October Edition 2023 - View From The Fort

In any sport,? you play offense, and you play defense. As it stands currently in commercial multifamily, we are having to play some defense while, at the same time, preparing to put our offense out on the field.

The commercial real estate industry has faced significant challenges within the last year and will probably continue into '24. There is a stat that 30% of large commercial multifamily could be in distress currently, and that number in '24 could rise. Why is that?

Most debt placed on large commercial real estate is known as floating rate debt. It's similar to an adjustable-rate mortgage in single-family homes. Why choose a floating rate? Investors require a good return, and earning a good return requires room for value to be added. Once the value gets added through renovations or operational improvements, rents rise, along with NOI and property values. To capture these values, we must return to the bank and refinance or sell it on the open market.

The window for this value-added business model is roughly two years and fixed-rate debt won't allow that quick of exit - and therein lies the problem. If you sell or refinance early with fixed-rate debt, the lender requires you to pay hefty prepayment penalties. They are so hefty that they wipe out all the added value, so the logical choice was Floating rate debt. Talk about a catch-22.

How did investors protect themselves from being exposed to the unprecedented rise in rates we witnessed over the last year and a half? By purchasing a rate cap (more on these in a moment) and relying on "forward curves" to forecast how high-interest rates would climb. How well did the world's best and brightest fare predicting this rate spike? Not well.

Forward curves projected today's FED funds rate to be around 1.3%. Today's actual FED funds rate? 5.33%, so about 4% or 400 basis points off. Instead of mortgage rates hovering around 4% (after lending institutions add their spread), they are now pushing 8%. But it's okay because everyone purchased rate caps - right? Purchasing a rate cap insulated investors from exposure to the spike in interest rates. However, rate caps come with their own downside.

For those who do not know, rate caps are financial instruments designed to limit the impact of rising interest rates on borrowers. Still, when rates surge rapidly, the likelihood of reaching or exceeding the cap's designated limit becomes more probable. This increased risk necessitates financial institutions to charge higher premiums for rate caps, reflecting the greater potential for them to incur substantial payouts as they attempt to offset the borrowers' elevated interest expenses.

Lenders require you to escrow funds to cover expiring rate caps. In many cases, monthly escrowed reserve requirements ballooned from 6k to $20k/month to $1.2M/month! It is tough to cash flow with those requirements, and explains why many deals paused distributions.

This is where the?defense?comes into play. Now is the time to find creative solutions to fill the gap in financing, to bridge to better days ahead. This could mean working with lenders on loan modifications or, in some cases, capital calls. It is now less about cash flow and more about time and appreciation. Now, it is time to manage controllables and maximize revenue and occupancy. Everyone likes a happy ending, so let's turn our attention to our?offense. We can now make some fair assumptions based on what is happening in the market. There is strong absorption in multifamily, but deliveries will be higher than absorption in the coming months, with deliveries peaking in 2024. This will lead to a period of oversupply and place downward pressure on rents in the mid term. The good news for investors is new supply has stopped (due to rising interest rates and costs, and much tighter lending), and this is where we install our offensive game plan. Once the new supply runs out sometime in '25, rents will again grow in '25, '26, and '27. Property values will increase along with the rent growth. So what should that signal to you? 2024 is the time to buy. Sales transactions have reduced by 80% this year, meaning deal opportunities are a mere 20% of what they were last year (Hence, our reduced deal flow this year). Thus, if you find a good opportunity that pencils, pounce on it. Opportunity is approaching. We have the offense ready.