As the U.S. economy continues to strengthen, the Federal Reserve is positioned to continue raising interest rates for at least another year. As rates seem to be rising faster than rents, the real question becomes how do landlords refinance out of their existing mortgages? While it has indisputably become more complicated to finance commercial real estate projects, a borrower can nimbly refinance a maturing loan by tapping into structures higher up on the capital stack, such as mezzanine financing or preferred equity.
(From left to right) Matthew Dzbanek, Capital Services Professional; and Dusan Racic, Analyst - Investment Research Division
A red-hot labor market and muted inflation has the Fed confident that the economy can withstand the impact of higher rates, with gross domestic product – the broadest measure of goods and services produced in the U.S. – growing at a 3.5% annual rate in the third quarter. While that’s below the second quarter’s 4.2%, which was the strongest since the third quarter of 2014, it was sharply above the first quarter’s 2.2%. A stronger economy has led to a surge in demand for housing in rapidly growing markets, such as Brooklyn, where new jobs are being created amid a growing population.
The Fed’s policy-making arm has raised short-term interest rates three times this year, with one more penciled in for its December meeting and at least another three forecasted for 2019. This should put more upward pressure on rates and eventually lead to even higher borrowing costs on consumer and business loans.
The 10-year Treasury yield, which influences everything from mortgage rates and small business loans to state/government bonds and corporate loans, has been hovering near a 7-year high. Meanwhile, interest rates on five-year multifamily loans are roughly 75-100 basis points higher than where they were a year ago.
From 2016 through 2017, Brooklyn saw 301 transactions consisting of 515 properties totalling $4.3 billion in gross consideration, according to Ariel Property Advisors’ Investment Research Division. These properties likely used financing for the acquisition, with the 5-year maturity being the most common term. Private lenders have been extremely active in Brooklyn due to the large amount of appreciation and rental growth in that market, and borrowers have been actively taking advantage of that.
It has therefore been a busy year for Brooklyn because as loans mature, investors typically choose to refinance or sell their properties, and the buyers of these assets often seek financing to fund their purchases. Indeed, Brooklyn, the most populous borough, has dominated commercial lending activity this year and September was no exception, snaring a 40% share of New York City’s 374 transactions, according to the Commercial Observer, citing the latest data available from lending database Actovia.
The Capital Stack Solution
For most of the past decade, record low interest rates fostered feverish demand for multifamily properties in Brooklyn, which, in turn, sent prices substantially higher. Prices have held steady and even appreciated in some areas of New York City, but Brooklyn was the only region that witnessed depreciation in the third quarter, with the average price per square foot dropping 1.2% to $367, according to Ariel Property Advisors’ “Multifamily Quarter In Review.” For our exclusive report, click on http://arielpa.com/report/report-MFQIR-Q3-2018
Commercial real estate principles teach that an investor should not purchase an asset with a cap rate, or an investors’ rate of return, below the cost of their debt. However, this principle holds up less with value-add projects because today’s cash-on-cash return, the cash income earned on the cash invested in a property, is less important than stabilized cash-on-cash.
Over the past few years, many sales in the borough were purchased at sub-4% cap rates with the hopes of being able to increase rent and add value to the properties. Private lenders were very active in this segment of the market, providing higher leverage loans than the properties current cash flow supported in order to provide the capital needed to complete these projects.
As interest rates increase, the biggest constraint in Brooklyn is debt service. So, the big question for these property owners is how they can increase their cash flow enough to support a loan to take out acquisition financing. For example, and using basic numbers, if you purchased a rent stabilized building below a 4% cap rate with a 75% leverage private loan, you would need to increase your net operating income (NOI) by approximately 60% to refinance out all of your debt in today’s environment.
For investors who got extremely aggressive during the upswing of the market, selling might not be the right move as buyers might not be as aggressive as they once were. Refinancing is likely their best option. With lenders aware of this problem in a rising rate environment, they are starting to get more creative in solving these concerns. This is being done by adding more structure to their loans, such as master leases, holdbacks for vacant units, burn off personal guarantees, underwriting to lower debt constraints, etc. In some cases, they are allowing borrowers to take mezzanine financing or preferred equity to fill up the capital stack.
Despite higher financing costs, Brooklyn’s multifamily market has fared quite well in in 2018. In the year through October 31, the borough saw 118 sales that included 220 buildings for a total consideration of $2.57 billion. Versus the same period in 2017, these figures represent increases of 19.2%, 13.4% and 106.6% in transaction, building, and dollar volume, respectively. The spike in dollar volume can largely be attributed to the $904.61 sale of the Starrett City Portfolio in the first half of 2018.
Now more than ever, utilizing an experienced mortgage broker is crucial as they can peruse an array of options for a borrower to attain an ideal financing package that best suits their business plan. While interest rates are on the rise, there are many ways to maneuver the current financing environment and moving up the capital stack is one of the best strategies around.