Today’s snippet will be a bit longer than usual. However, in an effort to keep you aware of current market dynamics, we think it is important to share our takeaways from two industry conferences we recently attended and address recent news. We have gone through unprecedented series of events that are still developing and will likely be discussed years from now in textbooks and case studies.
The two industry conferences we recently attended include Multifamily Investor Network (MFIN) in Houston, TX (2-2023) and The Best Ever Conference in Salt Lake City, UT (3-2023).
We would dub the theme of both as expect the worst and hope for the best (see the Headline snippets below). The rooms could not be more polarized, in terms of market expectations, at both events. There was one consensus – while deal flow has continued (albeit at a slower pace), it has become harder to find deals that are penciling in.
On one side of the camp are operators who have put pencils down, focusing on building reserves and liquidity to acquire properties at attractive prices when the commercial real estate price collapse ensues later this year. On the other side were investors who are continuing to buy aggressively with the belief that prices have already adjusted and there is a short window to take advantage of this buy opportunity.
Buyers and sellers are continuing to stare at each other to see who will blink first. On the one hand, sellers are still expecting to realize large profits on the properties purchased within the last 2-3 years with bridge (short-term) debt. On the other hand, buyers are struggling for deals to pencil in due to the rapid and continuous rise in interest rates, rent growth slow down (and in some cases rent declines), vacancy increase, and overall operating expense increase (particularly taxes, insurance (increasing 2x-3x in some markets year over year), and labor/materials), which are compressing returns (barring meaningful price adjustments from the seller). This impasse has resulted in overall deal flow volume reduction, down 45% in the second half of 2022 vs. same period last year according to John Chang at Marcus and Millichap.
As Robert Helms stated at MFIN: “A bend in the road is not the end of the road unless you fail to make the turn.” The sponsors who believe that we have not seen the worst of it yet, are focusing on operations and expense management while nurturing their investor base and building liquidity to deploy when prices normalize.
Many of the more prominent operators like Neal Bawa, Joe Fairless, Robert Martinez, Brian Burke expect that more distress is on the horizon and likely to come in late 2023/early 2024 (we recognize no one has a crystal ball and these expectations assume no new exogenous or unexpected geopolitical, market, natural, or economic events). Others like James Eng at Old Capital encouraged operators to do what they can to “survive to ’25.”
$6.2BN of CMBS debt is already under distress. And more is likely to come.
Let’s back up for a moment. Why are we here?
The growth in money supply during CV19 coupled with historically low rates, resulted in excess liquidity in the market and voracious appetite for assets. Specifically in multifamily, such assets were under limited supply and in certain markets that benefited from net in-migration during CV19 coupled with ongoing population growth (that had started prior to CV19), such supply shortage resulted in unprecedented demand spike and cap rate compression. Many deals were bought based on proformas at inflated valuations, high leverage, variable rate loans (sounds familiar? A la 2007-2009?), and in some cases with negative leverage (at a purchase cap rate below the loan interest rate) with expectation that rents will fill the void…which they did as the migration patterns cited above coupled with the overall shortage of apartment supply resulted in rapid rent growth (as high as 30% year over year in some markets). We saw a lot of deals come on the market only to be flipped within a year or two, like a game of musical chairs. Inflation continued to rise in the meantime, dubbed by officials as “transitory” at the time. Money continued to be printed to forgive student loans and extend various CV19 initiatives, adding fuel to the fire. That transitory period turned out to be longer than expected and the Fed finally decided to start taking action (when inflation spiked at 8.6%) and set on a conquest of rapidly increasing interest rates to reign it in.
Operators who were under these floating rate debt structures will soon feel the distress. This is a great video that summarizes the issues many will have to solve for (minutes 1 to 11). Even those that purchased rate caps (a derivative used to hedge floating interest rate risk, which we will cover in an upcoming snippet), are feeling the pain, as lenders are starting to escrow funds to ensure the Borrower can purchase a new rate cap (the cost of which could be as high as a million, depending on loan size and tenor) at the time of the loan renewal or extension, neither of which is guaranteed and certainly not at the forecasted loan terms projected a year or so ago.
In this environment, many operators are having to suspend distributions to preserve liquidity. Unfortunately many are having to do capital calls and in some cases others have already handed in the keys to the lender.
Neal Bawa discussed strategies to avoid capital calls and to recapitalize, including: infusing shareholder loans or own/GP capital in the deals, selling equity shares, reallocating capex budget to stem the bleed, borrowing money by pledging your LP /GP shares as collateral, reducing costs, bringing in rescue equity. As Joe Fairless noted, sellers will have to eventually come to grips with reality.
Both Neal Bawa and Kathy Fettke reminded operators to be transparent and to communicate early and often, especially during periods of distress. Neal further noted a cash call should never come as a surprise, should contain supporting information showing how market conditions (vs poor operations assuming poor operations were not the cause for the call) are impacting the deal, and communications should be in one on one as well as in a detailed webinar format.
Joe Fairless also shared his Tips for Limited Partners:
- Understand how the operator(s) have they evolved with the times – income, expenses, debt, exit plans.
- Ask if they notice disconnect between legal docs and the marketing package – e.g. what date are year one projections based on? Is the LP maxed out on what they can make? Am I as an LP paying the same price per share as others who invest before and after me?
- Size does not matter (5 unit vs. 500 unit building), only returns do.
- Confirm the underlying asset is a marketable one, i.e. if all things go sideways, it can be sold to cover losses.
