The Fix(ed)

I recently returned from the National Multifamily Housing Council conference in Las Vegas. I have been attending the conference since very early in my career, which makes me one of the pioneer attendees as the organization was fairly new then, and there were probably no more than 500 people at the conference in the early 1990s. Given the consistent and very strong growth of the industry and the importance of rental housing for the economy and society, it’s not surprising that the number of attendees has exploded higher to an estimated 7,000 to 9,000. As a result, the organization can no longer hold the conference in the former locations of La Quinta and San Diego in California and Orlando in Florida.?

From my perspective, there was nothing earth-shattering at the conference other than how few transactions are actually happening. It is very typical for apartment owners to engage brokers to bring properties that they want to sell to have them first presented at the conference so brokers can talk to other buyers about those properties, and owners can talk to other owners about them as well. With so many people congregating in one location, it’s obviously a good place to introduce new deals to the market. We found that we were in the unusual position of having five properties under contract. Every broker we met with said we’re the only company they know with that many properties under contract. Most firms are lucky to have one if any.

There is very little supply of properties for sale and still a fair amount of capital to buy, but the capital is not stretching to acquire properties because there is almost unanimous consensus that there has been a reset in the market given the?aggressive Fed tightening cycle?and correspondingly much higher interest rates, particularly on the short end of the curve. Although 10-year Treasury yields are in the 3.50% range, which on a long-term historical basis is quite reasonable, it is still up quite a bit from its low of approximately 0.5% and still meaningfully above the 10-year average of 2.17%.

Higher rates, slowing rent growth, and concerns about an economic contraction have led to lenders tightening their lending standards which, all else being equal, requires a lower price to compensate for less leverage that is now at a higher cost. And while everyone knows the new reality, many sellers do not want to sell at these new valuations because, in some cases, this could lead to investor disappointment as it may result in a loss. And yet, most people also believe that there will have to be some sponsors who will have no choice but to sell because they will not be able to raise money to cover their negative cash flow resulting from much higher rates from their highly leveraged, floating rate bridge loans with large spreads over?LIBOR or SOFR. On top of the negative operating cash flow, they risk potentially needing to purchase very high-cost interest rate caps. And finally, if their loans are approaching maturity, they may not be able to qualify for enough proceeds to pay off their existing loans. They’re in a vice, and they will have to have difficult conversations with their investors.

One person we talked to who has invested with us said he appreciates how proactive CWS is in our communications and how well-informed we keep our investors such that there are very few surprises. He invested with someone else who gave no warning that not only are distributions being suspended, but cash will be needed as well. Dropping a bomb on investors is never a good way of building confidence and putting oneself in a position to raise more money. Unfortunately, I think there are a lot of newer and younger sponsors who have not experienced a downturn, and they know that raising capital is their lifeblood, so they are waiting as long as they can to convey the bad news hoping that things get better or they can find other ways out of their quandary. Our experience is that this rarely works and that open, honest, proactive, and transparent communication is what builds investor trust, and it’s when times get tough you see what people are made of. Ducking issues until they become urgent is the worst path to follow.

Time will tell how much distress there will be. With last week’s jobs report coming in quite strong, it doesn’t look like the Fed will be backing down from raising rates. There’s virtually a 100% chance the Fed raises by another 25 basis points at its March meeting and a greater than 50% chance that it brings it higher by another 25 basis points in May. As I’ve written about a number of times, all roads lead to the labor market in terms of gauging Fed policy. And right now, it seems to be holding up remarkably well.

One can see how the?2-Year Treasury Note yield?jumped after the employment report came out on Friday. The yield is still quite a bit lower than where the Fed Funds rate will be after the March hike (4.75% to 5.00%), which still suggests the Fed is over-tightening and will have to cut rates. That doesn’t help highly leveraged borrowers with high spread, floating rate loans, however, since that is probably more of a 2024 potential.

