Higher interest rates are wreaking havoc in multiple parts of the market, from blow of up of Silicon Valley Bank due to lower prices of Treasury Bills to recent acquisition of Credit Suisse by UBS. Closer home, in the real estate sector, we are seeing the impact primarily in the commercial part. For the savvy investor, commercial real estate syndication deals are a good buying opportunity with some distressed deals popping up due to a debt blow up on floating debt obligations, leading to capital calls with investors. This was from a recent capital call from a syndicator:
'Pride swallowing moment. Have a deal facing foreclosure (rate hike blew up the debt service) doing an outside capital call. We have an LOI from Marcus and Milichap to refi the new investors out when we hit our target NOI and Occupancy. Need about 1.5M and we’re offering 18% annualised interest and 6.75% kicker at refi. Target to have this done is Friday 24 Feb. 5M of investor equity at risk. '
Why this is happening now:
During a low debt environment, syndicators made deals at 4-5 cap, and assumptions of IRR based on exit value based on a low interest rate environment that would continue forever.
Commercial real estate is uniquely different than residential in one major aspect: the use of floating debt, or an interest only arm (typically 7 years). Commercial deals lock in loans for a few years and then floating, typically 7 year loan locks. So their exit value is highly dependent on timing of the economic cycle, as the next buyers purchase deals based on the interest rates at the time of exit. Buyers would typically buy a deal which is prevalent interest rate + 400 bps above that as cap rate (refer to graph below). The 400 bps is the incremental risk of the commercial asset class. With debt at 6-7%, the going market rate for these deals is 9-10 cap.
Refinancing these deals is also challenging currently as you need to put good money after bad, as banks will require debt to equity ratio based on an 9 cap deal given that's the current market value, instead of the 4 cap they purchased at. An acquintance of ours who bought a 4 cap is already concerned as even with all the improvements he is making on his commercial deal, he won't make any money when he sells for 9 cap a couple of years down the line.
It's rare to see mom and pop flippers, new construction builders, and syndicators survive in this business for multiple decades. It's for a specific reason - they operate on a boom and bust cycle related to debt. There are a few large PE and hedge fund shops that have proper quantitative analysts who can do this successfully at scale, but most mom and pop don't have the required financial acumen to model this risk-reward cyclicality related to debt cycle, till they get burned once.
How to find deals in this market:
For the savvy investor, this may be a good time to buy a deal at 8-9 cap, and hold out for the next boom cycle by locking in debt for 7 years if you find a distressed deals. With Return To Office trend set to become more prominent, you may be able to get opportunities in deals with low occupancy currently, and work towards increasing occupancy in next few years. Be careful of short debt locks and due your own thorough due diligence as you may end up in a blowout situation as well if you can't hold the investment.
If you are already locked in one of these deals from 2020-22, you might want to check the IRR assumptions and health of your deals, and have spare capital at hand in case of a capital call in a couple of years based on the lock period of your interest line.
Why is this not happening as prominently in residential:
Residential has 30 year locks so you don't see that volatility as much with the debt cycle, as owners can simply choose to hold their rates and only refinance when it goes down. Most home owners have financed debt at 2.75% for the next 30 years, so can simply hold out if need be. For reference, usage of ARM was only 8.5% of loans in May 2022 so much fewer of these blowouts are expected in residential. Expect a slower grind down, and if you have cash to invest, focus on finding good commercial deals.
