Key Insights

Uncertainty around how many rate hikes will be needed to bridle inflation - Ukraine conflict reduces visibility
Higher Secured Overnight Financing Rates (SOFR) impact interest coverages on transitional loans until higher CFs achieved
Term credit risk unlikely to be material with substantial cash equity and capable sponsors
Long-term rates will drive valuation changes although a materially higher SOFR could slow transaction activity
Equity buffer afforded private real estate credit insulates sector except for extreme scenarios

Private real estate credit has experienced heavy investment flows aided in part by record levels of property trades and ultra-low interest rates. Meanwhile, inflation has moved beyond the initial transitory characterization into a period where the financial markets are significantly concerned about its containment. In response, the Fed has switched from quantitative easing (QE) and near zero rates to quantitative tightening (QT) and raising shortterm rates. The end goal is to reel in inflation without putting the economy into a recession.

Now that short-term rates are increasing, the level of Secured Overnight Financing Rates (SOFR) will have a more meaningful role on the risk assessment of loan opportunities. With near zero interest rates, an asset’s ability to generate enough cashflow to pay debt service while the sponsor executes its business plan (renovations, repositioning, lease-up, etc.) generally penciled out with little concern for potential interruption. In this new higher short-term rate environment, floating rate lenders will need to spend additional time on an asset’s projected cashflows to gauge the potential reliance on the sponsor to infuse additional equity in order to “carry a loan” or make shortfall payments, should one occur.

EXHIBIT 1: Daily SOFR forward curve

Line graph showing the daily SOFR forward curve by rate from March, 2022 to January, 2026

Chatham Financial, 21 March 2022

Debt Service Coverage Ratio (DSCRx) is back in play

To keep things simple, the focus here will be on the bridge loan market (levered senior mortgages secured by transitional properties). A common investment profile in today’s market is for a sponsor to buy a multifamily asset, renovate the units and then sell or refinance with a permanent loan. As part of this process, it can take time to complete the property improvements and start turning over the rents to the point where a significant increase in cashflow is realized. During this period, increases in SOFR could push the DSCRx (Net Operating Income (NOI)/debt service) below 1.0x. How high can SOFR climb before NOI growth is needed to stay above 1.0x? One example is outlined in Exhibit 2 below. The lower end of the table is in our rear- view mirror but it helps to establish where things were going into this tightening cycle.

Table highlighting the impact of SOFR on DSCR Loan A and DSCR Loan B as of March, 2022

Principal Real Estate Investors, March 2022

Note #1: Loan A has a Spread of 275 bps; Loan B has a spread of 325 bps.

Note #2: The loan used to model the DSCRs in the table was 70% LTP/LTV based on a 3.75% cap rate. Inclusive of additional fundings, the loan has an approximate debt yield of 5%, prior to rent/NOI increases. For example and illustrative purposes only. Not actual loans that are available for investment and not a guarantee that future loans will have similar characteristics to those shown above.

As you can see, in this example the loan does not dip below 1.0x until SOFR gets in the range of 2% to 2.5%, depending upon the loan’s spread. There are several factors which affect the outcome of the analysis including the cap rate (NOI/ Value), initial loan-to-value, and how the additional fundings are structured.

Lenders can use escrows or recourse to credit enhance the loan should a material shortfall be expected. For example, a debt service reserve calculated using the forward curve is an option with the proceeds returned to the borrower after the property starts generating a higher level of cashflow. Certainly, any holdback which enhances the credit quality of the investment will require a lower quoted spread to win the loan relative to lenders comfortable the sponsor will make the shortfall payments, if needed. In addition, although the market for multifamily loans has moved away from the following construct, additional fundings could once again be hurdled to debt yield thresholds. Interest rate caps will also be part of a loan structure. However, due to the cost to purchase, the market generally utilizes interest rate caps to mitigate scenarios where short-term rates exceed the market expectations embedded in the forward curve.

Positive property fundamentals and equity buffer protect private credit investor

The outlook for the multifamily sector calls for continued rental growth driven by a solid economy, elevated singlefamily housing prices, and higher construction costs. In addition to growing NOIs, lenders benefit from 25% or higher equity cushions (Value – Debt). Should the DSCRx drop below 1.0x it does not mean the loan will automatically default. Absent a major change in multifamily fundamentals and expected property performance, it is highly likely the sponsor carries the loan in the event of a shortfall, infusing additional capital allowing time for the business plan to be realized. In the case of acquisitions, the recent fresh equity strengthens the sponsor’s commitment to the asset. Shortfall amounts totaling 5% to 10% of the initial capital contribution should not be of concern for capable sponsors.

CONCLUSION: The private real estate credit market can absorb higher short-term rates but of course there are limits to this statement

As long as exit debt yields (debt yield at loan maturity) remain at reasonable levels, the expectation is the market will accept the pressure on loan term DSCRs and will attempt to mitigate with additional loan structure, asset selection, and quality sponsorship. However, should short term rates start to get into the 2.5% to 3.0% range, leverage levels and/or the cost of debt will likely be impacted. This in turn would slow acquisition activity, and potentially could seep into valuations depending upon the level of longterm rates and the state of the economy. The equity buffer afforded to private real estate credit can help protect investments should the Fed’s campaign against inflation be prolonged or end up being too aggressive (recession occurs).


Risk considerations

Past performance does not guarantee future results. Investing involves risk, including possible loss of principal. Potential investors should be aware of the risks inherent to owning and investing in real estate, including: value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk. All these risks can lead to a decline in the value of the real estate, a decline in the income produced by the real estate and declines in the value or total loss in value of securities derived from investments in real estate.

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