Here is Where You Will Find Distress in Multifamily

Article originally posted on Globe St. on February 8, 2023

Some Owners Will Need Help Rebalancing Their Capital Stack.

Rents may be falling but fundamentally multifamily fundamentals are very strong. Widespread distress is highly unlikely to happen; indeed forecasts for the asset class’ long-term growth are quite rosy.

But for investors eager to get a cost-effective foothold in this category or expand their holdings, here is an emerging opportunity: developers or owners that are highly-leveraged and unable to make debt payments as interest rates rise, according to Jahn Brodwin, senior managing director and co-leader of the Real Estate Solutions practice at FTI Consulting.

This group will need rescue capital – most likely mezzanine capital – to help them rebalance their capital stack, he says.

It’s not a bad place to be, distress-wise, he says, as there is plenty of capital waiting to swoop in for such opportunities.  “‘Bad distress’ is having acquired a property that is now generating lower NOI. But you don’t see too much of that.”

There also won’t be that many opportunities in this category, Brodwin continues. “Most people didn’t overleverage significantly. There has been a lot of discipline.”

But for those that did, it is easy to see where the struggle will be. The property has likely remained stable and the owner probably borrowed at a 3.5% rate. Then they put in mezz debt and leveraged up to 80% basically taking out their equity. Now it’s coming due and the refinance rate is, say 7%. The owner must put the equity back in but the market won’t allow them to finance the property at the level anymore. So they will either have to come up with the cash or put the property on the market. “That is where the distress comes in.”

While there may be some distress sales, Brodwin believes most will bring in new partners to refinance. “There will be good opportunities for mezz lenders. The original equity owner will just have to sit on the sidelines and wait for inflation to catch up or wait for interest rates to come down again and then refinance out of it.”

Patience in general is a virtue for multifamily owners, he adds. “Very few people get rich quick on multifamily. The long-term hold is the path to wealth.”

There is another possible source of distress on the horizon, Brodwin says, but this will be more of a local issue: government regulations such as rent control are increasing and when they are put in place they scramble the assumptions that buyers originally made about their properties. “People bought apartments, overpaying for them often, in New York City with the thought they would raise the rents to market rates. But they can’t do that anymore. That is very unfair of the government.

“People are making business decisions assuming they have a stable set of rules they can count on and when the government changes the rules that can change values.

“That is something to be nervous about.”