The US multifamily sector is facing a series of significant near-term risks which are being understated by many market participants, says Bert Crouch, managing director and head of North America at Invesco Real Estate.
The impact of near-term loan maturities in a higher rate environment, plus the expiration of interest rate caps on loans originated two or three years ago, combined with the impact of higher insurance costs in coastal markets and an expected influx of new supply, mean a significant change in the math around multifamily refinancings and valuations.
“The wave of maturing bridge loans and the interest rate caps associated with those loans will be the biggest catalyst on floating-rate driven stress in the near term,” Crouch told Real Estate Capital USA. “Insurance expenses are up materially, and loan maturities and financing costs are also way up. This is creating a stressed scenario for select multifamily assets purchased at historically low cap rates and financed with higher leverage via floating rate bridge loans.
“I think the catalysts are coming in the second half of next year, which is when you will start to see a lot of very motivated multifamily sellers.”
Rate caps and the maturity wall
The US commercial real estate market is coming up against a roughly $1.9 trillion wall of maturities over the next three years, according to a third quarter report from Newmark. The New York-based brokerage also found multifamily specific loan maturities of $115 billion in 2023 and $88 billion in 2024, explaining about a third of the loans maturing through 2025 were originated at a time of record low rates and high valuations.
In addition to being able to borrow at extremely low rates prior to March 2022, the cost of obtaining interest rate caps was similarly inexpensive, Crouch said. That cost has risen commensurately as the Federal Reserve has increased the target rate to 5.25-5.5 percent to fight inflation.
“Prior to the rise in interest rates seen over the past 18 months, many lenders were offering two-year loans with two one-year extension options. Lenders were also offering borrowers interest rate caps which matched the initial duration of the loans,” Crouch said. “These caps were shorter duration and, accordingly, had a lower strike rate at a time when the interest rate curve was less steep. And because the interest rate curve was less steep, interest rate caps were cheap.”
In many ways, the rising cost of interest rate caps is as significant as today’s higher rate environment, Crouch said, adding that borrowers are coming back to lenders to negotiate new caps at a difficult time.
“Any caps with in-the-money strike rates today are extremely expensive,” Crouch said. “Borrowers are coming back to lenders and saying, ‘What else can I do? Partial recourse? Paydown? Higher strike rates?’ Regardless of where you end up, it is a very clear catalyst for a capital event sooner rather than later, especially if it involves injecting significant new equity.”
“The structural elements of interest rate hedging will be one of the primary catalysts for near-term sales, recaps, liquidity events or worst-case scenario, loan sales.”
Lenders and borrowers are also grappling with higher insurance costs, particularly for properties in coastal areas or markets in which there are environmental risks.
“Insurance used to be a box check. Now it is materially more expensive,” Crouch said. “If your average multifamily insurance is up 30 percent year over year and if you need catastrophe coverage or you’re in a market that has a higher probability of flooding or hurricanes or significant events, you’re seeing insurance costs are up as much as 200 percent or more.”
He added: “The reason why the insurance costs are more significant than interest costs in some ways is that these costs are above the line, so it is a capitalized cost adversely affecting value.”
At the same time, sponsors are bringing online properties at a time when rents have softened. Dodge Data & Analytics projects that there are about one million units in the pipeline, a level that is 75 percent higher than in 2019.
“The affordability crisis is really tough and home prices are still going up,” Crouch said, noting Invesco owns about 38,000 apartment units. “We have seen rents change from going up at a significantly increasing rate to a decreasing rate to now falling in certain markets. We have gone from managing for rents to managing for occupancy. You’re also seeing concessions start to come back.”
Prior to the current dislocation – which Crouch said is the most significant since the Global Financial Crisis – multifamily sponsors often managed interest rate risk by obtaining long-term financing from Fannie Mae or Freddie Mac.
“But that was when the 10-year was sub-3.5 percent. The 10-year is up over 125 basis points, so it is no longer possible to refinance with a Fannie Mae or Freddie Mac fixed-rate loan and save as much on your rate. As a borrower, you don’t have an out anymore, and that means the stress coming is more significant than most perceive.”