SAN FRANCISCO, CALIFORNIA (November 17, 2022) - Interest rates have increased substantially in a short period of time, which significantly impacts commercial real estate financing. As the cost of capital increases, it obviously becomes more expensive to borrow. While this article focuses on the multifamily sector, the financing fundamentals apply to other commercial real estate product types as well.
On Nov. 2, the Federal Reserve hiked interest rates by 75 basis points for the fourth consecutive time. The current target rate is 3.75 to 4.0 percent, the highest level since 2008. In comparison, one year ago, the rate was 0.25 percent. Fed officials forecast hiking rates as high as 4.6 percent in 2023.
Why the increases?
The Fed continues to raise interest rates to curb inflation, which currently sits at 8.2 percent. Although the increases may be beneficial for long-term economic health, what about in the short term? And specifically, how do the increases affect real estate financing?
The Fed’s actions have ripple effects throughout the economy. The rate hikes impact the overall markets, which in turn, affect treasury rates and SOFR (Secured Overnight Financing Rate), which are also on the rise. The 10-year U.S. Treasury has increased from a low of 0.52 percent in August 2020 to its current rate of 4.07 percent in just over two years. The SOFR 30-Day Avg has increased from 0.5 percent in March 2022 to 3.03 percent today.
Rock-bottom rates are currently over
The days of historically low interest rates are over for now. Here is an example of a unique financing deal that closed in July, in which Northmarq secured $33 million in permanent debt refinancing for the 385-unit Granite Pointe Apartments in Sacramento. The deal included a forward rate lock that allowed the sponsor to hedge against rising interest rates for the nine months prior to funding. With rates rising significantly over that period, the opportunity cost of not locking the rate would have been several million dollars in additional debt service over the life of the loan.
Today, the focus is on what rising rates mean for multifamily borrowers. Higher interest rates will constrain maximum loan proceeds since lenders utilize metrics like debt service coverage ratio to size loans. In other words, if the debt payments increase with no increase in NOI, the total loan amount must be reduced.
The good news is that as the Fed tries to slow rising inflation, multifamily may be less affected than other real estate sectors since demand for housing remains relatively strong. The multifamily market is more recession-resistant due to the need for affordable housing. Additionally, as mortgage rates rise and the ability to afford a home attenuates for many in the working class, more people may be renting for longer than they expected. This is especially true for Millennials and Gen Z, who have been saddled with higher costs of living and found purchasing a home to be difficult even prior to the rising interest rate environment.
Work from home gave people flexibility to relocate, Sacramento saw large migration
By way of example, the multifamily market in Sacramento remains on solid footing. The COVID-19 pandemic drove an increasing number of residents to move out of urban areas to markets like Sacramento in search of a higher quality of life, lower cost of living, and proximity to outdoor recreation.
As companies eased restrictions on employee location, Sacramento significantly benefited by surpassing net migration figures by 50 percent over the prior decade’s average, according to the CoStar Multifamily Capital Markets Report (Sacramento). At the end of the second quarter 2020, 40 percent of potential renters in the Sacramento area were looking from outside the metro, meaning this trend continued long after the early surge fueled by the pandemic.
This confluence of factors led to Sacramento’s multifamily market vacancy rate falling to an all-time low of 3.6 percent paired with a 12.5 percent year-over-year rent growth as of Q3 2021, according to CoStar. Since then, new product has been delivered to the market, and the vacancy rate currently sits at 5.2 percent, with 2.3 percent rent growth year-over-year as of Q3 2022. Despite the supply pressure and slower rent growth, Sacramento’s multifamily market remains “full.”
Borrowers may find themselves in difficult situations
Despite solid fundamentals in the multifamily market, the impact of interest rates and inflation will create headwinds for sponsors, regardless of what stage in the real estate lifecycle they participate.
There are a several scenarios that borrowers may be currently facing or will face in the next few months:
- A developer may have a construction loan on a project that is nearing completion or is in lease-up. The construction loan will need to be paid off, but the permanent takeout loan that the borrower was anticipating obtaining is no longer sizing to where they can fully take out the construction loan and pay back some of their equity.
- A borrower has a permanent loan on a property maturing in the next six to 12 months. With lenders sizing to higher interest rates, a new loan today no longer sizes to the same amount for a full takeout.
