealth as part of a well-rounded portfolio. Finally, we are still bullish on multifamily over the long term, and know that when bought in economically strong areas, such as Texas, it will continue to be a strong asset class for many years to come.
Live with Purpose,