For Distress Buyers, Peak Market Multifamily Deals Are ‘Fertile Hunting Ground’
Multifamily has been a darling asset class for U.S. commercial real estate investors for years, as a national shortage of homes drove consistent rent growth, which spiked to record highs last year and spurred a gigantic wave of investment.
But many of the buyers who jumped in at the top of the market in 2021 and early 2022 had to bring in additional financing through bridge loans, mezzanine debt and preferred equity in order to win deals. As interest rates have shot up, those complex capital stacks could soon lead to overleveraged owners, creating opportunities for distressed asset investors to swoop in for a deal, industry experts said at Bisnow’s Multifamily Annual Conference last week.
“There's some pretty easy ways to find high probability default or distress situations, even with a generally positive multifamily operating overlay,” Jones added. “If you look back over the last 18 months, there's a lot of capital stacks that are quite precarious relative to the interest rate environment right now and the availability of capital that we have right now.”
The about-face from the heady days of 2021 — when $335B of multifamily properties sold, nearly double the previous record — has been swift. Earlier this year, the Mortgage Bankers Association predicted commercial real estate transaction volume would top $1T for the first time ever.
Now, equity investors and lenders at the event said they are bearish on the multifamily market over the next year or two. After 2021 saw record rent increases, the sector has faced three straight months of declines that experts say may be a sign of an overheated market beginning to cool.
If rents start growing again, they could continue fueling persistent inflation, which is precisely what the Federal Reserve is moving aggressively to tamp down with rising interest rates. Its aggressive campaign of rate hikes has driven a rise in negative leverage, which happens when interest payments exceed the underwritten returns on an investment.
“That negative leverage phenomenon is a real issue for us over the next 12 to 24 months,” said Tom Noble, senior vice president and chief operating officer of Archway Capital. "If you're buying multifamily property today and you're assuming rental growth, you're assuming higher rates, and that's a problem."
Geri Borger Urgo, head of production at NewPoint Real Estate Capital, said the owners of properties with complicated capital stacks or floating-rate loans may soon find themselves overleveraged, forcing the need for a capital infusion.
"I'm more curious about early 2022, late 2021 purchases that built up capital stacks involving lots of parties ... they don't have the deep pockets, necessarily," Urgo said. "There's a lot of opportunity in that."
There are early signs that a property type known for its complicated financing schemes, affordable housing, is experiencing that crunch. D.C. Department of Housing and Community Development interim Director Drew Hubbard said at the event that the public agency has had to pour more money into some of its previously closed financing deals in order to ensure much-needed housing projects in the District could move forward.
“Some of the deals that we selected for underwriting two years ago, the numbers that they relied on are totally different today,” Hubbard said. “We are redeploying and adding to those projects to make sure that they actually close and actually go into the ground.”
The buyers frenzy that occurred before the interest rate hikes also led firms that typically commit to long-term holds to begin selling assets for favorable prices, said Jason Morgan, president of special situations at Morgan Properties.
Morgan said the firm, which is typically a long-term owner, sold $1.5B worth of real estate assets over the last 12 to 18 months, sometimes to buyers that would take on a 3% cap rate or less and syndicate out all of their revenue.
“There was tremendous euphoria out there from a lot of groups,” Morgan said. “They really were expecting rates to stay low for longer, lease trade-outs to continue forever. And it’s just not going to play out.”
Today, Morgan said his firm is seeking fixed-rate loans over the next few years, but on terms that allow rates to float in the mid- to long-term when he expects interest rates will go back down. He believes that those with the capital to grit through the present interest-rate environment are well-positioned to weather the storm in a property sector that’s long been seen as an inflationary hedge.
“It is a good asset class overall if you buy right, didn't buy at a really low cap rate and if you financed with reasonable leverage,” Morgan said. “We’re generally saying ‘Stay alive till 2025,’ because you really have to manage through this.”