Multifamily and Commercial Real Estate Investment Trends

Let's jump right into our topic today. Current trends in Multifamily and Commercial Real Estate Investment since around mid 2022. It's no surprise or news to anyone real estate transaction volume has fallen. Why have investors stopped allocating capital to Multifamily and Commercial Real Estate?

EisnerAmper consultant:
Thanks, Ryan. Great to be here. Well, yeah, transactions have fallen the latest statistics through the most of the second quarters that they've fallen about 70%, which is extraordinary. And the great cause of that really is the higher interest rates that we've seen since mid '22 rates have gone up. They may continue to go up and the problem is that capitalization rates haven't really kept up yet. So we're still on a period of negative leverage on most deals where the mortgage rate is actually higher than the yield to the investors.

So things are upside down right now and the math won't work until we can get an adjustment in values, and that's going to take cap rates to rise. We're also seeing some slowdown of growth, rent growth, and we're seeing inflation pickup operating expenses. So on a lot of properties, we're getting thinner margins on top of higher capital costs and that's all putting a lot of risk in the system. So the bottom line is values are going down and they're going to continue to go down. Right now, where we are, we don't really know what values are because we're in this transition period and the lack of transactions and data tells us we don't know what properties are worth. And therefore, investors have stayed on the sidelines.

RE:
I think you're completely correct. No one knows what the properties are worth. And that even extends to the professionals, that's all they do. We've heard crazy stories where people getting multiple appraisals and the lowest appraisal is half what the highest appraisal is, and that's just unheard of.

RC:
So with so much uncertainty, how are lenders reacting to this market, ?

EisnerAmper consultant:
Well, again, same thing really. Lenders need to know what their collateral's worth and with people unsure. And with appraisals coming in with the spreads that Ralph mentioned, it's very, very difficult for them to underwrite a deal. It should be pointed out that really for the last many years, most lenders have been really strict in their underwriting. Loan to values have been lower, debt yields have been good, but now in the last number of months since interest rates pop, the underwriting has become extremely strict and the loan to values are going down even further.

So the lenders know that they have the cushion they need as property values also declined. And so it's very tough to make the math work for underwriting loans just as it is for equity investors and property. And you have to also remember that particularly banks, which are about half of all commercial real estate lending, are facing a lot of regulatory scrutiny right now. The credit committees, the supervisors are all looking over their shoulders. They're concerned about even higher capital requirements that are being proposed as part of Basel III that we should be hearing about any week now. So there's just a lot of reticence in the lending community to dive into this market.

RE:
I think lenders today are more focused on the loans they've already made than making new ones. They've been very aggressive in cutting off any type of new construction draws, whether that's for development or just even TI or lease inducements. Just a couple stories. We've had one client where they had a potential tenant and all they do was finance the ti and the bank said, "No, your loan is going to be up for refinance in a couple months and we don't think you're going to be able to refinance at that level."

We've had another situation where they were in the middle of construction, the bank came in and said, "Well, you're not letting you draw any more construction draws because you're going to fail your debt covenant when that comes up." And it's been very troubling for those clients and it's very tough to have that all of a sudden stop and cash flow.

EisnerAmper consultant:
Yeah, so the lenders really are pulling back in any way they can. And what's interesting though is it creates something of an opportunity for the alternative lenders like debt funds and mortgage REITs to come in where maybe the banks, and the insurance companies will step aside. They will come in with fresh capital to the market, but obviously that capital is super expensive. And the ironic thing here is that even though they may be capital availability from these alternative lenders, that could create a more permanent increase in the interest rates paid on commercial mortgage debt because they may be getting two or even 300 basis points higher than a bank would get.

RC:
So things are getting more complex, more expensive. What are our clients telling us about their ability to refinance their debt?

RE:
Clients? And probably more specifically over the investors over the past 10 years have become very accustomed to cash out refinancing to the point that the investors are reaching out and saying, "Hey, why don't we do a refinance again? I need some cash." And that's just not the market anymore. And in order to refinance, you're going to have to put some cash in. And that's even if you can refinance with the same bank. There's a lot of banks out there that if you have office buildings, they don't want anything to do with it.

EisnerAmper consultant:
Yeah, I think it's interesting to think that the last few years value add real estate has really been the big play for most investors. And that value add included in the strategic plan, a cash-out refinance. So the typical process was fix up the property, raise the rents, get the cash flow up, and then go to the bank because your property value was higher now, and get some cash out of the deal. And that was promised to investors when it began, and that cash would go back to the investors so that they could reinvest it.

And it would also, with lower capital going forward, goose the yields to investors as they got distributions. That has been completely upended as we switch from cash in, from cash out refinance because now, as Ralph said, you got to write a check to get a deal done. So many investors who bought into these deals thinking it was going to give them cashflow and then they're going to get a big check when they refi are being extremely surprised because instead of getting a check, they're getting a capital call, and they need to write a check to keep the deal going.

RC:
So refinancing requires additional cap. Question is where is that cash coming from?

RE:
I think the smartest sponsors out there that are seeing or refinanced coming in the next year or two are cutting distributions now and hoarding that cash, so they have it when the refinance comes out. The only other real option you have is do a capital call. And a lot of investors are reluctant to put any more money into these deals. The other option is to have some rescue capital come in, but that's very expensive and sometimes just unfeasible.

RC:
I suppose having a floating rate mortgage makes matters even worse.

EisnerAmper consultant:
Oh, absolutely. That's the worst-case example, and it's really relating not only to the interest rate, but the cost of the hedge. Usually most borrowers, most lenders frankly, require borrowers to get a cap or a swap when they originally do a loan, but that cap or swap probably expires before the loan expires. So maybe it was a two or a three-year cap on a five-year deal. And what happens is now to re-up that hedge is fabulously expensive. So everybody's very concerned about the expiration of these hedges.

