Is Floating Rate Debt still Bad?

[Evan Polaski]

I just posted a similar discussion to LinkedIn, but would love to get your insights here.  This is concerning syndications, and specifically directed to those that are truly open to making syndication investments (if you are adamantly opposed to syndications, I respectfully ask that do not reply, as much as I generally respect your opinions on if syndications are good or bad).

I just returned from the Best Ever Conference.  As usual, I thought it was great.  But my topic comes from listening to a small panel (two operators), both with multifamily portfolios in the billions.  One of the two operators was asked about fixed vs floating rate debt.  He is a fairly well known multifamily syndicator, who I don't believe has lost any properties, but does have several with paused distributions.  He noted how he continues to prefer floating rate debt.  His reasons were: a) he can borrow capital improvement budget, thereby not diluting LP returns and b) he could not underwrite yield maintenance.

He continued to imply that his business model will remain short term holds (under 5 years) so this debt works for him and is better than fixed rate.

My question to this community: would you still be willing to invest with an operator taking out floating rate debt in today's world?

[Brian Burke]

Floating rate gets a bad rap.  In part, justifiably so, and in part by mistaken identity.

Justifiable:  Floating rate debt carries interest rate risk.  And right now rates are at multi-decade highs after a rapid run up, so the wounds are not only fresh, but the bleeding hasn’t been controlled yet.

Mistaken Identity:  If the syndicator on the panel says he prefers floating because he can borrow capital improvement funds, he is talking about bridge debt, which happens to have a floating rate but isn't the primary characteristic nor the reason people use it. Operators use bridge debt because the lender is more flexible as to DSCR and LTV/LTC than banks and agencies. Bridge debt is used to "bridge" a property from its current state to an improved state and by virtue of that purpose, the maturities on these loans are short, typically 3 years with two possible one-year extensions (if the covenants are being met).

The reason this distinction is important is that if rates rise, property values tend to fall.  And with only 3 years to maturity there isn’t enough time for the market to come back.  Thus, when the loan comes due, the property could easily be worth less than the loan amount, leaving the owner with very few options, none of them good.  This panelist says his business model is to hold less than 5 years…until it isn’t.  If the market doesn’t support a sale in that window, what then?

Bridge debt can be toxic.  A lot of the foreclosures and failed / troubled syndications used this debt structure, and people are hearing about it or experiencing it, and loathing floating rate loans when really what they mean is bridge debt.

But floating rate bank or agency debt with long-term maturities is different.  It still carries interest rate risk, but doesn’t have the yield maintenance risk found in fixed-rate loans.  Floaters are painful today, but fixed was painful a couple years ago if you wanted to sell 3 years into a ten-year loan.  Unfortunately there’s no free lunch in commercial real estate finance.  You have to pick your poison.

Should you accept interest rate risk, and are floating rate loans (not bridge) a good option?

Borrowers historically (but maybe not at the present moment) have come out on top using floating rate, in other words, they are getting paid for the risk. A study published by the CCIM institute looked at 50 years of history and reverse-engineered the interest costs of 5-year fixed and floating loans over 562 starting points and found that floating rate borrowers “won” 72% of the time. That study did NOT include the impact of yield maintenance. Had that been factored in, my guess is floating rate “wins” closer to 90% to 95% of the time.  Starting points within the last 36 months could very well end up in the 5-10% of starting points where floating lost.

And I think that’s where we sit today—the inverted yield curve is making floaters difficult to pencil.  With 30-day SOFR around 5.3% and the 10-year UST around 4.6%, floaters have a starting rate considerably higher than fixed debt.  That rate will float down if rates fall, but first-year yields are the toughest and that’s not a good time for the higher rate.  This is making floaters almost unusable right now…but that will change once the yield curve corrects.

And bridge debt?  I stopped using that years ago and have no plans to use it in the future—it’s just not worth the risk.  People use it because the higher LTVs allow them to raise less money (which newer syndicators and “portfolio builders” need), and project higher returns (which attracts capital from investors who might not fully appreciate the risks).  But if the tide shifts, they get wiped out.  I’ve survived this biz for 35 years without losing investor principal, across many adverse market cycles, and I couldn’t do that by taking on much “wipe out risk.”

[Chris Seveney]

Quote from @Evan Polaski:

I just posted a similar discussion to LinkedIn, but would love to get your insights here.  This is concerning syndications, and specifically directed to those that are truly open to making syndication investments (if you are adamantly opposed to syndications, I respectfully ask that do not reply, as much as I generally respect your opinions on if syndications are good or bad).

I just returned from the Best Ever Conference.  As usual, I thought it was great.  But my topic comes from listening to a small panel (two operators), both with multifamily portfolios in the billions.  One of the two operators was asked about fixed vs floating rate debt.  He is a fairly well known multifamily syndicator, who I don't believe has lost any properties, but does have several with paused distributions.  He noted how he continues to prefer floating rate debt.  His reasons were: a) he can borrow capital improvement budget, thereby not diluting LP returns and b) he could not underwrite yield maintenance.

He continued to imply that his business model will remain short term holds (under 5 years) so this debt works for him and is better than fixed rate.

My question to this community: would you still be willing to invest with an operator taking out floating rate debt in today's world?

"so this debt works for him and is better than fixed rate" - keyword "works for him". They have billions and have paused distributions, but as mentioned by Brian (which is an EXCELLENT READ), they hold five years until they cannot sell and hold longer. 

My question is, are they still getting fees during that time. Floating rate debt has worked in the past, and it could still work today as rates most likely will go down over time, but with our debt exploding, will they really? Will other countries continue to buy our bonds? What if they do not?

For me, not the risk I am willing to take. Lets say I make a $50k investment into a syndication, I am 100% ok with getting a 10-12 annualized return with preservation of capital and lower volatilty / lower standard deviation versus 15-20% but high volatility and high standard deviation. 

To me the $1500-$4000 a year delta between a 12% and up to 20% is not worth the risk of potentially losing a significant portion of my capital. I am all about capital preservation. 

[Evan Polaski]

@Brian Burke and @Chris Seveney, thank you both for your feedback.

You are correct, Brian, he is using bridge debt, and even referred to the product as such, so no hiding it.  I appreciate you siting the study on Fixed vs Floating, as I had seen you make that point before, but without a direct source, at the time.  What is interesting to me is all the owner/operators I know and/or know of that were founded in the 90's, have an almost allergic reaction to interest rate exposure.  While some use floating rate debt, for say, corporate unsecured lines of credit or capital commitment facilities, they also tend to use Swaps versus interest rate caps, and often times will build interest rate collars on their floating rate debt.  

What is interesting with these groups is they are all "old school" operators first and capital raisers many layers down.  They also place SIGNIFICANT amounts of their own capital into deals (not the $100k - $500k, while pulling a $1mm+ acquisition fee, but in one case, the founder is funding 80% of the equity).  I imagine this level of personal capital exposure has an effect on how much risk they are willing to take in a deal, both with the asset itself and the structuring of the transaction.