I understandably got a lot of questions about our floating rate strategy. A number of people told me they read this blog and appreciate the content and to keep it up, which was gratifying to hear. It also means they know my position over the years on variable-rate loans, so it was not surprising that they wanted to know how I feel about them now. Fortunately, we knew there was a chance something like what we are experiencing could happen, but it was definitely thought to be a low-probability event. I was in a meeting, and someone said something about rates exploding higher, and that led to an aha moment where I think I may have coined a new phrase. I said our floating rate loans had become exploding rate loans. Gallows humor I guess.

Because of the reasonable leverage we have used, the low spreads on our loans, full-term interest only for most of them, 10-year terms typically, conservative distribution policy, and keeping large cash balances at most of our properties, we feel that we are in reasonably good shape to weather the storm. This was also aided by purchasing a very well-timed portfolio interest rate cap that expired in December 2022 and paid us more than ten times our cost.

To paraphrase John Maynard Keynes, when the facts change, I change my mind.

To paraphrase John Maynard Keynes, when the facts change, I change my mind. For many years we benefited tremendously from the starting rate advantage that?floating rate loans?offered compared to the fixed rate alternatives. And oftentimes, this advantage stayed with us for the entire loan period. This not only produced higher cash flow but gave us a cushion when purchasing new properties if the integration initially was more challenging than expected and we fell short of our projections. These savings were very helpful.?

Having low-cost prepayment penalty floating rate loans also provided us with enormous flexibility that we took advantage of by prepaying over $2 billion of these loans by refinancing into better loans or through sales that allowed us to deliver properties free and clear to the market without any requirement for buyers to assume our debt. And then everything changed when the Fed finally realized it was behind the ball with inflation spiraling to levels not seen since the 1970s.?

The situation is now reversed in that floaters have a starting rate disadvantage that is virtually certain to persist for at least a year. Lenders have now started to provide alternatives to floaters via 5-year fixed-rate loans, with the first three years having prepayment restrictions and the last two being open with a 1% penalty, excluding the last three months, which is open at par. This is now a serious consideration for us since we’re really dealing with a three-year comparison to determine if we should pursue the new financing or not because, after three years, both loans have 1% penalties.

The math is something like this. If a 5-year fixed rate loan has an interest rate of 5.50%, then for remaining in a floater, a few things would be required. We intend to hold the property for at least three years, and LIBOR or SOFR will be low enough to result in our average interest rate being less than 5.50%. In addition, with a fixed-rate loan, there is no requirement to purchase an interest rate cap, but there will be transaction costs to convert the floater into a new fixed-rate loan. I’m assuming they cancel each other out, but there are no ongoing cap purchase requirements with a fixed-rate loan which definitely has value in this market.

Here is the forward curve as of Friday.

Assuming our average spread over?LIBOR or SOFR?is 2%, and the forward curve has 30-day LIBOR averaging 4.76% (SOFR is 4.68%), then for the next year, our rate is expected to average 6.76%. This means that for years two and three, LIBOR has to average 2.87% to break even with the fixed-rate loan. Based on the forward curve LIBOR is projected to average 3.15% and SOFR 3.03%. It’s close but not quite there. Of course, these are estimates for the future and not set in stone. What you give up is the optionality that comes with the Fed having to drop rates even more significantly. And while I’m not in that camp, I think it’s a higher probability than the Fed having to raise them much higher. The inverted yield curve, the level of the?2-year Treasury Note yield, and the Fed’s own projections suggest that there’s a much higher chance of rates going lower than higher. And if we’re wrong, we’re only wrong by two years since the first-year rate is pretty much known for the floaters.

So we’re at this paradoxical point in my career in which the fix for our variable rate loans could be something I’ve avoided like the plague when I’ve had the chance over the last 15 years or so. Namely, fixed-rate loans. Yet the product we would consider shifting over to still has a lot of flexibility and can allow us to use the optionality we have in our loans to help improve our cash flow fairly meaningfully while mitigating some of our risk. And unlike many highly leveraged floating rate borrowers, many of our loans have low enough loan amounts that they should qualify for these new fixed-rate loans.

We are currently in the process of analyzing a number of our loans to see which ones might be good candidates for such a move. It’s always good to have options.