Across the U.S., apartment investors who paying floating-rate construction or bridge loans are now struggling to keep up with interest payments that have often doubled. New permanent financing may help, but permanent lenders rarely offer enough to fully pay off a property’s existing loan.
Help may be on the way. Private equity investors are eagerly lining “rescue capital” for these properties—but there’s a catch.
Rescue capital—often offered as preferred equity—is structured as a loan with its own high interest rates. Even properties with strong income from rents can only support so much debt, and the proceeds from a permanent loan and preferred equity still typically fall short. If they want to keep their properties, that means many borrowers will simply have to contribute more equity.
“I'm in the middle of the deal right now where a client is bringing about $1 million to the table to pay down a loan and that's cash out of his pocket,” says Matthew Dzbanek, a capital services professional at Ariel Property Advisors.
The borrowers who feel the squeeze the most took out floating-rate, short-term debt just before rates began to rise, when high-leverage capital was easily available and valuations of apartment properties were at their peak. Many of those loans are set to come due in the second half of 2023 and early 2024—and fatigued lenders are unlikely to offer extensions.
“Those are all starting to come due in the latter half of this year and the beginning of next year—so you're really just starting to see the beginnings of borrowers acting to get out of those deals,” says Kyle Draeger, a senior managing director for CBRE Multifamily.
ACRE provides a bridge in Savannah
ACRE, a private equity fund manager based in New York City, raised $400 million for its Fund IV, which is ready to provide preferred equity loans to apartment properties that need to fill gaps in their financing.
“We've got a lot of fresh powder,” says Michael Van Der Poel, founding partner of ACRE. Its discretionary, closed-end, fund welcomed wealth managers, registered investment advisors and high-net worth individuals among its investors, targeting yields for these investors from 15% to 18%.
Many apartment projects that received bridge financing or construction loans at the peak of the market in 2021 may need this rescue capital in the second half of 2023 and early 2024. “They’re going to struggle to find permanent financing because the valuation has changed, because they had interest pile up, because of all those problems,” says Van Der Poel.
ACRE is also already providing rescue capital for apartment developments that may provide a template for future preferred equity investments, even though these deals were stressed by a different set of problems during the coronavirus pandemic. They suffered months or even years of delays during the lockdowns and the shortage of workers and materials that followed.
Near the end of 2022, one of ACRE’s developer clients began to welcome tenants to a new, 150-unit, mid-rise building in Savanah, Ga. Work began on the project in 2019 and finished near the end 2022. “The project was a success, the leasing is going well,” says Van Der Poel. “There really no problem except that the construction loan is coming to the end of its term and the banks are not really excited to give anyone more money right now.”
ACRE provided a $25 million bridge loan to the property. ACRE’s bridge loans have interest rates floating 300 to 400 basis points over the Secured Overnight Financing Rate (SOFR). Since SOFR has risen sharply in the last year, the Savanah property cannot support as much debt as it once did. Its original construction loan was roughly $30 million.
To refinance with a new bridge loan, the owners had to contribute about $5 million of their own equity. “If you have capitalized borrowers, it's going to be very difficult to for people to walk away from that operationally sound underlying property and not put a little put in $5 million,” says Van Der Poel. But less well-capitalized borrower may have more serious problems. “It's gonna be a tale of two borrowers,” he says.
The preferred equity not taken
The story of one mid-rise apartment building in Chicago shows just how difficult it can be to bring rescue capital to a property.
“This is a highly complicated, negotiated structure,” says Ben Kadish, president and founder of Maverick Commercial Mortgage, Inc., based in Chicago.
One of Kadish’ clients owns (for now) a new, 40-unit building over-burdened by debt. A little more than two years before, the owner took out a $7.5 million floating-rate bridge loan. It covered 75 percent of the projected value of the property, based in its $500,000 annual income from rents. The interest-only loan had floating interest rate of roughly 4 percent. That works out to just $300,000 a year in mortgage payments.
