Last week the Fed communicated that they expect rates to remain “higher for longer”. While many in the market were expecting (read: hoping) that rates would reduce sooner rather than later, this puts a dampener on the outlook for many businesses and investors who currently rely on variable rate debt.
We have already started to see some stress in the multifamily sector, where some investors are on short term variable rate debt with significantly increased debt service costs and looming expiration dates on their bridge loans.
Investors in these deals fall into a few buckets:
- They will successfully refinance into fixed rate debt over the next 6-18 months. The asset value on paper may take a hit in the short term, but with no need to sell right now, they will weather the storm.
- They will look to extend, buy new rate caps, raise additional capital, negotiate with their lender, avoid defaulting on their loans and find a way to weather the storm
- They will try to follow the playbook of (2) above, but unfortunately fail and end up defaulting on their loans
- They will realize at some point that it is a lost cause and they will either sell their assets in the current market at a loss, or hand back the keys to their lenders
Unfortunately, if rates stay higher longer, we will start to see more of those investors in Bucket 2, start to shift to Bucket 3 or Bucket 4.
So what should passive investors do in the current situation?
Well, the one thing investors should not do is put their head in the sand and ignore what is going on. While it is true that passive investors do not necessarily have decision making control in the current situation, it is important that investors understand the situation with each investment and try to figure out which bucket their investment fits into.
We are seeing many capital calls being made to investors, where sponsors are asking investors for additional capital to buy more rate caps, for cash-in refinances or to fund other aspects of the investment.
In a situation where investors are being asked for additional capital on multiple investments, it can be difficult to make a decision on which projects, if any, new capital should be provided.
The best approach may be to determine which bucket the asset is likely to fall into. With the injection of additional capital, does the asset have a better chance of remaining in Bucket 1 or Bucket 2 and therefore survive and eventually prosper over time? In these situations, additional capital may be the difference between losing all of the original investment and actually earning a positive return on that capital.
On the other hand, it may be that despite the sponsor’s best intentions, the asset is destined for Buckets 3 or 4. In these situations there may be no use in throwing good money after bad.
It is not always easy, but the investor needs to evaluate whether the sponsor’s plan is realistic. Do we have a good asset and a good business plan to navigate the current environment? What happens to the business plan if rates stay higher, longer? Do I have confidence that the long term prospects for the asset and investment are positive, as long as we find a way to navigate the current debt environment?
These are all reasonable questions to ask any sponsor, to ask fellow investors and to ponder and evaluate on your own.
Despite the high returns that most investors have achieved over the last 3-4 years, investing is not easy. There will always be ups and downs to navigate and it takes resilience and patience to make money over the long run. When times get tough an objective assessment of likely future paths is always better than tapping out and deciding to do nothing.
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