As elevated interest rates and tighter lending standards have made capital more difficult to obtain from traditional debt markets, private credit is creating solutions for borrowers—and opportunities for investors. In the multifamily real estate space, regional banks have been one of the primary sources of financing in recent years. But with many banks taking a conservative approach, private credit is filling the gap and helping to finance quality projects at attractive interest rates from a protected position.
Loan securitization markets are experiencing ripple effects from the broader lending environment as well. For example, commercial banks and government-sponsored entities (GSEs) pool multifamily loans to create commercial mortgage-backed securities (CMBSs) and collateralized loan obligations (CLOs). As banks and GSEs have adopted more conservative underwriting standards, there’s generally been an improvement in the credit quality and profitability of these securitizations. But these atypical conditions won’t last indefinitely, so savvy investors need to be able to evaluate and take advantage of opportunities in private credit while they last.
How Market Factors Led to Current Credit Environment
In 2021 and 2022, after the height of the COVID-19 pandemic, there was a surge in demand for multifamily properties that resulted in many sponsors purchasing value-add, older-vintage properties at or above replacement cost. This market behavior was fueled by rock-bottom interest rates and the expectation that 5% to 10% year-over-year rent increases, typical at that time, would continue. As interest rates remained low, investors were forced to accept lower returns or take on more risk to achieve higher potential returns on their investments. Many chose to take on additional risk by purchasing assets at peak valuations and using higher-leverage bridge debt.
But the zero-interest-rate policy that was prevalent for much of the past 15 years ended abruptly in early 2022, when rising inflation prompted the Federal Reserve to begin a series of rapid interest rate hikes. The ensuing credit contraction crimped capital market activity across the commercial real estate (CRE) sector, which in turn made it more difficult to discern property valuations. Meanwhile, an influx of new apartment supply has come online over the last year, and this wave of new deliveries is expected to continue through the end of 2024.
While the culmination of these factors has created near-term challenges for multifamily real estate more broadly, emerging market stress and distress have specifically impacted investors that took on too much risk. However, the long-term fundamentals of multifamily real estate remain strong. Despite the current supply glut, the U.S. has a long-term housing shortage that could be exacerbated by a recent decline in construction starts. While it is expected that this supply-demand imbalance will right itself and rent growth will return to historic norms, tighter lending conditions continue to persist and even high-quality multifamily projects will need alternative sources of financing.
With more than $682 billion in multifamily loans maturing over the next two years, according to Newmark, these circumstances appear to be creating creating the conditions for compelling and potentially rewarding investment opportunities.
Multifamily Loan Maturities by Origination Period
Note: As of Oct. 24, 2023
Sources: MBA, Trepp, RCA, Newmark Research
An Overview of the Private Credit Market
Private credit is commonly associated with non-bank institutions making loans to private companies or acquiring loans on the secondary market. However, private credit spans many asset classes and encompasses a wide range of strategies, including direct lending, distressed lending and mezzanine-level financing, among others. With this type of flexibility across the capital stack, lenders can provide customized solutions with varying levels of risk and return potential. For example, investing in a senior secured loan backed by a cash-flowing, Class A property offers lower risk and lower potential return than a junior mezzanine loan backed by a real estate development project.
Mapping the Opportunities in Multifamily Lending
The primary lending base of the multifamily credit market includes banks and GSEs, which together make up approximately 80% of total debt origination (see chart below). The largest multifamily private credit providers, such as debt funds, insurance companies and mortgage REITs, make up the remaining 20%, each holding 1% to 9% of outstanding debt. While private credit includes a wide range of strategies, three structures stand out as opportunities today.
GSE Share of Multifamily Finance
Note: As of Oct. 24, 2023
Sources: RCA, Newmark Research
Senior mortgages: Senior mortgages are considered the lowest-risk position in the capital structure. They are first lien—ahead of other creditors to receive repayment—and have a priority claim on all assets, including a property’s cash flow, in the event of default. This type of capital protection comes with lower returns than those that might be offered with high-yield, subordinated debt products. However, traditional financing for transitional assets such as a value-add or ground-up development projects has become more difficult to obtain.
Prior to the Federal Reserve’s hawkish shift in interest rate policy in early 2022 and bank collapses in 2023, loan proceeds would be 60% to 70% of total project costs. Today, loan proceeds may be 50% to 55%, and many banks now require a loan guarantee or a pledge of deposits. This opens the door for private lenders with multifamily expertise to provide an attractive alternative by offering better loan terms in exchange for a higher interest rate.
Subordinate secured positions: Subordinate secured positions, also known as B-notes or B-Pieces, are a tranche within a securitized investment such as CMBS product or CRE-CLO. It’s worth noting that B-notes are part of the first mortgage, meaning there’s only one mortgage payment from the borrower’s perspective. In the event of default, B-notes are paid after A-notes and carry higher return potential for this additional level of risk.
Freddie Mac K-Series certificates (K-Bonds) are an example of a CMBS product that features loan pools where 90% or more of the loans are secured by stabilized, cash-flowing, multifamily properties that are moderately leveraged. K-Bonds have a 28-year track record with annual credit losses averaging only 0.04% since 1994. These securities allow investors to acquire diversified pools of loans with significant capital protection.
Preferred equity: Preferred equity has debt-like characteristics. It sits in a protected position behind common equity holders and earns income that equals or can exceed the expected returns being received from common equity today. In a typical preferred equity real estate deal, lenders contribute 60% of the capital stack and earn the right to be repaid first. The preferred equity owner holds up to 20% of the financing and is next in line for repayment. The remaining capital is in common shares. With this capital stack, if a $100 million deal loses $20 million, preferred shareholders receive full repayment of their invested equity and common shareholders bear the entire loss. In the current lending environment, investors are demanding higher premiums for taking on risks, and this is playing out in the preferred equity space as well.
As an example, the rate of return on a multifamily preferred equity investment currently ranges from 13% to 15%, while occupying 55% to 80% of the capital stack. In 2021 and 2022, the range of returns was 10% to 12.5%, occupying from 65% to 85% of the stack. This means investments in preferred equity are potentially generating 20% to 30% greater returns, while being protected by an additional 5% to 10% of common equity.
There are numerous real estate credit funds available, but few investment vehicles participate in all the strategies referenced above. The Strategic Credit Fund provides multiple ways to expose investors to both securitized products and direct loan originations. It’s a unique opportunity for investors seeking a comprehensive solution in the real estate credit market.
The December meeting of the Federal Open Markets Committee hinted at several interest rate cuts in 2024. However, the forward SOFR curve, a forward-looking indicator that reflects the expected future value of short-term borrowing rates, still points to base index rates above 3% for the next several years. Floating rate loans on multifamily properties are mostly priced using the one-month SOFR rate as the base rate plus a profit margin, also known as the credit spread. This indicates that interest rates could remain elevated for some time, providing attractive conditions for private debt originations and securitized credit investing.
SOFR Forward Curve, 1-Month Term
Source: Chatham Financial
While credit investments have continued gaining attention, multifamily credit is uniquely positioned by offering a high-yield stream of income and significant capital protection from loans that are secured by a necessity-based asset. While it’s impossible to predict how long this period will last, this confluence of factors is creating new opportunities in private credit.