3 RISKS FACING MULTIFAMILY IN 2023
By: J SCOTT
As I think most of us in the multifamily space can agree, 2023 is shaping up to be a very interesting year. While nobody knows exactly where the economy is headed, where the overall multifamily market is headed or where individual markets are likely to end up this year, it’s becoming clear that there are a number of headwinds facing multifamily operators that could result in projects missing projections or – in a worst-case scenario – failing completely.
THE BIG DEBT RISKS
While there are a dozen factors that could potentially adversely affect multifamily owners this year, there are three that currently stand out as posing the most financial risk across the industry. And they all revolve around the debt multifamily owners commonly use to finance their properties.
Because these three debt risks will likely drive the bulk of the “motivated seller” transactions this year, I wanted to provide a little insight into what multifamily operators are currently concerned about.
1. Interest/Mortgage Rate Risk
This one shouldn’t come as a surprise to anyone. With commercial mortgage rates up significantly over the past 9 months, multifamily owners with floating rate debt (mortgages where the rate fluctuates with the market), are starting to feel the pinch in their cash flow.
Let’s look at an example:
Imagine a $20M apartment complex with a $15M interest-only floating rate mortgage and $100,000 per month in NOI (income before the mortgage payment). If that mortgage was taken out a couple years ago at a rate starting at 4%, the monthly interest payment would have been $50,000, leaving the operator a monthly cash flow of about $50,000.
Let’s say that floating rate has now increased to 8% (not unrealistic!). The monthly interest payment has increased to $100,000, leaving absolutely nothing in free cash flow.
Total cash flow is gone! This means that investors are seeing no distributions (they aren’t happy), operators are seeing no distributions (they aren’t happy) and if the property is generating choppy monthly income -- or has a surprise expense -- it wouldn’t take much to turn that breakeven deal into a monthly loss (everyone won’t be happy).
Keep in mind that most value add multifamily properties will see choppy income in the first year or two, so some properties purchased in the past 24 months using a floating rate loan are going to find themselves in a potentially tough -- if not completely untenable -- position over the next 6-12 months.
2. Refinance Risk
For properties facing an impending refinance in the coming year (most properties purchased with bridge debt in the past 3-5 years), there is a much more immediate and threatening risk.
When lenders loan on against a property, one of the key metrics they look at is Debt Service Coverage Ratio (DSCR). DSCR is an indication of how much more income the property is generating above what is needed to pay the mortgage. Typically, lenders like to see that a property is generating at least 120% of the mortgage amount in income at purchase, and will not loan any amount that generates a mortgage payment that reduces DSCR below that target.
Historically, operators haven’t been concerned about having to refinance 3-5 years after purchasing a property, as they (rightfully) expect that the income being generated by the property will be considerably higher than 3-5 years earlier when the property was purchased. Not only do they expect to replace their old loan with a new loan, but in many cases, they expect to be able to get a new loan that is bigger than the original loan, allowing them to pull money out (which can then be used to partially or fully pay back investors).
But, these days, even the additional income being generated by the property isn’t necessarily going to be able to compensated for the increase in mortgage payment when it comes to refinancing and ensuring that the property achieves the minimum DSCR (especially given that many lender require a higher DSCR at refi than at purchase). Many multifamily operators could find themselves in situations this year where not only can’t they get money out from their refinance, but they may not even be able to qualify for a loan big enough to replace their original debt.
Operators with loans coming due in 2023 may have to make some tough decisions this year – specifically, whether they do a capital call (ask their investors for more money) or sell the property, even if it’s not an opportune time to do so.
3. Rate Cap Risk
When a multifamily owner gets a floating rate loan, the lender will almost always require them to get an insurance policy called a “rate cap.” A rate cap insures against the floating mortgage rate going above a fixed amount, so that the lender can be sure the borrower can always pay their mortgage, even if rates rise.
Up until last year, these insurance policies were very cheap. Because nobody expected rates to rise quickly or exorbitantly, owners could purchase these rate caps for as little as $10-20K per year. On a property generating $100K per year in income (our hypothetical above), this was a drop in the bucket and most owners didn’t even think about the cost.
Most rate caps are locked in for one to three years, after which a new rate cap has to be purchased at whatever the new prevailing rates are. With interest rates rising and lots of volatility in the capital markets, rate cap premiums have soared over the past several months. Rate caps that could be purchased for tens of thousands of dollars per year over the past few years would now cost hundreds of thousands – or even millions of dollars – to renew right now.
Imagine that same property that is generating $100K in income and that is now paying a monthly mortgage payment of $75K, and on top of it now has to pay $40K per month in new rate cap premiums! Long story short, any properties with floating rate mortgages that were purchased 2-3 years ago likely have rate caps that are scheduled to expire in 2023 and face a potential huge cash flow risk.
But, it’s actually worse than that. Most lenders will require that property owners start escrowing for the new rate cap 12 months in advance of their current rate cap expiring, at the prevailing price. So, if a property has a rate cap scheduled to expire in January 2024, the owner is likely to have to start escrowing payments this month at the current rates.
While there is a good chance rate cap prices will drop considerably in 2023, many operators are already facing these escrow payments that have the risk of derailing their business plan.
While many operators were conservative in their underwriting the past few years and will be able to weather the upcoming storm of financial issues surrounding their debt financing, not all operators will be that lucky. And even those who were conservative and will weather the storm may not do so without having to make some hard decisions along the way.