The looming debt maturities that we will see in the next few quarters will be a reckoning for many investments made in the post-covid boom. While many investments made during this period are providing investors with sizable returns, others are under tremendous stress as higher debt costs drive up cap rates.
We have seen many commentators start to be more bullish about interest rates beginning to fall in early 2024. While this would provide relief for many apartment owners, it may be premature. Inflation is still above the Fed’s target of 2% (their preferred measure of CPE Inflation is currently 3.5%) and it is still possible that the next move will be an increase in the Fed Funds Rate, rather than a decrease.
Whenever rates do start to fall, our view is that we are much closer to the bottom of the cycle than the top, and that the next buying opportunities may be just on the horizon. Now is a good time to review the fundamentals of debt in real estate investing and take an analytical look at how to improve the debt that we are structuring on future investments.
How debt affects the risk and return of an investment
To truly understand the role of debt when investing, we need to boil it down to the most basic elements.
Investment is about taking on risk to generate reward, and the more risk you take, the more potential reward you could gain. Each investor has their own risk tolerance and investment goals. Because of this, the most efficient way to setup an investment, is to have multiple parties involved, each with their own position in the capital stack.
Investors seeking low risk will be the first to receive capital back, and in exchange for receiving priority of capital distributions they accept a lower, and often times, fixed rate of return. Debt investments are considered to be the lowest risk, as they receive first priority of capital distributions and are secured by the underlying collateral. Equity investments are considered to be the highest risk, as they are last to receive payment, but they receive all of the upside once everyone else has been paid what they are due.
Investors can choose to leverage a little, or a lot, and this impacts the returns (and the risk) that they may generate for equity holders in an investment. For example, investors seeking high rates of return may leverage up to say, 80%. Doing so limits the investor’s capital into the investment to 20%, and thus leverages their potential return – if an asset is leveraged 80%, a 10% increase in asset value will represent a 50% return to an equity investor (10% increase, divided by their 20% investment).
However, by leveraging 80% they are also increasing downside risk for equity holders. In this example, just a 20% fall in asset value will completely wipe out all of the equity in the deal. So, leverage clearly boosts both returns and risk.
Leveraging allows an investor to limit the amount of capital investment into any one investment. It may allow them to diversify into more deals, into more markets, or more asset types. However, a reliance on leverage does also introduce capital markets risk, and any dramatic shift in capital markets could put the whole portfolio at risk if debt maturities occur during an unfavorable shift in the market.
This is the exact scenario that we are currently seeing play out for many investors. Multifamily is still a fundamentally strong asset class – demand for housing is high and is forecast to remain that way in the medium term. However, the capital stack that has been put together on many deals over the last few years is now proving problematic. And this is an opportune time to reflect on how to structure and enhance the debt that we are using, when structuring investments going forward.
Types of debt for available multifamily
Broadly speaking most real estate investors are aware of the two basic types of debt available.
Bridge debt – which has the benefit of higher leverage, future funded proceeds, and low prepayment penalties. However, these features come at the expense of variable rate interest, and a short term.
Permanent debt – which offers predicable fixed rate payments, and partial to full term interest only payments. However, permanent debt typically has a higher prepayment penalty, doesn’t offer future funding, and loan proceeds are often lower.
Depending upon your risk tolerance, investment time horizon, and investment strategy, each of these products have advantages when matched with the right investment. Matching the right debt product for your project is easy when markets are stable, and the future is relatively predictable, but what do you do when markets are chaotic, and the future uncertain?
How does an investor choose the right debt after interest rates have risen to historic highs, at an unprecedented velocity? How do investors decide if the prepayment penalty of fixed rate debt and the cost of funding capital improvements with equity is more or less expensive than purchasing a very expensive interest rate cap?
These are the tough questions without clear answers that investors are facing as they make investments in the market today. And this is where the terms and features of the debt may be more important than the debt product itself.
Enhancing permanent loans
In today’s environment the most popular loan add-ons are rate buydowns on fixed rate debt. These allow investors to pay an upfront fee (usually 1-2% of the total loan proceeds) to receive a 10-34bps reduction in the interest rate. Not only does this have a positive impact on cashflow, because it lowers the monthly payments, it can also increase loan proceeds as the loan is sized using the reduced rate.
Additionally, investors have the option to pay a slight increase in interest rate in exchange for lowering the prepayment penalty on a loan. This can be advantageous to investors who have light to moderate value-add projects and plan to refinance in the future, but don’t want the timing risk of a short-term bridge loan.
Using interest rate caps wisely
For new investments, many investors are expecting rates to start to fall, so may be nervous about spending money on rate caps that may not be needed.
As we discussed above, there is a lot of uncertainty about when rates may start to fall. So, the question becomes, what interest rate cap should you buy when you don’t know exactly when rates may drop? If you buy an aggressive in-the-money cap the value of the cap will be reduced in the event that rates drop, and the earlier they drop the more money will be lost from the cap purchase. However, if you buy too far out-of-the-money and rates hang on or even increase, investors could see negative cashflow.
The best solution may be a hybrid approach. Purchase a moderately in-the-money cap with a term that matches the time horizon of the investment and hold cash reserves equal to the additional protection that an aggressive in-the-money cap would provide. This way you have almost all the insurance of an aggressive in-the-money, full term cap, but a good portion of the cash is held on your balance sheet and doesn’t lose value when rates drop. In this example, and if you are lucky enough to see rates drop early, you can distribute any excess cash reserves back to investors.
Who are you working with?
Lastly, one of the most important and often overlooked decisions when choosing the right debt for your project is the choice of lending partner. All investors are looking for best terms and conditions, but just as important is “who is the counterparty in this loan agreement?” Will the lender be reasonable and easy to work with? Will the lender hold the loan on their balance sheet, or will it be sold to market? And who is the loan servicer?
As important as the economics of a loan are, the logistics of working with the lender and the loan servicer post-closing are just as important. In the current market environment, we are learning that some lenders are more willing to work with borrowers than others. And this can make all the difference in adverse market conditions.
While leveraging with debt can significantly increase returns, it is important to remember that it increases risk and this risk comes from various sources – interest rate risk, debt maturity risk and systemic capital markets risk.
When using debt, there are enhancements and tactical choices that can be made to improve the risk-return profile of your deals. Having a detailed understanding of the debt market will allow you to choose the best debt product, with the right enhancements, provided by the best partners to work with. As we make our way toward 2024 and begin to invest in what we expect are improving market conditions, this is the playbook that we will be following.
To learn more about how we can help you to generate superior investment results through professionally managed Real Estate investments, click here to register for our investor club.