Borrower profile: Three Pillars talks squeamish lenders, rate caps dilemma  

The Houston-based firm recently refinanced debt on a $50m multifamily project. 

The refinancing dilemma keeps intensifying for borrowers as spreads widen and the cost of financing rises. A key component in this predicament is the increasing cost of rate caps, according to Gautam Goyal, CEO at Three Pillars Capital Group.  

“Refinancing loans is the biggest problem right now,” Goyal told Real Estate Capital USA. “As debt becomes more expensive, [and] rate caps keep getting more expensive, it will be harder and harder to get transactions that make sense.” 

The Houston-based manager, which specializes in class B and C multifamily, last month secured a $46 million refinancing loan for two residential communities – enabling the firm to return equity to investors. 

“We paid $50,000 for a rate cap when we bought the deal [two years ago],” said Goyal. “Today that would have been almost a million and a half, so you can imagine the difference to go from $50,000 to $1.5 million. People are going to have trouble unless they have created so much income that the income will support a refinancing that will cover part of or the whole loan.” 

An interest rate cap has three primary economic terms: the loan amount covered by the cap known as the notional; the term; and the level of rates, or the ‘strike rate’, above which the cap will pay out.  

Kennett Square, Pennsylvania-based advisory Chatham Financial gives the following example – a $100 million, three-year, 3 percent strike cap will pay out if SOFR exceeds 3 percent over the next three years. This puts a ceiling on the purchaser’s all-in loan coupon of 3 percent plus their loan spread. 

Interest rate caps have historically been a common method to put a limit on potential pricing increases on floating-rate loans, but rising rates is making this hedge more difficult to achieve, as covered by Real Estate Capital USA in October 

“Anybody who bought assets in the last two or three years and paid ridiculously high prices and low cap rates to get in the deal will not be able to refinance when their loan comes due because loan to values are getting compressed,” said Three Pillars’ Goyal. 

More pieces of the refinancing puzzle 

Other components in the current refinancing dilemma borrowers face today are low debt-service coverage ratios and the pullback from lenders. 

According to CBRE’s Lending Momentum Index published earlier this month, commercial real estate lending has slowed with data showing an 11.1 percent drop in lending volume from the second quarter of 2022 to the end of the third quarter of this year.  

Three Pillars is a witness to this pullback. But Goyal believes something else is going on between the numbers. And that’s lenders becoming more deal specific.  

“Lenders are becoming very squeamish about what kind of loan they want to give out on a certain deal, whether it’s a refinance or an acquisition,” says Goyal. “But if you have a deal that has a good DSCR, strong fundamentals, good cash flow – like our $46 million refinancing – then you should not have a whole lot of trouble finding financing.” 

Not all gloom and doom 

For sellers, depending on how much working capital they have or the rate caps protecting them, the situation is much more positive, Goyal added.   

“But once those rate caps start expiring, and once those loans mature, people won’t have an option unless interest rates come down. If growing income was not part of your business plan, it’s really a bit late to shift gears and look to create income by renovating a property and doing the whole value add programme,” he said. 

From an opportunity perspective, there are still deals to be had, especially in the multifamily space.  

“As time goes by more and more, those opportunities will unfold,” says Goyal. “As interest rates go up and stay elevated, homebuyers are getting priced out, unless the values of single-family homes corrects itself, so a lot of people have no choice but to rent – from a multifamily perspective, we’re in a pretty good spot.” 

But borrowers and lenders are also becoming more conservative in underwriting, projections and business models. “[We have to] understand that things may stay the same for the next two years,” says Goyal. “It really comes down to being conservative and looking at whether a particular transaction makes sense.”