Walker & Dunlop Execs Weigh In on Capital Market Turbulence
Brian Cornell and Marcus Duley look at the evolving financing environment and what's next.
Long after the Federal Reserve started raising interest rates in the spring of 2022, uncertainty is still widespread across the capital markets. Some real estate players are seeking to benefit from the devalued or distressed properties out there, while others continue to remain on the sidelines until the grey clouds over the economy disappear.
The commercial and multifamily mortgage origination volume index dropped 56 percent in the first quarter of 2023, compared to the same period in 2022, according to a recent survey from the Mortgage Bankers Association. All surveyed lenders have felt a drop in lending activity, with GSEs seeing the smallest decrease, and life insurance companies registering the steepest drop. The same source shows that the multifamily origination volume index fell 55 percent year-over-year through the first quarter and 44 percent quarter-over-quarter. Meanwhile, the commercial real estate loan delinquency rate at U.S. banks increased 12 basis points quarter-over-quarter to nearly 0.8 percent, according to S&P Global Market Intelligence data. The struggling debt market has also manifested in the much lower transaction volume across all commercial real estate sectors as well as diminished construction starts.
Multi-Housing News asked Walker & Dunlop Investment Partners Chief Investment Officer Marcus Duley and Managing Director & Head of Equity Brian Cornell to shed light on how to navigate the current turbulent capital markets clouded by recent bank failures and inflation-induced increases.
How have lender and investor sentiments shifted since the Fed started increasing interest rates?
Duley: In light of the Federal Reserve’s significant increase in interest rates over the past 12 months, lenders are now able to charge considerably higher all-in coupons on newly originated loans, whether fixed or floating, compared to a year ago. This increase in rates has made commercial real estate lending an attractive value proposition from a risk-adjusted return perspective, particularly in an environment marked by uncertainty around current valuations and future appreciation.
Consequently, there is an influx of real estate private equity debt funds entering this space. This can be attributed to the appealing yields now achievable on loans, as well as the anticipated growth in demand for such capital as a means to fill the gap left by the stalled CMBS market and the pullback of regional bank CRE lending. This pullback in lending follows the collapse of Silicon Valley Bank and Signature Bank, which resulted from the unintended and unforeseen consequences of the Fed’s rapid and significant interest rate hikes.
While higher interest rates benefit lenders, they simultaneously result in lower loan proceeds—less leverage—for borrowers, due to debt service coverage ratio constraints and more stringent underwriting standards. As a consequence, a growing number of borrowers who may have previously dismissed preferred equity or mezzanine loans are now exploring these financing options as viable or necessary solutions to bridge the gap and complete their capital stack.
What are the main challenges in moving multifamily transactions forward today?
Duley: Today’s multifamily transactions face challenges due to the rapid value decline across the asset class, which can be attributed to the sharp increase in interest rates over the past 12 months. In a macro environment characterized by volatility and uncertainty, multifamily property owners have little incentive to sell. They are reluctant to accept suboptimal returns, or worse, losses—particularly when the fundamentals and secular tailwinds for multifamily investing remain strong, promising solid returns over longer holding periods.
Transactions may begin to move forward as owners facing maturing loans are compelled to either sell or refinance. Many owners will become forced sellers, as they lack the capital for a ‘cash in’ refinance and are unable to recapitalize their investments. Currently, buyers and sellers are still in the price-discovery phase. Buyers are hesitant to purchase properties with declining values, akin to catching a ‘falling knife,’ while sellers are unwilling to leave money on the table by selling too soon.
Furthermore, the higher cost of debt and underwriting with negative leverage poses significant challenges in making deals financially viable without downward adjustments in seller price expectations. This factor contributes to the lack of properties being marketed for sale.
What multifamily deals are being completed today and how?
Duley: The primary borrower and lender market participants in the multifamily lending space include borrowers looking to refinance maturing loans and those aiming to convert existing floating-rate loans with high current coupons and/or costly interest rate cap requirements to lower coupon fixed-rate loans. Key lenders in this market are the GSEs, known as the 800 lb. gorillas in multifamily finance, along with insurance companies and real estate private equity debt funds.
For stabilized properties, loans are overwhelmingly being provided by the GSEs, which offer countercyclical capital and ensure credit capital liquidity in the multifamily sector. In cases of maturing construction loans and high-leverage, multifamily bridge loans on assets not yet stabilized, debt funds and insurance companies that provide bridge loans are the primary financing options available. In both cases, borrowers face higher rates, receive less leverage, and contribute more equity—either directly or through preferred equity—to secure financing.
What should borrowers know about alternate financing options in multifamily?
Duley: Borrowers should know that despite the overall credit tightening experienced by regional banks, multifamily financing options remain very liquid due to the countercyclical lending of the GSEs and the overall preference and desirability to lend against multifamily as an asset compared to others such as office. For both refinance and acquisitions of stabilized properties, there is probably no better execution right now than Fannie and Freddie. And where they may fall short in proceeds, there are experienced preferred equity providers … who are able to provide financing to fill that gap. Additionally, although not mentioned earlier, a borrower should know that HUD provides very attractive construction financing solutions. Debt fund capital for non-stabilized and transitional properties will continue to play an increasingly important role in providing flexible and creative financing options.
In light of the current market environment and given the various financing alternatives, it is more critical than ever for borrowers to extensively explore the market and cast a wide net to identify the most suitable debt and preferred equity solutions.
Is the growing demand for preferred equity a short-term trend born out of necessity, or is it here to stay?
Cornell: The demand for preferred equity is the highest I have seen in my career—it is very much a ‘need to have’ product for many real estate owners to solve a gap between equity and first trust debt versus a ‘nice to have’ product used to increase leveraged equity returns. Preferred equity has always been an important part of the real estate finance landscape and will continue to be so, but overall demand for the product tends to be countercyclical to the liquidity of higher leverage debt providers.
A challenge for one investor looking to fill in a gap in the capital stack is an opportunity for another one. What are the dynamics at play in these cases?
Cornell: Owners with a gap in their capital stack have limited options to avoid selling into a down market or handing the keys back to the lender. They can make a capital call, recapitalize with new equity, layer preferred equity, mezzanine debt, onto their existing capital stack, or try to work something out with the lender. All of these options provide opportunities for different market players to provide capital with attractive risk-adjusted return dynamics. As long as there is long-term value and equity to protect, owners are well-served sharing their upside with these capital providers in order to work through shorter-term distress and see their way to full value realization down the road.
Any advice on how to navigate the coming months?
Cornell: While growth is anemic, overall multifamily fundamentals remain healthy and most people expect rates to settle down once the Fed’s tightening ceases later this year. This suggests that pain in the multifamily market will be most acute for high-leverage floating-rate borrowers relying on a value-add business plan to push NOI. My advice to these owners is to do whatever you can to survive until 2025 because a lot of their issues will resolve themselves as rates settle and the market normalizes over the next 18 to 24 months.