Rising Interest Rates Reshape the Multifamily Mortgage Market Landscape

This article is the second in a series examining the impact of rising interest rates on the U.S. multifamily housing sector. Clickhereto read the first article.

Over the past two years, capitalization rates have continued to decline, and apartment buyers have turned to different financing sources. For example, investor-driven vehicles, including debt funds, captured a 12% market share in 2021—the highest proportion ever recorded, according to MSCI Real Assets data.

"Debt funds have been particularly active on the acquisition side over the past 18 to 20 months," said Kyle Draeger, senior managing director of multifamily debt and structured finance at CBRE Capital Markets. "If cap rates are only 2% or 3%, you can't get the leverage you need from government agencies, so most of the deals have flowed to debt funds."

Meanwhile, commercial mortgage-backed securities (CMBS) accounted for 15% of transaction volume in 2021, while government agencies accounted for 41%. Although government agencies still hold the largest share, their proportion has shrunk significantly compared with previous years.

However, recent Treasury market volatility and rising interest rates could interrupt the trend of borrowers moving away from government agencies. Many observers believe that as spreads widen this year, borrowers may again turn to government-backed capital sources and commercial banks.

"This is prompting borrowers who had planned to use debt funds to reconsider: do they really need such high-cost debt, or can they accept a slightly lower-cost fixed-rate loan, such as through a government agency," Draeger said.

Although debt funds are currently less attractive, not everyone believes that highly leveraged investor-driven loans will disappear. Other capital sources, such as insurance companies and commercial banks, remain active in the market.

New York-based ACRE is an institutional fund manager that both invests in multifamily properties as an owner and operates a debt fund, providing financing at 65% to 70% loan-to-cost. "Floating-rate debt still has a value proposition, offering additional leverage," said Daniel Jacobs, partner and head of credit at ACRE.

Debt funds pull back

As interest rates shift, the lending capacity of some debt funds has been called into question. According to Draeger, over the past few months, some of these lenders have retraded deals, but it is not widespread.

"In most cases, if an application has been signed or a deal has progressed to a late stage, quality debt funds will try to maintain the original terms as long as they can," Draeger said. "They prefer to do this for quality clients. Lower-tier debt funds may have to retrade."

Some debt funds have exited the market entirely.

"Most debt funds are essentially closed for business for at least the next quarter or two, because the CLO market is not accepting new issuances," said Max Sharkansky, managing partner of Trion Properties. Trion is a multifamily investment sponsor and private real estate firm headquartered in West Hollywood, California, and Miami. "Large funds are somewhat more competitive, but not enough to compete with other lenders. There are other financing options that don't rely on debt funds."

Government agencies return?

When one debt source begins to retreat, borrowers look for other options.

"Debt funds are all private market, and they are re-evaluating their spreads," Draeger said. "Compared with government agencies, debt funds have lower execution certainty. When situations like this occur, you do see more capital flow back into the Fannie Mae and Freddie Mac pipelines."

Sharkansky is one of those borrowers paying more attention to Fannie Mae and Freddie Mac. "In the current environment, government agencies are starting to look more attractive," he said. "Relative to the prices buyers need to pay, the loan sizes from government agencies are more appropriate."

In previous cycles—such as the 2008 global financial crisis and the COVID-19 pandemic—apartment borrowers turned to government agencies when other lending sources dried up.

"Historical experience shows that when capital markets are disrupted and traditional deals become more difficult, demand for government agency programs increases significantly," said Richard Ortiz, managing partner of New York-based Hudson Realty Capital. The company provides bridge loans and government agency loans.

Commercial banks remain active

At Trion Properties, Sharkansky has been able to obtain bridge loans from large regional and national banks even as debt funds retreat. "We just closed a few, and have several more in the pipeline," he said.

According to Draeger, large national banks offer 50% to 60% leverage. "Banks are still relatively active," he said. "They are still looking to lend, and their cost of funds is lower."

But Draeger said these large banks are starting to become more selective.

"Everyone has plenty of capital to lend," he said. "They are just being more selective about deals."

According to Draeger, this selectivity is not limited to large banks but also extends to other lenders such as insurance companies. "They are making sure the exit yields they are considering are appropriate," he said. "So they are being more meticulous in underwriting. If they have 15 deals on hand, they won't do all of them—they'll pick just a few."

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