Harsh Reality: Bifurcation within Multifamily Assets

Is Multifamily a doomed asset class?

No, but there is a very harsh reality of bifurcating pathways emerging within multifamily. It’s important to recognize this will cause pain for some investors and present opportunities for others. First, however, let’s talk about the liquidity bubble.

Many analysts now refer to the “liquidity bubble,” a period from 2020 to early 2022 in which multifamily acquisitions were supported by high leverage, low variable interest rate bridge debt. In essence, there was a huge amount of liquidity in the system and, while initially low interest, it was variable-rate with short terms—anywhere from 3 to 5 years. Many operators married these variable rate loans to interest rate cap policies that limited the exposure to rising rates. Others raised interest reserves to serve the same purpose. Some operators did neither, especially in those acquisitions in the early part of the liquidity bubble as there was little indication the Fed would raise rates at such a historic pace in such a short period of time.

If an acquisition was executed during this liquidity bubble with variable rate bridge debt, the current challenge is that the loan term is expiring. Whereas previously a bridge-debt-to-fixed-rate-refinance was a predictably successful pathway for many multifamily assets, the current environment has gone through a paradigm shift.

There are 3 components of this paradigm shift facing multifamily owners with expiring debt terms in 2023 and 2024.

First, the liquidity tidal wave has turned into a trickle.

One of the main impacts of such historic Fed actions is to slow down the flow of money. The availability of capital in the lender markets for multifamily assets has been greatly reduced. Partially, lenders are feeling the pains of higher treasury yields. Also, regional and small lenders may have disproportionate balance sheet exposure to multifamily. Certainly, there are more reasons than these, but the main impact is that the liquidity enjoyed by this asset class has drastically reduced and multifamily operators do not have the extensive source of options and leverage they enjoyed in 2020 and 2021.

Secondly, interest rates are obviously higher.

This is no small impact. Multifamily operators facing a required refinance will face much higher interest expenses this time around. This will require assets to have higher net operating income to handle the debt service coverage ratio (DSCR) needed for a refinance into agency debt.

Lastly, valuations have changed.

In many markets, there’s been considerable repricing of multifamily assets. The liquidity bubble may have elevated pricing temporarily. With less buyers and liquidity in the system, the buyer pool has shrunk. Also, buyers need to accommodate for higher interest rates on their acquisition debts. In order to still return attractive numbers to their investors, acquisition firms in this climate cannot afford the pricing seen in 2020 and 2021. Valuations in 2023 for many assets are markedly different and could be so through 2024.

Does all of this spell trouble for the multifamily asset class in general? No, but it is creating a very harsh reality of bifurcated pathways. One path is still strong and the other not so much.

Along one pathway are the multifamily assets that will survive the current climate and do well long term.

These assets may have been one of the few who utilized fixed rate debt before or during the liquidity bubble. Typically, these would be longer term debt vehicles with the ability to ride out the high-rate storm. Even assets with variable rate bridge debt may be able to successfully refinance into fixed rate agency debt if they are performing well and located in strong markets. As a recent Globist article states, “Most loans will be able to absorb higher interest costs.” But, these assets must be performing well in terms of occupancy, NOI, and cash positions.

Since multifamily assets are intended to be long term investments, the investors in assets along this pathway will do fine long-term. Near-term returns and valuations will suffer, but the long term outlook is still healthy.

Along the other pathway is a harsh reality that will result in pain and loss for some multifamily operators and investors.

Those multifamily assets who have underperforming occupancy and NOI are higher risk. Lower valuations and inability to meet DSCR requirements needed to refinance in these more troubled assets are going to meet one of several painful outcomes.

One outcome is a cash-in refinance if they can find lenders willing to facilitate in the first place. For troubled assets, the amount of cash brought to the table could be several million dollars. This is a very tall order given the underlying asset. If it can be accomplished, the refinance in these situations would allow for lower debt costs and a realistic runway for returning investor capital in the long term.

Another option could be to recapitalize or “recap” the asset. Some people use the term “rescue capital,” but investors should understand the recap environment has become more predatory and could still result in the loss of investor capital. Recaps serve the purpose of bringing capital to the asset by an outside capital group in a way that repositions the underlying asset for operational success. The recap group may replace the current operator but it also may push current investors further down the capital stack, making it more difficult to recoup their investments once the recap group disposes of the property.

Even more bleak, some of these operators may be forced to sell the asset at a loss or succumb to foreclosure. Both of these outcomes could wipe out considerable investor capital.

As the Globist article states, “data shows that $87 billion of multifamily loans originated during the bubble will mature in 2023, $96 billion in 2024, and $63 billion in 2025. Those loans will mature at a time of higher debt costs and more restrictive bank lending practices….most loans will be able to absorb higher interest costs; many will not.”

The higher quality assets and those that are running with operational and financial efficiency will weather this storm. Those who are having considerable deficiencies, however, could face significant challenges in this environment.

So, where’s the opportunity in multifamily?

The first opportunity in multifamily is in the acquisition of higher quality, Class A and B assets, in markets that are not facing oversupply, economic, or political headwinds. In fact, there are plenty of such assets. Their quality is allowing them to be acquired with fixed-rate debt at 6% or below in many situations. When these assets are coupled with asset managers with proven success, investors are being rewarded for their targeted approach. With valuations more favorable to the buyer side, there are strategic opportunities that will play out well over the long term.

Another avenue informed investors are taking is more targeted and opportunistic. As we mentioned above, there will be many operators that will simply be unable to refinance their multifamily assets. Some of these may be quality assets that are mostly overrun by the interest expenses. In these situations, recap groups have a very favorable opportunity. When executed correctly, these opportunistic investors can bring capital to the table, assume control of the asset at near-bottom valuations, operate and then sell the asset for healthy profit once the interest rate and valuations stabilize—which could be over a 2 to 3 year time horizon. Essentially, recap firms are starting to call the “bottom” in valuations are even able to acquire assets below the bottom depending on the interest-rate stress of the seller.

In closing, no, the multifamily asset class is not broken. But, the liquidity bubble of 2020 through early 2022, has created both opportunities for success and specific pain points for both operators and investors. While this may not be good news to those who are entrenched in distressed properties, the repricing and shift to fixed rate debt currently occurring aligns very well for the buyers in 2024.