I, like most people, was thinking there would be blood in the water when it came to the multifamily and real estate market in general back in late March, when the entire country and world shut down due to the coronavirus. I was getting flashbacks to 2008 when we were able to pick up foreclosures for pennies on the dollar by the dozens.
Flash forward 120 days and I think we can all agree that there is not the mass exodus from real estate holdings, particularly multifamily properties, that full-time investors like myself had expected to see.
I expect delinquency to remain 5-10% above what we have seen in the past five years, and vacancy to rise 3-5% across the board. However, due to these factors coupled with lending requirements tightening nationwide, I foresee some excellent buying opportunities on the horizon—but not necessarily for the reasons you may be thinking.
Here are three factors that I see creating buying opportunities for investors in the multifamily space for the remainder of 2020 and into Q2 of 2021.
More Conservative Lending With Agency Debt
Lending has become increasingly more conservative from agencies (Freddie + Fannie Mae) as well as local banks.
Six months ago, Freddie and Fannie were offering 70-80% LTV financing, and although they required quite a bit of due diligence like six-month seasoning of rents, qualified guarantor and operator, and verified rent roll, it was pretty cut and dry to check the boxes and get approved.
Today, if you want to get an agency loan on a multifamily property under $5 million, they will not only scrub your rent roll and verify that tenants have been paying for the past 90 days, but they will also require that the borrower put down an additional 12 months of operating reserves.
Let me say that again, they will require the borrower to put down at closing an additional 12 months of operating reserves. This may seem like an insignificant box to check but let me assure you that it is not. Twelve months operating reserves on a $4 million loan would be equal to an additional $25,000-40,000 per month depending on the market (property taxes, utilities, insurance etc.). For the sake of round numbers, that is an additional $300,000-400,000 or roughly 8-10% of the total loan amount.
What does all of this mean? More cash is needed to fund deals, which means there will be fewer and fewer qualified buyers for multifamily properties. It also means that the return profile when using agency debt will be lower due to the additional cash needed to bring to closing (the less cash you have to put into a deal, the higher the return).
For direct owners who are long-horizon investors, this may not move the needle much in their underwriting or ability to close. However, for syndicators that rely on mid- to high-teens IRR returns (15-18% average IRR) to provide their investors, this could be a significant factor to watch closely, especially on larger syndications ($10 million+ purchase price) where reserves required are $1 million and up.
Stricter Underwriting From Local Lenders
Local lenders, while they may not be requiring 12 months of operating reserves like agency lenders, are almost exclusively lending to previous clients that they deem “qualified operators.”
Over the past 90 days, we have reached out to more than six local banks that, prior to COVID-19, had expressed interest in lending to us and wanted to compete for our business. Every single one of those local banks has said to some degree that their loan committee is not approving any new borrowers at this time or they are not lending on commercial properties through the end of 2020 or until there is more clarity on a vaccine.
The good news is that rates have gone down, and the local banks that we have done business with in the past are giving us pretty great rates that have been the same as or better than some agency rates the past 90 days. The bad news is that these local banks that are still lending are almost exclusively lending with a personal guarantee included, and they are charging a pre-payment penalty if the loan is refinanced or sold inside of three years.
Due to the pandemic, a lot of individuals have sold public securities and have been sitting with more cash than usual, so some local banks are sitting on more cash than they know what to do with. As a result, they are willing to lend at aggressive rates, but there are strings attached; namely, the personal guarantee unless the LTV is under 60% and a pre-payment penalty if sold or refinanced with another bank in three years or less.
What does all of this mean? As with agency loans, most people buying multifamily properties in the $4-$10 million range (non-institutional) are not looking to personally guarantee a loan of that size. So what does that leave them with? Having to bring 40-50% equity to close a property in order to qualify for a non-recourse loan (no personal guarantee).
The second ripple effect of dealing with local banks is that they are going to be very thorough in their underwriting of the operator. In years past, if the operator was new or didn’t have a long track record to stand on their own, the property would be able to get the approval of a loan committee almost exclusive to who the operator was. In today’s world, the property, while important, will need an experienced operator to get the green light from the loan committee.
There have been five property owners that we made off-market offers to in the last two years that have called asking if we were still interested in their property and revisiting our previous offer. What does this tell you? It tells me a couple of things.
Landlords, although they may not be distressed, are finally coming around to selling for one reason or another, most likely due to higher than normal delinquency and lower occupancy than they have been accustomed to over the past five years.
What does that mean for operators or investors like you and me? We need to stay disciplined and stay ready; opportunity is coming. Although it may not be in the way that I had anticipated back in late March, it is coming! For me that means being very disciplined with our underwriting; conservative on current rent and rent growth the next three to five years; and conservative on maintenance, construction, and the amount of equity we will need to close on any deal that we decide to pursue.
If you have access to deals and can’t quite get the financing or raise the equity, find an operator in your area to partner with. If you’re an operator that has the equity and ability to get financing, look for hungry foot soldiers to bring you opportunities and compensate them accordingly.
I am currently in the middle of closing on a small 20-unit deal in my market with a buddy that I met online a few years ago. He has been diligently cold-calling owners for the past two years, and finally, one of them called him in March and said they were ready to sell and did not want to list it with a broker but wanted to work with him. Immediately he called me, and we had the property under contract within 48 hours, with closing set for the first week of July.
Stay ready, stay disciplined, and stay liquid!