How to lose money in real estate, part 2

Today's Wall Street Journal has a scary piece about Multifamily Real Estate: "A Real Estate Haven Turns Perilous With Roughly $1 Trillion Coming Due." If you missed it, the gist is summed up for small investors like this:

A new crop of private real-estate firms, funded mostly by floating-rate debt and small-investor cash, have become bigger competitors in the multifamily market. Some paid higher prices based on rosy expectations of steep rent increases for years to come. Now, they are having trouble making the numbers work.

The back story is familiar: in good years (say 2017 into 2022), multifamily syndication firms grew very quickly buying lots and lots of buildings. They attracted a new cadre of investors into private real estate with the promise of cash flow and double-digit annual returns upon sale. Most of these deals worked very well, often offering triple digit returns after 3, 4, 5 years--money doubled when the building sold. The Internal Rate of Return or Return on Equity was gaudy on these deals, encouraging more and more people to pursue this strategy.

These deals worked mostly due to very low costs of capital. The debt that could be obtained from banks and agencies was plentiful, cheap, and could be easily fixed. For private multifamily deals that have roughly 3% fixed debt, it would be hard to miss unless the project is badly mismanaged or bought for way too high a price. We have a number of these in our portfolio--and they are doing just fine.

But then there is a crop of deals, mostly from 2021 and 2022, in which investors jumped on overpriced deals and borrowed a lot of money using adjustable rate debt. Sound familiar? Sounds a lot like 2007 and 2008 to us. Back then, families and individuals bought overpriced homes using adjustable rate mortgages that made no sense given the income of those families and individuals. The same is true for multifamily buildings: they can only generate so much income, just as a family has so much income. If that income cannot match the cost of the debt service in a rising rate scenario, the multifamily syndicator (or operator) risks losing the building to foreclosure. We have already seen that happen with Applesway Investment Group as the most spectacular (read: disastrous) scenario.

The Wall Street Journal points out that the firms falling for this problem can be those with "small investors" but also some of the biggest firms on Wall Street. For instance:

Blackstone, the world’s largest alternative-asset manager, is in special servicing on mortgages related to 11 Manhattan apartment buildings, according to a person familiar with the matter. A spokeswoman for Blackstone said the buildings have unique issues and are “not representative of the strength we’re seeing in our broader rental-housing portfolio.”
...while at the same time, the reporter is quick to add that it might not be all bad news:
Apartment landlords still have reasons for optimism. Fannie Mae and Freddie Mac offer a reliable source of government-backed lending even as banks retreat. Most analysts expect housing shortages, and high rents, to persist. If interest rates come down, property prices could bounce back quickly. Multifamily owners with fixed-rate mortgages are better positioned to ride out any near-term turbulence.

What do these insights mean for the limited partner in syndications today?

  • Certainly this story is a cautionary tale: don't invest in deals with adjustable rate debt if you can avoid them--or at least with operators who don't know what they are doing.
  • Those who have adjustable rate debt need to have rate caps.
  • Even if the deal has a rate cap, those expire--and then can be very expensive to replace.
  • If you are in an excellent cash-flowing deal with adjustable rate debt that also has a rate cap, you may be fine if the syndicator is experienced and has a good relationship with the bank, plenty of cash on hand and so forth.
  • You may need to save cash for capital calls for deals in your portfolio that have adjustable rate debt. Limited Partners may be called upon to help bring cash to the table for a refinance or otherwise to stave off a foreclosure.
  • You have to face the reality that you could lose money on deals in private multifamily syndications--including your entire investment if the syndicator has mismanaged things, especially debt and other costs that may have risen due to inflation (e.g., insurance) and were not well-budgeted for in the pro forma.
  • These failures will happen more and more in the next few years as adjustable rate mortgages kick in (i.e., a short fixed period may end), balloon payments come due, and so forth.
  • If rates drop again quickly, that may provide some relief--both as carrying costs would fall again and as it may make the buildings attractive as sales targets, while rents may remain high. That's the "Goldilocks scenario" that could save the bacon of some investors who took on too much risk.