The State of Multifamily Lending

How do you know you’re in a challenging interest rate environment? You plan your weeks around Federal Reserve announcements and speeches.

And that’s been the case since the Fed, in an attempt to beat back inflation, raised the benchmark federal funds rate high enough that they become more than slight annoyances every time a CRE professional tried to pencil a deal.

It’s understandable. After years of ultra-low interest rates and high leverage, doing business became a challenge. But it may have been particularly unsettling to the multifamily industry where financing was generous and at low rates. Now more than 60% of banks are still tightening lending for multifamily. The GSEs are still lending, but they have limits and don’t offer high LTVs.

What’s going on in multifamily lending is a challenge and both borrowers and lenders are trying to adjust.

THE GOOD OLD DAYS The multifamily category, along with industrial, had been one of the twin stars of pandemic disruption. Values raced upward and cap rates plummeted. That was fine because rent increases promised a successful future no matter how high building prices rose.

“If you go back two years ago, we were in peak multifamily,” says Jon Siegel, chief investment officer and co-founder of multifamily investment firm RailField. “Markets were crazy hot, and properties were selling for three-caps.” Many people he says were financing with variable rate or bridge products at just 300 to 350 basis points over SOFER — and SOFER was only 5 basis points at the time. Plus, LTVs of 80% were common.

“A lot of people want properties and were able to get 75% leverage when interest rates were 3% and they were buying at 5 caps,” says Jahn Brodwin, co-head of FTI’s real estate solutions practice. “The more money you borrowed, the more equity you’d make.”

The big mistake was that so many people assumed the conditions were a new normal and that the good times would continue to roll like a never-ending Mardi Gras parade. “Everyone thought, ‘I’m buying at a low return but will be able to raise rents soon enough that I can refinance at a fixed rate loan or sell to the next guy,’” says Brodwin. “You were basically giving the lender the present value of the interest payment for the whole term of the loan.”

Even bankers stocked up on low-interest rate, long-duration assets, a move that eventually put some of the biggest offenders out of business. But the parade eventually does end. People go home and back to their regular lives.

In the case of multifamily finance, regular life for many no longer included a good night’s sleep.

THE NEW NEW NORMAL

Now 7% is a more likely rate and “as a result, valuations on real estate have cooled off, and what was a 5 cap is now a 6 and the more money you borrow, the more equity loses,” Brodwin adds. More common LTVs now are 50% to 60%.

But absolutes on what to expect are also hard to come by.

“Certain banks, local banks and local credit unions, are shutting down credit completely and others are offering aggressive terms, depending on their balance sheet,” Michael Margarella, principal at Next Play Investments, says. “We are talking to some lenders who said we’re not interested in lending on commercial real estate.” At the same time, he says that some smaller commercial banks might still offer some terms similar to 2022, like 70% LTV. “If the smaller banks have an aggressive board, they’re looking to deploy capital.”

However, that is rare. There is less flexibility. A bank once might have agreed to let a property owner complete some value-add changes and increase rents and therefore NOI over time to reach a 1.25 debt service coverage ratio. “In the past building up to it was fairly common,” says Margarella. “That’s part of value-added investing. But now the banks don’t want to be caught if rent increases don’t continue and your NOI isn’t going up. They don’t want to get to the point of not having that 1.25 DSCR.” One lender he had worked with for years “completely changed their policy, basically overnight.”

“Financing is a challenge,” according to Edward Ring, CEO of vertically integrated multifamily company New Standard Equities. “Everything that can pencil to today’s debt yields that lenders are requesting means that we’re effectively 50% or 55% leverage, which is missing the mark on some of our assets that went through the pandemic eviction moratoria cash shortfalls. Assets weren’t performing. On some of our properties, it’s fine. On some it’s challenging to get to the level of debt we need to finance or make it pencil for the equity yields.”

New Standard typically passes on bank financing for non-bank entities “because we refer to borrow on a non-recourse basis and banks usually have a recourse component,” Ring says. “We have had banks in the past, but sometimes banks get caught up in their own portfolio problem and wind up pulling back from credit, like now.” For example, a bank loaded with office-related loans probably won’t be too interested in financing multifamily.

Like Margarella, Ring has also seen “lenders trying to stretch, trying to make it palatable for whatever the borrower is trying to do.” However, they will add terms like interest rate floors so they can consider their own cost of money when making a variable-rate loan.

“It’s matching that capital to the business plan and having some certainty around what the cost is,” Ring says. “I think the industry was caught off guard, not that interest rates moved but so much happened so quickly. I think most people expected 200 to 300 basis points and this was a 500-basis point movement that was too much to bear too quickly.”

SEEKING NEW PLANS

Given the current state of multifamily borrowing, it’s understandable that many in the sector are considering how to change their financing strategies.

“We had a property we bought in 2017. It was going to be a value-add property,” RailField’s Siegel says. They’d put money in and then sell quickly. “A lot of the time in these value-adds, you turn around and sell the dream,” maybe renovating 10% or 20% of the units and improving some of the common space.

“Our investor at the time wanted to do a fixed rate low because rates were low at the time,” he continues. “We told them at the time we probably shouldn’t take on this fixed rate loan because we’ll probably try to sell in a couple of years.” They held the property until 2021 and ended up having to “pay over $2 million in yield maintenance.” That ate a significant portion of the return they’d have otherwise seen.

RailField rid itself of its last variable rate loan in 2021. “The last interest rate cap we bought was in 2020 for $50,000,” says Siegel. In current conditions, that rate cap would have cost $1 million, effectively pushing the finance rate to nearly 8%. Still much better than at times in the 1980s, but the speed of change has made it a challenge.