- Create additional income streams – e.g. via short term personal loans
Rob Beardsley and JC Clemens discussed important concepts like factoring in prepayment penalties on fixed rate debt in the deal analysis along with performing sensitivity analysis. JC Clemens also shared his firm’s strategies to vet operators (while those were specific to institutional investors’ perspective many of those are relevant to LPs looking to vet potential sponsors) – how much is their skin in the game, do they know their deal/ market/ numbers, can they provide references, what are their performance history and activity level, are they vertically integrated, and are they able to support their assumptions.
Kathy Fettke’s presentation was reminiscent of 2007-2009 when high leverage floating debt saddled the residential space, showing how history can repeat itself in a different form or manner. Kathy further discussed a few case studies showing how operators (even skilled ones) can both make and lose money in both good and bad times. Neal Bawa’s presentation further noted that 40% of loans will be in distress by summertime and that 25% of operators will no longer be in business by 2025.
Only the future will tell where we will be.
Let’s also take a look at the recent Silicon Valley Bank collapse and some recent news.
In the meantime, rising rates are causing bond yields to fall (particularly for bonds purchased before the rapid rate hike ensued). Inflation is eating away consumer savings causing banks to lose deposits. We recently read the news of the Silicon Valley Bank (“SVB”) collapse (news are still evolving as of the time of this article). Based on a recent Trepp/CNBC/CNN article, SVB deployed its capital to buy bonds as “securities seemed a relatively safe bet and were readily available” given concerns around the economy. “As venture capital began to dry up, the bank was sitting on a mountain of unrealized losses in bonds just as the pace of customer withdrawals was escalating”. One VC firm’s call to another cased an increase in withdrawals, with SVB having to sell its securities at a loss, making matters worse, causing a run on the bank, and leading to the eventual collapse. Many of the smaller banks and financial institutions in the industry who were less regulated (and likely had lower capitalization requirements) and/or tied to industries like tech and crypto will likely face challenges. It is unknown at this stage, if or how much people will recover of their deposits. It is also unknown what the ancillary effect across the industry or the investment landscape will be, though it will likely get worse before it gets better. Yet, as the government continues to print money to service the now $31Trillion in debt, inflation has remained rather sticky and the possibility of continuous rate hikes, remains.
Brace up …as this is only the beginning. More and more news of this nature (headlines below) will be in the press over the coming months. Some due to tightly underwritten deals with no room for error, others due to floating rate short term debt the cost of which has escalated, others due to low or no reserves to absorb the higher cost of debt, interest rate hedge reserves required by lenders, or higher insurance premiums, etc. While lenders have cushion (by virtue of limiting loan proceeds to 50-80% of the property value), borrowers will feel the pain.
“When God wishes to give you a gift, he sometimes wraps it in the form of a problem. The bigger the problem, the bigger the gift.” Robert Helms
We recognize this is not easy to talk about. However, we think it is important to face reality and have at least general awareness of the market landscape, so you can be better educated and more empowered investors. For operators that are well capitalized and either staying the course on core investing and diligence principles OR able to pivot and take the turn, this would be a time of great opportunity…probably an opportunity we might not see in a while.
While we remain net buyers, we also stay true to our core underwriting principals and investment criteria. This means we will continue to grow albeit at a slower pace this year. We will only jump in on the right investment opportunities and not at all cost, as we are ultimately stewards of our (your and ours) hard earned money and we are in this business for the long run.
Do not let the news scare you. Analyze the information, extract learnings from the news, and then position accordingly. Real estate goes through cycles too but real estate is real and presents not only a hedge against inflation in the long run but also helps protect and grow your hard earned savings. Noone could have predicted CV19, the ensuing money supply growth, hurricane Ian and its impact on insurance premiums, high inflation, and the effect of such, including bank runs. However, those who position accordingly and remember that this is not a sprint but a marathon will survive the storm and build wealth over time.
- Multifamily Real Estate Is At Risk Of Crashing — Here’s Why (biggerpockets.com)
- Deleveraging: The Dominoes are About to Fall (biggerpockets.com)
- (43) Sound the Alarm: A Commercial Real Estate Crash is Likely – YouTube
- Per Globest, “CRE Prices Slide at a Rate Not Seen Since 2010”, with multifamily being hit the hardest in 1-2023
- Investment firm KKR has followed in Blackstone’s (BX) and Starwood’s (STWD) footsteps by limiting investor redemptions from their non-traded REIT, KKR Real Estate Select Trust (KREST
- Chetrit and Veritas defaulted on their $481MM and $450MM loan, respectively.
- A Brookfield real estate unit warned in November that it may struggle to refinance debt on two downtown Los Angeles towers and raised the prospect of foreclosures, which Barclays Plc analysts called “concerning” for the market.
- Per Bloomberg, Credit Suisse Cuts Payouts on $3.5B RE Pool as Clients Seek Withdrawals Amid Rising Rates
- A $279M Blackstone (BX) loan backing 11 Manhattan properties was sent to the special servicer.
- Per the Real Deal, there’s a possibility that Vornado Realty Trust could walk away from a prominent retail strip along Fifth Avenue after executivesthat the REIT defaulted on a $450 million non-recourse loan.”
- 2-16-2023 Real Deal article: “This month alone, RXR’s Scott Rechler confirmed that his company is considering handing two outdated office buildings “back to the bank,” halting debt payments and relinquishing control of the properties. Related Companies and Bentall Green Oak have agreed, sources say, to surrender a mostly empty office campus in Long Island City to whoever buys the debt on the buildings.
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to firstname.lastname@example.org.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.