Real Estate is Business as Usual, Not Quite...

Navigating through Rising Interest Rates

Tighter Lending Market

Overeating has many side effects; without discipline, you will eventually need a new pair of jeans. We tend to bloat our stomachs until we have no choice but to go on a diet, but is the lap-band procedure the best first step? The Fed has been pumping money into the economy to the tune of trillions of dollars with COVID relief, additional infrastructure projects, etc. And within one year, the Federal Funds Rate was increased on six occasions, putting the capital-intensive economy into quick ketosis. Federal Reserve Chairman Jerome Powell's "late-night tv diet" quantitative tightening strategy, which aims to get immediate results, is sure to backfire. World leaders are bracing for an economic recession, and many paint a gloomy picture of the road ahead.

At the beginning of 2022, the Federal Funds Rate was a trivial .09% due to previous periods of quantitative easing, causing the upside of a red-hot economy but the downside of rampant inflation. Facing double-digit inflation, the Federal Reserve began to offload the balance sheet and induce a series of rate hikes. Even with six rate hikes this year, Powell plans to keep his foot on the pedal through Q4. The current Federal Funds Rate as of December 2, 2022, is 3.83%. Such an aggressive change in rates has caused a sharp slowdown in transaction volume as interest rates, and asset prices have adjusted accordingly (as interest rates increase, asset prices decrease).

Boutique Lending

In 2008, new regulatory requirements made it increasingly difficult for banks and traditional lenders to participate in commercial and construction lending. This sparked a significant increase in boutique debt funds that are nimble and operate with different leverage criteria.

Matthew McManus of M2 Equity discusses the current debt market and the impact of rising rates. With over 28 years of experience in capital raising and structured finance, McManus has seen the booms and busts of real estate lending. His firm originates structured financing products in ground-up development and value-add Multifamily acquisitions. Additionally, the firm participates as an operator of boutique multifamily assets, giving them a competitive advantage in the industry.

Risk ON

We asked McManus, "how his firm has positioned itself in the rising rate environment?" He explains how full leverage rate pricing, 75-80% Loan to Cost (LTC), for ground-up, adaptive re-use, or transitional multifamily assets today (Interview in Oct 2022) is hovering around 9%. A 125-150 basis point hike compared to six months ago.

To help sponsors facilitate healthy operating ratios, the rate is structured as pay and accrue - 6.5-7% paid current from NOI or reserves with the balance paid at disposition. As for their underwriting criteria, while they do not have any debt yield constraints going in, they require a minimum debt yield today on projected stabilized NOI of 7.5%; however, they generally prefer yields approaching 8% to factor in future risk. This is compared to a 6.25% yield in March/April of 2022.

Even in this shifting environment, M2's agility as a firm continues to win them new business. McManus details how two-thirds of his most recent business stems from last-minute changes from other lenders re-trading deals. In addition to their execution capacities, M2 can provide their clients with more leverage than traditional structured capital markets. Today they can push 75%-80% loan to cost on a single loan product.

Higher lending rates pose a risk to assets that previously traded at an extremely low cap rate. We asked McManus his thoughts on the risk of future balloon payments and although he doesn't see the significant risk of an equity wipeout, he explains, "I don't see loan maturity risk automatically attacking the capital accounts of equity investors. I think it's just going to defer and reduce returns" and "If a cash-in refinance is something sponsors decide against, a sale should yield sufficient proceeds to make most investors whole."

M2 is still willing to place some high-leverage bets. They are bullish on growing markets such as Florida, Texas, and the Carolinas. Not surprisingly, many of their investors have requested the firm to invest exclusively in business-friendly states with great employment opportunities. Thus avoiding the risks of some states' policies towards rent control and tenant eviction laws.

Doom and gloom or a bump in the road?

Turn on the news, and you will see the most prominent CEOs of finance and banking forecasting a great recession. So, where does an investor place cash they need to deploy? Like previous articles in this series, "Times of great doubt often present great opportunities." Invest responsibly and do your research. CMBS and structured debt data feeds such as Trepp, Inc. can be an excellent resource for gauging the operating health of individual assets and markets. You might consider additional consumer sentiment indicators: Amazon Sales, FedEx Parcel Volume, and Credit Card Balances.

McManus says the financial stress is not there yet. He commented on the availability of debt now compared to previous downturns. "We lived through 2008. Debt essentially went from being as prolific as it was in the early 2000s to almost zero in 2008. Today debt is still actively flowing. There might be fewer providers, particularly on the structured finance side, but agencies are active."

M2 Haves and Wants

M2 wants to expand participation in Arizona, Colorado, and Southern California.

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