“We came off of a seven-year high, where the lenders were as creative as possible, practically giving away money and doing everything they could to convince you to take more of it,” says Jeff Klotz, founder and CEO of The Klotz Group of Companies. “All of a sudden the faucet stops.”

Klotz’s firm is both a borrower and a lender. “We own real estate, primarily in multifamily, so we’re borrowing money from both banks and other lenders to buy real estate and also to build real estate,” he says. “But we also have a financing and lending business. We understand it from both sides of the table, and it’s frustrating for us on both sides of the table. Over a period of several months, interest rates have doubled or more than doubled. That pretty much affected the entire multifamily market nationwide, but more in the southeast. The entire market has suddenly changed almost overnight, and it will take time for the rest of the market to adjust and adapt to these changes.”

Klotz says that the government-sponsored enterprises like Fannie Mae and Freddie Mac “still remain the top choices, the top opportunities. They’re still offering some of the best lending opportunities available in the marketplace. You have seen a resurgence of loan funds and debt funds, non-bank lenders, that are able to offer a greater loan amount than the GSEs, the life insurance companies, or even CMBS.”

WHERE LENDERS ARE

“As a lender, the focus on the quality of the borrower, the strength of the sponsor of the borrower, and their ability to withstand future market deterioration is critical for us,” Klotz says. “There is much more emphasis on the quality of the asset, too.” That includes the quality of the borrower and better business plans.

At the same time, lenders are making up for previous decisions. “We see lenders in this pre-workout stage a lot longer than we’ve previously experienced,” says Klotz. “They’re definitely not in any type of rush for a default or to take the keys back. We’ve been in the business nearly 30 years, so it’s reminiscent of previous cycles. But we became spoiled for so many years. The ease of transactions was phenomenal for so long, the entire market became spoiled. Few transactions now pencil out or work.”

Forman Capital is a private multifamily lender in Florida, Texas, and Georgia. “We’ve always gravitated to residential,” says managing partner Brett Forman. “There’s a need for housing, and as long as you’re in a decent market, there’s a price at which someone will occupy the residence.”

Conditions are confusing and difficult right now. “Cap rates have moved but because of price discovery we can’t find where they are,” Forman says. “Rents have gone up, check the box, but expenses have gone up measurably. People talk about rental growth, but they’re not quick to mention expense growth. In my mind, you don’t get dollar for dollar credit for the rent growth if expenses have gone up. I got an email yesterday from a fund I’m personally invested in. Their insurance costs have risen by 70%. That changes the cash flow dynamics. It’s a big line item.” Insurance companies, especially in Florida and Georgia, have been hit by climate change and natural disasters.

All this makes it harder to know NOIs because, with increased expenses and other costs, they’re a moving target. But if a lender doesn’t know net operating income, it can’t accurately calculate the DSCR, leaving a big potential risk factor unchecked.

“It’s already happening because of interest rates,” says John Vavas, a commercial real estate finance attorney at law firm Polsinelli. “But you add into some of these other geographic-specific issues like California or Florida, and it makes it harder to pencil a deal.” It’s still possible to structure a transaction, but it tends to need more equity on the part of the borrowers. “When things start to become negatively convexed, when the cost of equity becomes cheaper than debt, then it will become a really interesting conversation.”

“Going forward for Forman Capital, the next 24 months will be quite a bit of what I call rescue capital,” Forman says. “If someone has to pay their bank or lender down with fresh capital, we can come in and do that, but that’s going to put more money senior to the equity and it’s going to make the equity harder to realize value.” In effect, everything is an equity play. “It’s a form of kicking the can down the road.” Maybe if interest rates come back down things will be okay, but that’s far from a certainty.

Merchants Capital does multifamily loans, debt financing, construction lending, equity tax credit bridge loans and acquisition financing, all through the agency licenses. “There have been concerns in the construction lending areas,” Dwayne George, executive vice president and national head of production, explains. “A lot of banks are not inclined to do construction lending with higher LTVs in certain markets.”

THE FUTURE

Both lenders and borrowers face complex and conflicting choices given current macroeconomics. Going into the year’s end, being able to predict anything seems like wishful thinking. The Federal Reserve has been clear that while things seem to be improving with a chance of a longer hold on interest rate increases, should conditions change, the central bank will be ready to raise rates again.

“I believe that on a longer-term basis, two years, three years, interest rates will come down again,” FTI’s Brodwin says. But that doesn’t mean back to the previous easy money period. “A normalized mortgage interest is more like 5% or 6%. When you have interest rates that are higher than the cap rates on property, it knocks most people out of the market.”

“I think lenders are going to be very selective with quality sponsors, quality properties they’re comfortable with, and low levels of leverage,” Brodwin adds. And getting more stability will be difficult while buyers and sellers can’t agree on pricing. “It’s hard to buy at 7% when someone is selling at 5%. You need a story about how it’s going to get better. But if you buy a fully stabilized property that’s already well managed and everything’s at market rents, it’s hard to borrow. The numbers don’t make sense. But over some period of time, people will be forced to sell.”

Whatever happens, don’t expect quick resolutions. Patience will become a critical tool. “You’re going to have to ride it out, revise your capital stack, and either work it out with the lender or lose the property,” Klotz says. “There’s lots of capital out there willing to take advantage of offering help, but what they look for may not work. The borrowers are still in denial of the new market, so they’re not willing to accept the new market conditions yet.” But as time goes on, they’ll have no choice.

The multifamily lending market has gone through a lot of strain. And yet, to those old enough to remember enough previous cycles, or those who did their history homework, as extraordinary as the present seems, maybe it isn’t so much.

“We’ve actually been through this kind of stuff before,” Ring says. “As much as we all think maybe it’s going to be different, it’s never really all different.”