Rise Rates Affecting Multifamily Deals

We are all aware of the increase in interest rates during 2022. In fact, a total of 7 increases. It took a minute for the rate increases to affect the real estate market. The 4th quarter of 2022 felt the rise in rates the most, and especially the end of that quarter as the housing market slowed to a crawl, with days on market increasing while values were decreasing in many markets.

Multifamily is experiencing the shock of rate increases in a different manner than single family residential. The affect of the rate increases are happening in multiple forms in the multifamily industry to include the following:

Long-term debt transitions – Many value-add multifamily operators use the business model of purchasing properties that need updates or improvements, accomplishing the improvements and raising rents, which helps accomplish the added asset value. The operator assembles what is called a capital stack, which represents the capital needed to acquire and improve the property. The capital stack could consist of capital raised from limited partners (LP’s), capital from any general partners (GP’s) and financing from 3rd parties (lenders/banks/etc.).

The financing portion is often short-term financing, also known as bridge debt, that serves as a tool to help in the acquisition and improvements. This bridge financing usually carries a higher interest rate, and the exit strategy from the bridge debt is to refinance the property into long-term financing at a lower rate once the property is improved and more stabilized with the new rental rates.

This step of refinancing into lower rate long-term financing is critical as it is what helps accomplish the profit center in the proforma calculations of the project and hence be able to supply favorable returns to the partners (LP’s and GP’s). The increase in rates has seriously reduced or in some cases eliminated the critical step of securing the long-term financing as the property has to demonstrate that it can pay its own bills (mortgage, insurance, taxes, etc.) and have established reserves to cover any capital expenditures (capex) that occur from usage. The rise in rates makes it difficult for many properties to qualify for financing or qualify at a large enough loan-to-value (LTV) to make sense in the refinancing and exiting of the bridge debt. The operator may find themselves stuck in the high interest bridge debt. Some bridge lenders may have an issue with this as they are unable to recover the capital to lend to others.

Change in established long-term debt – Multifamily financing is considered commercial financing and is much different than residential financing. Commercial loans sometime supply the ability to have the interest rate capped at a certain percentage to ensure that the rate can’t continually increase. This rate cap, as it is referred to, comes at a cost to the borrower when the loan is originated. This is particularly familiar on an adjustable rate mortgage.

The rate cap often has a time period associated to it and the rate cap expires after the stated period. A new rate cap may be offered to the borrower at the cost associated to it at that time, if the borrower choose to purchase the new rate cap. If the borrower chooses not to purchase any rate cap at all, then they will experience rate increases driven by the current rates available.

Interest rates were very low for commercial financing for several years, so many multifamily operators felt no need to purchase a rate cap and felt that choosing a variable rate mortgage made sense supplying the project a lower debt service cost and better profit. Or, if the borrower did choose to purchase a rate cap, that cap is likely expiring and the cost to purchase another has greatly increased.

Now these same operators are facing increased mortgage payments if caps expired, or they had no cap initially. The increase in the monthly mortgage payment increases the property’s expenses, and in most cases beyond what the operator had projected, thus either lowering the positive cash flow or wiping it out entirely!

Some operators will scramble to either: raise additional capital from the partners (LP’s & GP’s), this is called a capital call; or they might dip into the cash reserves that lenders require are maintained for those necessary repairs, etc. to cover the mortgage payment increases. However, if the lender discovers that the reserves are being tapped into, it could see it as a breach of the loan agreement and call the loan due. If that were to happen, or if the operator is unable to make the increased mortgage payments and not come to terms of some form of workout arrangement with the lender, then the industry could experience what is called fallout, AKA (also-known-as) foreclosures.

Acquiring new multifamily projects – The increase in rates has made it difficult for targeted purchases to pencil out. In other words, the larger long-term mortgage payment makes it difficult to accomplish favorable positive cash flow figures on stabilized projects. This means that operators need to acquire the properties at lower purchase prices than sellers are currently seeking. Many sellers may not be able to accept a lower figure and hence the sales of multifamily assets will decline. In fact, at the time of writing this nugget, sales have already declined 5% with anticipation of additional declines coming.

The cost of bridge debt has risen as well with the increase in rates, so operators find the need to do a balancing act between the percentage of funds gained from the bridge loan vs raised from LP’s.

In attempts to continue to purchase multifamily assets, some operators have begun seeking purchases where an existing lower interest rate mortgage is in place on the asset and that mortgage can be assumed as part of the acquisition offer. This means that the operator may have to increase the capital raised from partners in the capital stack to cover any value-add improvements needed on the project, or seek secondary financing for it, of a combination of the two.

The impact on multifamily investing caused by the increase in interest rates for monies borrowed is real, and we see adjustment taking place weekly in that sector. The next 12 months will be interesting as we watch who and how the impact will affect.

We want to share that not all multifamily operators will be negatively impacted with the adjustments taking place in rates and the market. The ones that will not be were likely prudent to not over leverage, stockpile cash reserves or negotiate some form of locked-in rates or safety net to offset any rate cap expirations.

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