Syndication Using Fixed Rate Debt

[Duke Giordano]

Hello All,

I am seeing more and more syndications get me nervous with the current debt terms at this juncture of the market and interest rate risk. Many value add syndications are still using bridge debt in a typical 3+1+1 structure that has been used for the last several years. Many of the caps these days are based on SOFR, and what used to be a 60k cap for 1 point is now a 600k cap for 3 points. This to me is a huge risk. Any limited partner should ask to see a sensitivity table on interest rate risk and how deals perform as rates rise. As a limited partner, I would almost prefer syndicators go to a lower LTV model in the 65% range and with fixed rate debt to de-risk a bit and I would wonder if educated passive investors would be willing to take this incremental decrease in returns to de-risk.

For those multifamily syndicators and LP passive investors in syndications whats your thoughts on the current debt market in a rising interest rate environment, and how are you underwriting deals this days to account for this risk point.  In my mind this is one of the highest risk points at this stage in many multi-family syndications.

Look forward to your perspective. Have you seen large syndicators out there now in large syndications using lower LTV, fixed rate debt? This is a time you may need to zig when others zag...

[Brian Burke]

@Duke Giordano I know that these days I'm in the minority here, but I've long been averse to bridge debt, favoring lower leverage with long maturities, preferably 10 years.  A few years ago I did a couple of deals with bridge because we had an institutional investor providing the majority of the capital and they insisted on it.  I regretted it every day until I sold them.  Ultimately the IRRs were mixed--half did amazing, half were just OK.  And that's the thing about high leverage--it amplifies results...both positive and negative.  In a rising market it can work out well, but when the tables turn it can be a disaster.  Many syndicators using bridge haven't experienced a time when the chips were down, so this is a lesson they have yet to learn.

Your suggestion that you'd prefer 65% leverage, fixed rate debt, as a tool to de-risk, I half agree with.  The problem with fixed rate debt is two-fold:  First is that I think you'd find that borrowers who take the risk of interest rate movement usually get paid for that risk.  There was a study I read once that opined that about 95% of the time floating rate debt had a lower total interest cost over the typical life of the loan than a fixed rate loan.  Maybe that's true, maybe not, but I'd bet it's close.  The second problem is yield maintenance.  YM causes two problems:  First is that it's very existence can cause owners to make decisions that they might not otherwise make, meaning that debt considerations can drive the exit rather than market considerations.  Second is that it can be extremely costly in an early exit.

So to be fair, if you think that sponsors using floating rate debt should do a sensitivity analysis to show various outcomes at various interest rates, then balance that with a similar sensitivity analysis for various yield maintenance costs when fixed-rate debt is to be considered.  Heck, I bet that if you look at many sponsor memorandums using fixed debt you won't even find yield maintenance as a line-item on the cost of sale analysis.

My personal happy medium is low leverage floating rate agency debt.  Somewhat the best of both worlds in that you get the ten year maturity and you have no yield maintenance...meaning you can sell or refinance at any time for only a 1% exit fee.  But there's one more thing--this should be coupled with an interest rate forecast that ties to the borrowing rate so that there is true variability in the underwritten rate--not just assuming that the index remains flat for the life of the loan.