By Taylor Williams
DALLAS — Just 18 months ago, multifamily lenders and investors in major Texas markets were underwriting record-high levels of rent growth to accompany historically low cap rates, giving capital sources little hesitation to lend at negative leverage. Following a spate of nearly a dozen interest rate hikes, the opposite is now mostly true.
Negative leverage occurs when a buyer’s going-in capitalization rate is lower than the all-in interest rate on the debt attached to the property. The scenario tends to manifest when a property with an encumbered cash flow is purchased in a high- or rising-interest-rate environment. As a rule of thumb, net operating income should comfortably cover debt service, or at least clearly be moving in that direction at the time of acquisition.
When times are good — meaning prices are high for sellers and money is cheap to borrow for buyers — negative leverage can present a flexible and creative way of getting deals across the finish line. Lenders and equity partners may be willing to accept negative leverage in the short run because they are confident that rents/cash flows will soon increase, or that interest rates will remain low, or both.
But the ability to borrow at negative leverage is rapidly melting away from multifamily deals in major Texas markets as owners face hard ceilings on what kinds of rents tenants can afford in a persistently inflationary environment. Lenders and investors taking defensive positions, which means their tolerance for negative leverage is significantly less than it was just 18 to 24 months ago.
So said a quintet of capital markets professionals that formed the lending and finance panel at the InterFace Multifamily Texas conference that took place on Oct. 2 at the Renaissance Hotel in Dallas. Now in its 12th year of running, the event drew hundreds of multifamily investors, lenders, developers and operators from both within and beyond the state. Greg Smith, senior managing director of investment sales at Berkadia, served as moderator of the investment panel.
Garrett Pisarik, director of acquisitions at Stoneweg US, a Swedish owner-operator with a U.S. headquarters in South Florida, was the first panelist to speak at length about the aversion to negative leverage in today’s world of multifamily investing.
“Right now, nobody wants to touch deals with negative leverage, but every deal that’s being brought to market is negatively levered unless it’s a loan assumption,” he said. “There has to be a very clear and manageable path to positive leverage within six months or less, ideally. “
Multiple panelists stated that they were pushing clients to take interest rate buydowns. By doing so, deals can become neutrally or even positively levered in the short run. When the rate buydown expires in a year or two, the Federal Reserve will have shifted to quantitative easing and started cutting rates — or so capital sources hope. This strategy can be particularly effective when financing deals with fixed-rate debt.
“The new deals we’re underwriting are typically fixed-rate agency executions with a buydown,” said panelist Ammanuel Metta, managing director at TruAmerica Multifamily, a Los Angeles-based investment firm with a Dallas office. “We’re trying to make these deals as palatable as they can be. But negative leverage is a big hurdle for our institutional partners to clear right now, so we try to mitigate that with a buydown without being dilutive to buying the asset.”
Cap Rates on the Move
The discussion then shifted to the other side of the equation: cap rate movement.
The cap rate compression that multifamily assets in Dallas-Fort Worth, Austin and other Texas markets saw prior to the rate hikes attests to the very healthy level of demand for product that allowed many owners to achieve record levels of rent growth.
“In Dallas, we saw 3.5 percent cap rates, and we thought that was exceptional until we talked to our guys in Austin, who were quoting 2.75 percent caps,” said Smith. “That’s when we knew we’d likely reached the peak of the market. Now that interest rates have risen, cap rates have doubled in some cases, and we’re seeing more differentiation on cap rates based on location and quality of the product.”
When cap rates reach historically low marks, the threshold for crossing into negative-leverage territory shrinks with each passing rate hike. But when cap rates are rising and interest rates are falling, then the willingness for doing a deal at negative leverage tends to increase. Some panelists believe that scenario could materialize in 2024.
Bill Rose, investment officer at institutional investment firm EQT Exeter, was the first to address the likelihood of this dynamic becoming reality.
“Cap rates are going higher, but not much higher, and the deals we’ve looked at this year have been priced at about 4 [percent cap rate] and located in major metros throughout the state,” he said. “We feel like if we can get close to a 5 [percent cap rate] going in, we’ll be OK, even if there is some negative leverage in the first year or so, as long as the business plan allows you to get out of it. Those are deals we’d do right now, but we’re trying to be patient.”
Over the course of the discussion, multiple panelists alluded to how traditional capital stacks have changed in response to aggressive rate hikes. The main takeaway was that lenders were offering significantly less leverage — down from 75 to 80 percent to 55 to 60 percent, all other factors notwithstanding — thus creating greater demand for equity sources to bridge the gaps.
But equity partners have their own reservations about negative leverage and going-in cap rates, according to panelist Clark McLaughlin, managing partner at Dallas-based Aspen Oak Capital Partners. McLaughlin provided anecdotal evidence to support his analysis.
“We were recently awarded a deal in San Antonio, and we couldn’t get any equity groups to even have a conversation unless we could [underwrite] a 6 [percent cap rate],” he said. “We’ve had similar conversations with equity groups across the country, and even if we would do the deal at a 5.5 or 5.75 [percent cap rate], equity doesn’t seem interested unless it’s at a 6 [percent cap rate] and has a good story.”
“This biggest challenge for us right now is being able to sell positive leverage,” McLaughlin concluded. “But we’re not seeing many equity groups be willing to take that risk of negative leverage, so it’s a lot harder to get deals done.”