And of course, if you didn't have a hedge, then you've already gotten whacked and it's likely that most of the property cash flow is going to the bank instead of the investors. I just want to point out one other thing that we're very focused on right now, and that's the debt service coverage ratio covenants that are written into most loan agreements. These are things that most people didn't think about before. You might've come into a deal with a 2.5 coverage ratio, but if you had a floating rate loan, that coverage ratio was often written and everybody should go back and look at the loan agreement, that it's based on the actual loan rate with the higher interest rates than the cap rate that you're actually paying on.

And if that's the case, in all probability, you're in breach of this covenant and sooner or later the bank's going to figure it out, and it's better for you to figure it out first and come up with a plan. And once the bank does figure it out, they have different remedies as you're in technical default. And it could be a cash sweep, it could be a resizing a loan, again, a capital contribution to lower the loan balance. So everybody really should be focusing on rereading and understanding their debt covenants.

RE:
Those debt covenants are usually tested on a quarterly basis. So I'm anxious to see what happens now since June 30th just passed. I think there's going to be a lot of either spring lockbox or sweeps activated, and some clients may be very surprised that's even in their loan.

RC:
So speaking of problems, everyone's talking about problems in the office market. What are you hearing?

EisnerAmper consultant:
Well, the office market has got a lot of problems. We're reading about it in the papers all the time. It may not be quite as disastrous as what we read about, what the problems are real. We're really witnessing a structural change in demand for office due to hybrid work. And it's going to take many years to understand and realize the full effect of this change, and years to recalibrate supply and demand. It's not new that tenants have been trying to reduce their space. This has been going on for decades.

After all, occupancy costs is one of the largest costs for any business. So tenants have almost really halved the space per person over the last 20 years. They've tried hoteling, coworking arrangements, need designs in the office. So this is all not new. The difference is that every time the tenant tried to reduce space, job growth got ahead of it.

And so they couldn't actually have less office space. Because they were hiring people all the time. Now what's new is hybrid work has severed that relationship, that correlation between job growth and office demand. So despite the continued job growth that we have, and it is still good, even though the last month was a little weaker than the months before, it's really pretty robust. Even though job growth is good, space demand is falling.

And of course, there's lots of evidence that businesses are reducing their space when their leases come true. And there's also great evidence that even they're not waiting for the leases to come due, that they're just subletting the space now. And in fact, we're at a record now of around 250 million square feet of sublet office space on the market now. And that of course is causing vacancies to climb in pretty much every market in the country. There are very few that are immune. And of course, we're also seeing loan credit on office properties starting to deteriorate. Delinquencies are definitely starting to go up.

RC:
So, you paint a pretty grim picture. What's the solution?

EisnerAmper consultant:
Yeah, well, it is grim for now, and the solution is time. It's going to take a while and it's going to be painful, but it's like the retail sector was 15, 20 years ago. Particularly in the mall segment of retail where we have to recalibrate supply and demand. And the problem is of course, that in these times, tenants always want to go into the best space. It's particularly true now because they want to bring their employees back to the office.

They want them to be in an attractive space with lots of amenities, good lighten air, and a lot of the office stock in this country doesn't meet that criteria. It's old, it's obsolete. And that's why we are hearing so much talk about maybe converting some of this office space into residential or hotel use. But the reality is it's really much more difficult than people realize and not that many conversions are getting done in the big picture.

RE:
Whenever there's stress in the market, there's always this talk of conversions. And just ignoring the economics of it and how hard it is to get stuff rezoned in Philadelphia, is there really enough capacity in whether it's multifamily or industrial to take over all that excess office space? I just don't think there is.

RC:
Yeah, I think there's definitely a drop in demand that Philadelphia inquirers, CBS, a bunch of other outlets have reported on the most recent census. I think it was since 2020, Philadelphia still being the sixth-largest city in the US has lost 36,000 plus residents. So that demand is decreasing.

EisnerAmper consultant:
Yeah. And it's in Philadelphia and as I said almost everywhere. And that bifurcation of quality versus obsolete space, I think unfortunately means that we're going to actually see a lot of office properties be demolished throughout the country. And while that sounds pretty dramatic, it could actually be very positive for the market if we get a new development of space that's needed and is more vibrant for the community.

RC:
So on that note, we've talked a lot about problems in today's real estate markets. Are there still opportunities?

EisnerAmper consultant:
There's always opportunities in real estate investments always. And a lot of opportunities come from all the distress that we've been describing whether it's buying non-performing loans from banks and working them out yourself or providing rescue capital, as Ralph said, there's just a lot of investors getting into the distress game, and that's just beginning. But even setting aside distress, we have down cycles. We have up cycles in real estate. There's tons of capital out there. It just needs to find the right deal.

And anytime we go into a down cycle, people get much more particular about what they're going to invest in. They need to pick their spots. But whether it's in self-storage, maybe life sciences, cold storage, some multifamily, some industrial around the country, even some retail, there's good deals to be had. The key is finding the ones that work and really doing your homework, building that model stress, testing all the assumptions to make sure that the deal isn't going to go flat on you.

RE:
I think you're absolutely correct. Over the past 10 or so years, the market has been very forgiving with mistakes. Going forward I don't think that's going to be the case. I think very small mistakes lead the very big disasters.

RC:
Well, Ralph and , thanks so much for all of your insights today. And thanks to our audience for listening. Please stay tuned for the next installment of Breaking Ground and have a great day. Thanks gentlemen.

RE:
Thank you.

EisnerAmper consultant:
Thank You.

Transcribed by Rev.com