The lending environment has changed rapidly over the last few weeks and months. Multifamily buyers at the end of 2021 were easily getting 80% leverage on nonrecourse bridge loans. Now a lot of loan terms are coming back at 70% after speaking with several lenders, brokers, and buyers.
Debt Yield
One of the recent changes causing leverage to decline is the debt yield test. Last year bridge lenders were comfortable with a going in debt yield of 4.5% to 5% and an exit debt yield of 7% or higher on year 3. That has moved up closer to 5.5% to 6% going in and closer to 8% on the exit.
Debt Yield = NOI/Loan Amount
Let us use an example of a $15MM purchase price and an NOI of $600,000. That is a cap rate of 4%. An 80% loan amount on a $15MM purchase price is a loan of $12MM. The debt yield going in would be $600,000/$12,000,000 = 0.05 = 5%.
Now, if the lender wants to see a 6% debt yield going in you cannot change the NOI because it is based on how the property is currently performing. Instead, they would need to lower the leverage to meet the higher debt yield percentage. Let us use 70% leverage on the $15MM and we get a $10.5MM loan amount. The debt yield in this instance is $600,000/$10,500,000 = 0.057 = 5.7%.
By lowering the leverage to 70% you can see how the debt yield gets closer to 6% which might be ok.
Year 3 Pro Forma
The other test that lenders are scrutinizing is the year 3 pro forma and doing the same debt yield test. Let us say our year 3 pro forma NOI is $840,000. With 80% leverage or a $12MM loan, our debt yield on year 3 is $840,000/$12,000,000 = 0.07 = 7%.
Last year in 2021 this was an acceptable hurdle. Now, moving into the summer of 2022 the percentage they are looking for is closer to 8% or 7.75% minimum.
Dropping the loan amount down to 70% leverage or $10.5MM the debt yield is $840,000/$10,500,000 = 0.08 = 8%. By changing the debt yield requirements, you can now see how the leverage in multifamily is being affected.
Mitigating Risk
Buyers of multifamily properties are learning quickly that the leverage they got last year is no longer available. This affects the market in general because it affects returns. The magic of real estate is leverage. The higher the leverage, the greater the returns can be. However, the higher the leverage, the more risk there is.
Lenders are wanting to take more risk off the table and make sure multifamily owners can cover their debt service payment. The last thing the lender wants to do is take back the property.
In addition, they securitize the loans and sell the paper to the market in the form of commercial mortgage back securities. If the market does not want to buy a low return for a higher risk, the leverage adjusts to the market.
Conclusion
There are market adjustments happening now as multifamily buyers and investors figure out this new lending environment and rising interest rates. Lenders are reducing risk by reducing leverage and the equity investors must cover the difference. This waters down the returns and investors should also adjust their expectations accordingly.
