The first half of 2024 was marked by tumultuous shifts, creating challenges for conventional bank lenders. While agency lending from Freddie Mac and Fannie Mae never goes away, traditional sources of financing have thinned out.
Traditional lenders have grown shy about the overall lending market. Who can blame them with interest rates so high, a mixed economy and the ripple effects of geopolitical tensions? Add to that the upcoming elections and uncertainty regarding property valuations. The bank runs that occurred last year have also rattled lenders.
As a result, credit unions are pulling back, publicly traded mortgage real estate investment trusts (REITs) are tightening their credit requirements and regional banks remain defensive. Loans of all types are significantly tougher to do with a more limited number of options. Getting a non-agency multifamily loan can be challenging. This has created a substantial opportunity for bridge lenders which may continue for the next 12 months. There also are signs of a shift of multifamily real estate debt from conventional banks to the private markets.
Pressure points
Banks are generally less interested in originating mini-perm loans to buy multifamily properties. “Mini perms” are short-term loans used to pay for commercial properties that will generate income in the future. Several factors are at work, putting pressure on the multifamily sector. There are concerns about oversupply, rising operational costs and slowing rent growth in many markets.
Floating rate borrowers who acquired assets at tight cap rates in 2020 and 2021 are struggling. Underwritten projections of net operating income (NOI) growth are not progressing as expected. Many owners are dealing with the cost of replacing interest rate caps, which sets a limit on how high a floating rate can rise.
They also are working to replenish interest and operating reserves and are in the challenging position of having negative leverage. In regional terms, there is a focus on oversupply in the Southeast and Southwest. As a result, banks are under regulatory pressures to shrink their exposures. Private lenders and debt funds are providing the mini-perms that banks would have done in the past.
Greater demand
Many lenders are differentiating between the product type of workforce housing, for which there is a huge shortage, versus the Class A market, which is suffering from different challenges. If you look at the deliveries of new construction in 2023 and this year, you’ll see there are continued headwinds for Class A, whereas workforce housing is experiencing a structural supply shortage.
Putting more pressure on housing is the fact that in the last few years, millions of people have come across the border and are living in hotels and other temporary housing. These people need to find a more stable form of housing somewhere. They cannot live in hotels forever. Once they start to get their work permits and establish an employment history, that will increase the demand for workforce housing in general. Given the current shortage, workforce housing will emerge as a very strong driver for multifamily investments.
Another factor attracting investors is the high mortgage rates associated with home purchases. These are expected to continue to drive demand for the rental sector as home buying slows.
Clearer skies ahead
Despite the ups and downs of the economy, multifamily housing retains its allure as a favored asset class for both foreign and domestic investors. The sector is buoyed by its robust historical performance and enduring stability. In particular newer vintage assets in population centers with a meaningful employment basis are in high demand.
Furthermore, bridge lenders anticipate that new supply pipelines will diminish during the next 18 months due to a significant lack of new construction over the last year. The U.S. Census Bureau and the U.S. Department of Housing and Urban Development recently reported that 278,000 units of multifamily housing were being built at an annualized rate in May, down more than 51% from 2023’s unit estimates.
The outlook is expected to improve in 2025. That will allow for a safe exit on the shorter term one- to three-year financing bridge lenders are now providing. Consequently, these multifamily assets continue to offer prime lending opportunities and private lenders remain cautiously optimistic, finding ample opportunities in markets characterized by positive net migration and strong demographics.
Short-term opportunities
Despite the current strains in the real estate markets, the U.S. economy has remained resilient, and a soft landing is more probable in the second half of 2024 than just six months ago. This may result in some positive trends in the macro environment, including the potential for declining short-term interest rates.
Declining spreads on commercial mortgage-backed securities (CMBS) and commercial real estate collateralized loan obligations, particularly in the past six months, reflect strengthened capital markets conditions. That being said, the risk of recession remains elevated as geopolitical uncertainty persists. And there is much uncertainty around how the Federal Reserve’s current monetary policy fully plays out across the economic landscape.
Given the conviction of healthy longer-term tailwinds in the multifamily sector, bridge lenders are expected to continue to deploy capital to support more housing. Generally, these loans will be at a lower loan to value than where the market was lending in 2021 and 2022. As a result, much of the refinancing activity will be cash-neutral or will require a modest cash-in refinancing as a result of more conservative valuations.
Although multifamily rent growth is slowing and it may take an extra year or two for sponsors to complete their business plans, there are still good values in the multifamily space. The Sun Belt will remain in favor as the oversupply will burn off in the next year or two. There is also a general sense that values in commercial real estate may bottom in the second half of 2024, creating an attractive entry point for new investors. It appears that the next six months may be the point where commercial real estate will be through the worst of it.
Waiting for change
The best guess now is that at least one interest rate cut will happen in 2024 but such cuts will be slow to materialize. As a result, it may take until 2025 for the conventional lenders to step back into the market at full speed to embrace the refinancings and recapitalizations required for the multifamily sector.
Until rate cuts happen, the banking system is likely to be constrained and bridge lenders will continue to absorb the unmet demand. There is a little more acceptance and resignation to the current elevated interest rate environment. Owners are open to do a cash-in refinancing because their relative optimism on significant rate drops has become muted and they will consider higher-cost bridge options. They see the cost-benefit of using shorter term financing with flexible prepayment terms that will allow them to refinance when rates are more favorable.
These trends will continue until there is greater consensus on commercial real estate values and fundamentals. Once there is more visibility from the Fed on rate cuts, transaction volumes will escalate, and conventional lending will re-emerge. Bid-ask spreads also will shrink, which should lead to increasing transaction volumes. By mid-2025 expect to see a gradual return to equilibrium and renewed appetite for lending from credit unions, regional banks and other conventional lenders as they gain conviction on the fundamentals for the multifamily sector.