“The property was making $200,000 a year in cash flow,” says Kadish.
All that changed when interest rates rose, driving the floating rate on the loan above 8 percent. Its mortgage payments doubled to more than $600,000. “That’s more than the building generates in rent,” says Kadish. Most bank lenders ask borrowers to maintain a debt service coverage ratios of at least 1.25x. “You have to find replacement financing to keep your properties.”
The hunt for new financing started with a new, permanent Freddie Mac or Fannie Mae loan. With an interest rate fixed at 5.5 to 6.0 percent, such a loan might cover 65 or 70 percent of the value of the building—much less than the amount of the existing bridge loan, which had covered 75 percent of the value, says Kadish.
Rescue capital from a preferred equity lender could fill part of the gap. But not all of it. Maverick identified four different small-balance, preferred equity lenders that quoted interest rates from 13 to 17 percent,” says Kadish. But the size of these loans was not enough to cover the amount needed by the borrowers.
Maverick spent six weeks fitting together different combinations of loans in an attempt to increase the total amount of loan proceeds, because different agency lenders have different underwriting criteria.
“The borrowers would have needed to bring another $1.2 million, on top of the preferred equity, on top of the new permanent loan,” says Kadish. Instead, the borrowers decided to put their property on the market for sale. “They decided to sell the building rather than write a check themselves.”
Kairos rescues 900 apartments
Kairos Investment Management Company, a real estate investment company based in Irvine, Calif., has already provided rescue capital to apartment investors in trouble.
Twelve months ago, Kairos provides $30 million to a portfolio of three garden apartment communities in suburban Philadelphia. Each has about 300 apartments, for a total of 900 units.
The owner of these properties had initially taken out a two-year bridge loan to pay for a value-added renovation, with options to extend. The aggressive loan covered 90 percent of the cost of the project. However, the coronavirus pandemic interrupted their plans. Lockdowns and the scarcity of workers and materials delayed the renovations and added new costs.
“The thing got delayed and they were out of their debt coverage ratio covenant,” says Carl Chang, founder and CEO of Kairos. “They got to the end of their two years and they couldn't get their year extension because the numbers were no longer working.”
Kairos provided $30 million in preferred equity, with an effective interest rate of 18 percent. The funds paid down some of the existing construction loan, reduce the debt service owed by the property. “We got the extension done and they had enough capital now to complete the improvements,” says Chang. Rents improved, and recently the stabilized property was able to secure new permanent financing.
Having Kairos as partner helped the borrower achieve their goals in other ways than just the infusion of capital. Permanent lenders have toughened their underwriting standards over the last year of chaos on the capital markets. That includes the financial resources of loan sponsors. “We have big balance sheets so we help bring credibility with the agency lenders,” says Chang.
By completing deals like these, Kairos is able to target yields around 18 percent for its investors in its funds.
ANAX rescues stalled developments in NYC
ANAX Real Estate Partners plans to provide $200 million in rescue capital over the next 18 months to apartment properties in New York City that need an infusion of capital. Several large, private equity funds have entrusted ANAX with these millions. ANAX, itself an experienced developer, has identified a pipeline of about a half-dozen potential investments so far and has already issued three letters of intent.
Each of the properties that ANAX has considered so far is a partially-built multifamily development that no longer has enough capital to finish construction. In some cases construction has stopped entirely, and ANAX is working with at least one construction lender who seized an unfinished building.
These cases may be more extreme than the budget gaps apartment owners face in other parts of the country. However, they are similar in that in many cases, apartment owners have realized the value of their properties have changed as interest rates rose – taking some of their equity with it.
“In many cases, if you can get 50 percent of your equity back, isn't that a win?,” says Eric Brody, founder and principal of ANAX, based in New York City. “We realized that with the way that the interest rates went up, I don't care what the net operating income was, it did not cover the higher interest rate.”