The red-hot US multifamily sector has so far weathered the current economic dislocation. But with rates and inflation rising, some lenders believe multifamily rent increases – up an average 12.6 percent in the year to June per Yardi Matrix data – are unsustainable.

For multifamily lenders, this has meant tweaks including more cautious underwriting from banks and considerable spikes in interest reserve accounts.

Chris Moore, managing director of capital markets and hedging at Pennsylvania-based advisory Chatham Financial, says the current environment is unprecedented regarding how dramatically pricing across the commercial real estate debt landscape has gone up in the last six months across all asset classes. “There is this question about how much longer pricing can go up in the multifamily space,” he says.

Tingting Zhang, founder and CEO of the El Segundo, California-based commercial real estate credit manager TerraCotta Group, says that in a standard environment, multifamily rental prices are supposed to be able to catch up and match inflation more efficiently compared to the office sector.

“The curve will come down if inflation continues, because at a certain point the affordability factor kicks in,” Zhang says. “There’s only so much that the tenant can pay.” 

She notes the current multifamily market has become more interesting because rental affordability has taken on a great deal of variation across different geographies wherein only some still have room for growth.

“When rents are not increasing, the cap rate is going to expand,” Zhang says. “We actually see that in some of the Sunbelt markets. Although there’s still greater demand for multifamily space, significant growth in rents in recent years has undermined the affordability factor in the inflationary environment. This may not be a good thing.”

Stalled deals?

The conventional wisdom is that dealflow is unlikely to be stalled in the short-term on account of current supply or decreased tolerance from tenants to keep up with rising rents. However, the constant hunt among lenders for premier assets – especially in Sunbelt markets – does make for a more complex environment where even the most senior specialists only want to bet on properties with every tailwind in support of a potential deal.

William Colgan, partner at New Jersey-based real estate manager CHA Partners overseeing the firm’s capital stack, says more caution is expected when looking at the increase in construction costs and subsequently the deliverance of new products.

Colgan believes there will be a slight slowdown in the multifamily landscape. “Covid-19 caused a supply-side shock as material production was halted and a lot of folks were left competing over the limited supply of goods, which led to high inflation. However, we believe the imbalance is being corrected as production has ramped up and there is a demand-side slowdown as underwriting projects have become more difficult with price uncertainty and interest rate hikes.” 

The interest rate hikes being rolled out by the US Federal Reserve to try to taper inflation have not added direct wind to the multifamily sails. After a 75 basis point rise in June and a similar hike in July, Colgan says the rosy sky assumptions must be adjusted to account for unknowns still at play.

Colgan says moving on more deals in the current environment will require greater scrutiny around development yields and increasing project costs. “You’re going to need a lot more NOI on a given project for it to make sense to move forward,” he says, adding that his firm has started to see cap rates creep up as firms update underwriting and factor in the interest rate hikes on a go-forward basis, even if they are a relatively low-leverage
borrower.

Benchmarking Growth

The impending launch of the first-ever debt fund index is among key talking points in the US commercial real estate debt market, writes Samantha Rowan.

A new standard

The US commercial real estate debt markets are nearing a key milestone with the introduction of the first-ever debt fund index, which is expected imminently. The project, a joint effort between industry bodies the Commercial Real Estate Finance Council and the National Council of Real Estate Investment Fiduciaries, is in testing phase and will measure return performance across a broad spectrum of US debt funds. 

The move comes as more institutional capital is allocated to US debt funds, which raised almost $30 billion of capital in 2021. Despite this growth, there is still no dedicated index for the sector, says Lisa Pendergast, executive director of CREFC, the New York-based trade group. 

While there is progress, a launch date has not yet been set. “As in many things, the devil is in the details,” says Pendergast. “It is vital that the index allows for a like-to-like comparison and identifies the varied investment strategies in the market today – think core, core-plus, value-add – which are well-worn terms in equity real estate circles but not widely used in the debt fund sector.”

Rate caps rising

Managing interest rate risk on floating-rate loans is shaping up to be one of the biggest challenges for US commercial real estate managers. While there continues to be good liquidity for well-capitalised, experienced sponsors that use relatively low leverage, hedging interest rates is becoming a key area of concern, says Kory Geans, chief investment officer at Middleburg Communities.

Middleburg, a Virginia-based manager focused on high-quality, attainable housing, attributes the current situation to the significant interest rate increases seen over the past few months. July’s 75 basis point increase, which followed a similar June hike, exacerbated an already complex situation. “The question is, what kind of cap will you buy? Or will you choose to implement an active hedging strategy to manage your exposure over the next two to three years?” Geans asks. “It has gotten very expensive.” 

US and Europe CMBS stay distinct

While EMEA commercial mortgage-backed securities issuance picked up after the covid crisis, Fitch Ratings is projecting deals in the sector will continue to offer significantly different structures from those in the US. To win deals, banks in Europe are offering more bespoke structures for borrowers, including the increased ability to pre-pay loans. But in the US, where CMBS structures have been fine-tuned for more than 20 years, this is not likely to happen.

“Would we expect US CMBS to adopt some of these EMEA features? We don’t think so,” says Steven Marks, a New York-based group credit officer at Fitch. “Given the structures today are fairly frictionless and given the volume of issuance, we think the goal of arrangers and issuers is to have a standardised product that enables scalability. When you get into more complex or bespoke structures it just takes more time.”

Fitch also found differences in the underlying collateral, with more heterogenous assets in CMBS in the EMEA region. The differences between the regions results in a more bespoke environment for rating transactions in the EMEA market.

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