Rising Interest Rates Put Pressure on Apartment Refinancing: Highly Leveraged Buyers Face Test

This article is the fourth in a series on the impact of rising interest rates on the U.S. multifamily housing industry.Click hereto read the third article.

Over the past two years, bidding on apartment properties has not been easy. Buyers often had to compete with 40 to 50 other groups for the same asset. Even when they ultimately won, in some cases they had to set aside caution and accept prices that would have been unimaginable a few years ago.

However, in the coming years, these buyers—especially those using floating-rate debt—may face a new challenge: refinancing properties they fought hard to acquire a year or two ago.

Undoubtedly, if interest rates continue to rise and valuations eventually fall, owners who bought aggressively will face problems. But there is widespread disagreement within the industry about the specific form these problems will take.

Some foresee a pessimistic scenario: keys handed back to banks and properties sold at a discount. But others see strong apartment fundamentals, ample debt capital, and banks willing to work with borrowers to limit losses.

"I don't think handing back the keys is a high-probability event," said Patrick McGlohn, senior managing director at Berkadia's Washington, D.C. metropolitan area office. "If it's a syndicated equity group, if the general partner (GP) needs to fund a capital call, some investors may be diluted. But at the end of the day, you can also sell the property."

Maturity Looming

Over the past two years, driven by enormous demand and extremely low interest rates, apartment property prices reached unprecedented highs.

"People paid high prices for value-add deals and underwrote aggressively," said Max Sharkansky, managing partner at Trion Properties, a multifamily investment sponsor and private equity real estate firm headquartered in West Hollywood, California, and Miami, Florida.

However, buyers who used highly leveraged, floating-rate bridge loans to pay a premium for these properties may soon face challenges.

"For someone who bought a multifamily property at a 3% cap rate, refinancing the debt in three years in a rising rate environment will be more difficult," said Daniel Jacobs, partner and head of credit at ACRE, a New York-based institutional fund manager that invests in multifamily as both an owner and a debt provider. "There are many owner-operators in the market who pushed leverage on floating-rate bridge debt and will run into some problems in the future."

George Goyal, founding partner at Houston-based Three Pillars Capital Group, which focuses on Class B and C multifamily communities, said he has heard stories of companies struggling due to interest costs on floating-rate loans. "Their debt service will climb, and they will need to fill the gap with incoming cash flow," he said.

If they cannot meet debt service or their loan is about to mature, these owners may suddenly face refinancing risk.

"Those who put on high leverage will find it very difficult to refinance or sell profitably," Sharkansky said. "If you underwrote at a 4.25% or 4.50% cap rate after renovation, betting on rent growth, and put 75% loan-to-cost bridge debt on top of it, and rates rise above 6%, you will have a hard time refinancing your way out of that."

If valuations fall while rates rise, some see a more severe scenario. "If rates rise significantly from here, we personally think many people will be in a position where they have to hand back the property," Goyal said.

Negotiating with Lenders

For any distressed owner, the first call is usually to the lender. Most lenders would rather work with the borrower than take back the property. During the 2008 global financial crisis, many apartment owners resolved issues by negotiating with banks rather than handing back properties.

"We expect a wave of distressed assets where the borrower assumed rates would stay low," said Aaron Cohen, chief operating officer at CGI+, an apartment owner based in Woodland Hills, California. "They will try to negotiate with lenders and seek extension options to avoid facing a foreclosure event."

In some cases, borrowers may discuss locking in an interest rate cap. "If you own a property with a floating-rate loan and want to lock in a rate today, you have to put cash into the refinancing rather than take cash out—which is usually what people want," Goyal said. "But owners are willing to put in cash to gain the security of an affordable locked-in rate."

McGlohn said the cost of interest rate caps has risen significantly. "Many debt fund loans did not set up replacement cap escrow accounts, so sponsors will have to purchase replacement caps, and in some cases, even if the business plan is on track, the rapid rise in SOFR could trigger a cash flow sweep," he said. "This is something that caught me by surprise and could cause stress in certain situations. When purchasing replacement caps, people will feel some 'sticker shock.'"

Refinancing Options

If there is one thing real estate investors have learned over the past decade, it is that there is always a wave of capital flowing into apartments. Some observers believe this capital is lining up to provide a lifeline to distressed owners—at a price, of course.

Jacobs sees a "middle-market opportunity" for lenders such as debt funds. "You will see refinancing opportunities because people will have a hard time getting out of the floating-rate leverage they took on over the past few years," he said. "So, by providing refinancing, you might be able to achieve excess returns or excess coupons."

Whether owners purchase an interest rate cap or refinance, they will typically need to contribute more capital. But raising that cash can be a problem. In many cases, it requires a capital call to equity investors.

"Capital calls are reputationally suicidal, but that's the reality," Goyal said. And making a capital call is still better than having to hand back the property.

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