One mistake many multifamily investors admit making over the last 5 years is having a fixed mindset. A fixed mindset in terms of interest rate. As the velocity of pricing increases so does transaction volume. Many multifamily syndicators are hitting their 5-year projections in 2 to 3 years. Or they are getting over a 50% total return and opting to sell. If they secured a fixed rate loan through Fannie Mae, they would have to pay a hefty yield maintenance penalty. In some cases that number can be multiple 7-figures.
Floating Rate
Floating rates started to trend in 2020. A lot of transaction volume in the value-add B and C multifamily space is now floating. Having a floating rate gives you flexibility on exit because the prepayment penalty is usually around 1%. So, a $10MM loan prepayment penalty is $100K which is more manageable, especially if your property value went up significantly.
Interest rate cap is one of the drawbacks with floating rates because the lender will require one for your loan. Nonrecourse bridge loans terms are typically 3 years with the option to extend out to 5 years. The extensions will cost you though. You will have to file for the extension and pay sometimes 50 basis points of the loan and buy an interest rate cap. Nonrecourse bridge loans are a great tool for getting higher leverage on multifamily properties, but you will want to plan to exit or refi rather quickly.
The interest rate cap is more important now that the central bank has indicated they will be hiking rates all through this year and likely the next couple of years. A 4% floating rate could easily be a 6% all-in rate by the end of the year. Therefore, the lender requires the cap because if the interest rate keeps going up you need insurance that your mortgage payment will not be too exorbitant. The more volatile things get, the higher the cost of the cap.
Still, some borrowers prefer the flexibility that floating rates provide. Easy exits and refinances make a deal more navigable.
Fixed Rate
There are still some good options for fixed rate loan products on the market. There are even higher leverage nonrecourse bridge products with a fixed rate. The rate is usually 6% and up, but if we are getting to 6% by the end of the year it might not be a bad idea to get 10% more leverage by fixing a higher interest rate. A CEO of debt fund had me convinced that it would be cheaper than getting expensive equity riding on top of the bridge loan.
Bank recourse loans can also be attractive if you can fix the interest rate in the low 4’s for 5 years. There is typically a stepdown prepayment penalty, but in some cases, there is no exit fee. The recourse loans start to look attractive when 6% interest rates are on the horizon, and you can lock in. However, most investors are allergic to recourse and would rather take their chances with a nonrecourse loan even if interest rates are going up. They should be prepared though to cover increased cap costs and increased mortgage costs
The government agencies Fannie Mae and Freddie Mac typically provide long term fixed rate debt; however, they do offer a floating rate product. The problem with new multifamily acquisitions is that the leverage is not high enough. They are constricted by a 1.25 Debt Service Coverage Ratio (DSCR) – Net Operating Income (NOI) must be 1.25 times the total debt service. If the total debt payment is $100,000 then the NOI must be $125,000. This limits how much an investor can pay for a property based on the income it produces. With the market being as competitive as it is, investors are willing to take on increased risk and bid up the prices of properties by using bridge loans which are not constrained by the 1.25 DSCR.
Conclusion
Hindsight is always 20/20. I wonder what investors will say in the next 3 to 5 years of things they should have done. We are already seeing a pullback in the bridge market in terms of leverage. 75% leverage seems to be the new ceiling for risk appetite and what the market will assume. Multifamily investors will likely keep a floating mindset unless they find a better fixed product with less prepayment.
