Maturity, for the lucky, comes for all. But how people and things survive and live through it is another matter.
In multifamily, as with all CRE categories, there is a coming wave of maturity. But for many, it will be ugly because of negative leverage, according to David Wegman of Trepp.
Investors of all stripes regularly use leverage. When working correctly, growing value outpaces the ongoing cost of acquisition from borrowing money. Or, as Wegman puts it, so long as the return on asset (ROA, the generalized equivalent of CRE’s cap rate) is higher than the borrowing cost, all is fine. There is enough value coming in to pay the debt service with the remainder going to the owner and return on equity (ROE) “moves directionally higher than ROA," Wegman said.
As many borrowers have learned since the recent days of low interest, leverage is not always positive, as when ROE moves directionally lower than ROA. There is less value coming in. That causes two problems that are showing up for many multifamily investors.
One, when net operating income (NOI) cannot cover the debt payments, then there is a debt service coverage ratio (DSCR) of less than one. The property cannot pay its keep. This becomes thornier when other costs like insurance, utilities, and taxes keep growing, decreasing NOI.
The second problem is that equity investors can become ever more reliant on property value appreciation for returns. “Since multifamily properties typically trade at lower cap rates given the perceived safety, the margin of error is low in a rising rate environment and becomes exacerbated when dealing with floating rate debt,” Wegman wrote. When interest on the debt climbs, NOI falls as does DSCR.
And floating rate debt is rampant. According to Trepp, there are currently more than 5,800 multifamily loans, a total of $96 billion, with a DSCR below 1, meaning incapable of covering debt. Of these loans, 79% are floating-rate debt with an average interest rate of 7.8%. The estimated cap rate at securitization is in the 5.2% to 5.7% range over recent years, meaning those with floating rates are likely on a raft to a tall waterfall.
It would be financially possible to buck the trend if multifamily properties were able to raise their rents sufficiently to provide enough income and drive up valuations that might command more favorable refinancing. However, Wegman notes the current oversupply of apartment units means that asset values remain “lackluster.”
A secondary problem he doesn’t note is the role shelter plays in inflation calculations. Residential rent has been perhaps the largest driving factor in growing inflation. Higher levels would likely mean the Fed would increase interest rates, having a deleterious effect on borrowing, which would demand even higher NOI.
Currently, underperforming loans with a DSCR below 1 are most concentrated in Texas, California, Georgia, and New York. Also, garden and low-rise apartments similarly represent the highest concentrations of underperformance by type.