For example, the borrower may have an existing loan of $100 million, but because interest rates have increased, a new loan is only going to provide maximum proceeds of $90 million. If they want to refinance, they will have to put $10 million of cash into the deal.
- An investor is currently under contract to acquire a property, but interest rates have increased over the due diligence period to where the pro forma loan amount is no longer attainable. The borrower does not have the equity on hand to make up for the shortfall in proceeds.
For instance, the investor thought they could achieve a 65 percent loan to purchase price, but today the loan is sizing to only 60 percent. The investor must try to obtain more equity or lower the purchase price they are offering.
- A value-add investor is utilizing a floating-rate bridge loan with a debt fund that was originated one to two years ago, which required them to purchase a rate cap (with a strike price that would limit the maximum increase of a floating rate). The rate cap is about to expire, but there is still some term left on the bridge loan, and the current cost of the required rate cap renewal is now exorbitantly high.
For example, the borrower might have been getting up to 75 percent leverage when they acquired the asset with the plan to either sell the asset or refinance it at the end of the three-year period. They are unsure whether selling the property would provide them the returns they anticipated, and if they are looking to refinance, the permanent loan may not size to where it needs to be.
The good news is that there are viable options for borrowers in all these situations:
Work with the current lender to find a solution
In most cases, the lender is not in the “loan to own” business, and therefore, would rather work out a mutually beneficial solution with the borrower. It is not always apparent to borrowers that the loan can be extended even if there are no built-in extension options. Similarly, the terms of a rate cap requirement can be renegotiated. It is helpful to work with an experienced commercial mortgage banker, who has a deep relationship with the lenders.
This can provide the borrower with additional negotiation power.
However, if it is not in the best interest of the lender and/or borrower to continue, there are other options as well:
Obtain additional rescue capital to make up the difference
There are many groups that specialize in deploying joint venture LP equity, preferred equity, or mezzanine financing that can help to round out the capital stack in the case where a new loan is constrained in proceeds. The cost of capital for these options is higher, so it is important to utilize the help of a commercial mortgage banker with existing relationships to help “clear the market” and obtain the best terms. Similarly, borrowers could obtain a stretch senior bridge loan from lenders that are focused on basis rather than current cash flow, even in the case where a borrower is going from a bridge loan to another bridge loan.
Refinance with a lender that can maximize proceeds like Fannie Mae or Freddie Mac
With a federal mandate to provide affordable workforce housing and liquidity to the marketplace, the agencies will continue to lend even during the toughest economic times. Freddie Mac and Fannie Mae compete on pricing and loan terms to reach their loan purchase cap goals determined each year by the FHFA, which this year was $78 billion each. The agencies are therefore a strong option, particularly if the property contains some degree of affordability (either naturally or by right) to the property. A commercial mortgage banker that is licensed by both agencies to originate loans can run an affordability calculator to determine the best execution for borrowers.
Evaluate a sale by getting a broker’s opinion of value (BOV) from a multifamily investment sales team
A BOV helps determine a property’s value and provides a potential seller with rental and sales comp analysis. The broker then partners with the client to position the property to maximize the sale and achieve their goals — whether the asset is for sale today or down the road.
In the case of Sacramento, it is still a good time to sell because the multifamily market fundamentals are very good, and the market has performed extremely well coming out of the pandemic, says Shane Shafer, managing director of investment sales in Northmarq’s Irvine office.
Shafer points to the strong rebound in job growth in the leisure and hospitality sector as well as the solid growth in public-sector jobs. Additionally, Sacramento experienced a 2.23 percent increase in population growth due to its quality of life and affordability.
“Rate increases due to the Federal Reserve have changed pricing and buyers’ expectations,” Shafer notes. “But due to Sacramento’s strong fundamentals, especially on the rental demand side, is allowing those changes to be more minimal than in other parts of the country and other parts of California.”
The best-performing areas of Sacramento, Shafer says, are the northeastern markets, and particularly the newer, more core properties, which recorded the largest year-over-year rental gains.
“Demand, rent growth, and population increases are driving some folks to widen their options as buyers to find the best next market,” Shafer says. “Sacramento is offering those investors that type of opportunity.”
While one borrower may be faced with a difficult situation on one property, a lender may be on the other side of that same situation with hundreds of different borrowers on hundreds of different properties. Therefore, it is vital for borrowers to seek the assistance of commercial mortgage bankers that can provide the attention needed to resolve any problems and act as intermediaries at the negotiation table.