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Navigating investing in a shifting debt environment

Now that the Fed has taken a stance to stop asset purchases, reduce its balance sheet, and combat inflation with higher interest rates. I want to discuss the impact of rate increases on multifamily investments.

Although I believe that asset prices will be largely unaffected in the near term, particularly for quality assets in quality markets where the flow of capital wants to go and where demand will continue to be high, it is important to understand how rising interest rates affect cash flow. This is crucial not just for future acquisitions, but for existing properties with floating rate debt.

Floating interest rates and the effectiveness of rate caps

Many deals that were purchased at the end of 2021 were financed using bridge debt because it has been the cheapest and most efficient source of funding in recent times. When used appropriately, this is a great strategy for reducing the cost of capital on a value-add project. However, bridge loans typically have floating interest rates and as interest rates rise, the cost of debt service will start to increase, and this will have a direct impact on cash flow.

All bridge providers require that interest rate caps be purchased. However, many providers do not specify how low the caps need to be. Some sponsors have purchased 200 basis point caps because they are cheap and usually the minimum required by bridge lenders. However, a 200 basis point cap means that the cap will only start to provide a benefit to a project once interest rates rise two percentage points above where rates are today – based on the current market view of where the fed rate will be at the end of 2023, these rate caps will effectively provide no value and no protection to these sponsors in the short term.

Hopefully sponsors on these deals have adequately taken into account projected increased debt service costs through the life of their projects to allow for this reduced cash flow.

When we underwrite a deal with floating rates we always take into account forward interest rates and any projected increase in debt service costs. We also look to purchase the most aggressive rate cap that we can afford, to make sure that we are mitigating any interest rate risk appropriately.

Refinance proceeds – a hidden risk?

Another important consideration that is seldom discussed, is the impact that increased interest rates will likely have on available proceeds at refinance.

Many projects purchased with bridge debt have a refinance built into the business plan in year 2 or year 3. Lenders typically use two metrics to size a loan – Loan to Value (LTV) and Debt Service Coverage Ratio (DSCR).

In the debt environment of the last 24 months, low interest rates have meant that loan proceeds have typically been constrained by LTV. In a higher interest rate environment however, it’s likely that loan proceeds will start to be constrained by the DSCR, given the higher cost of servicing debt going forward.

What this means is that sponsors need to be paying close attention to the projected DSCR at time of refinance. If DSCR does not meet Freddie or Fannie’s DSCR requirement (usually at least 1.25 times), loan proceeds at refinance will be reduced.

We have found that in some cases, it is likely that future DSCR points towards only 55% to 60% LTV proceeds being available at time of refinance and this may be a rude shock to some inexperienced sponsors who may have projected a simple 75% LTV being available in their business plans.

Sticking to the fundamentals

As we navigate investing in a shifting debt market, it is important to keep focus on the fundamentals of real estate investing. Purchase well located, quality, long term investment properties that produce steady cash flow. Always have debt terms that exceed the time horizon of the investment and be sure to accurately assess the impact that floating rate debt may have on future cash flow.

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