WHERE HAVE ALL THE DEALS GONE?
By: J Scott
A lot of our investors, as well as other people out there who follow Ashley and me, have been asking us about the fact that there seem to be so few good passive investment opportunities out there these days.
And yes, this is definitely a trend I'm seeing. Fewer deals available, and those that are available tending to have less attractive returns than what we were seeing just a few months ago.
Now, with interest rates going up and the economy starting to soften, it's probably no surprise that there are fewer great deals out there. But I wanted to take a few minutes to touch on some more specifics about what we're seeing in the multifamily space and why deals aren't penciling out as well.
One of the biggest issues that multifamily investors are having these days revolves around the loans we typically get for large commercial projects. Specifically, there are two types of loans that are common in this industry:
1. Agency Loans
2. Bridge Loans
Agency loans are how we often refer to conventional loans through large quasi-governmental lenders like Fannie Mae and Freddie Mac. As investors, we like agency loans because the loan terms tend to be longer (10 years is pretty common) and rates tend to be lower. Additionally, rates are typically fixed for the entire loan term, so investors don't have to worry about rising interest rates hurting the deal in the future.
The downside of agency loans is that there are often large prepayment penalties, making it difficult to refinance or resell in less than 5 years. Additionally, agency loans are more geared towards stabilized properties that are generating a good bit of income. They aren't typically good for investors who are buying distressed properties and spending the first year or two doing renovations and improving management.
With interest rates rising, it's getting even more difficult to use agency loans for projects that require renovation/turn-around, as more of the free cash flow is going towards mortgage payments and there's less cash flow to cover operations.
For this reason, with interest rates and project costs where they are today, agency lenders will typically only lend between 50% and 60% of the total cost of the project. This requires operators to raise more money from passive investors. And while we obviously don't mind working with passive investors, these investors rightfully want big returns. So the total cost of completing a successful project becomes more expensive, as we can’t pay as much to purchase the project.
In fact, it's very difficult for many operators to make deals work using agency loans these days. Instead, we instead start to look at bridge loans to make the deals work.
Bridge loans are essentially loans from large banks. They have the benefit of being shorter term without prepayment penalties and bridge lenders are typically willing to lend a larger percentage of the entire deal. Meaning operators can raise less money from passive investors and keep their total costs down.
The downside of bridge loans is that interest rates are rarely fixed – they adjust with the market throughout the loan term. So if interest rates are likely to rise, this has to be factored into the underwriting.
This leaves operators with two choices when it comes to bridge loans. They can assume a worst-case scenario for interest rate increases over the term of the loan in order to avoid risk. Or they can pay money to the lender to ensure that rates never go above a certain amount (often called a “rate cap”). These days, with interest rates so volatile, rate caps can be expensive, potentially costing into the seven figures.
Either way, to be conservative and reduce risk, operators have to be careful when using bridge loans.
Long story short, there are two choices that operators are facing today:
1. Using agency loans that will only loan at a low percentage of the deal (requiring more outside investors which lower the returns) and will incur large prepayment penalties if the property is sold quickly or refinanced (meaning operators can't take advantage of interest rates going down).
2. Using bridge debt that tends to have higher interest rates that aren't fixed, introducing either greater risk or greater cost (for those who want to reduce risk with rate caps).
Each of these choices introduces additional costs and or additional risk, reducing the amount of money and operator can pay for a deal, as well as reducing returns to investors.
And this is the reason why we're seeing fewer deals pencil out these days. And the deals we are seeing are providing lower returns than what we were seeing just 6 or 12 months ago.