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Capital Markets Explained

In life, there are things you simply cannot control. Uncontrollable factors create risk. If we could control everything, then we would never allow a negative. If we never encountered a negative, then we would never grow. Resistance equals strength. Strength is growth, and growth causes movement, and movement causes you to encounter even more uncontrollable outside forces. In multifamily, capital markets can be one of those outside forces that you cannot control and can have a large effect on the industry.

Capital markets are, basically, the discussion of debt. Who is lending? What are they lending on? How much are they charging for their money? In the multifamily sector of real estate, we have a few different options to choose from. These options are always changing and the effect on the multifamily industry is profound. So, what are the types of debt, how do they affect the deal flow and cap rates, and what are ways to track capital markets? Let’s take a look…

Types of Debt:

In multifamily, you have two types of debt that are most common. While other options exist at different levels and for different classes inside of multifamily, we will only look at the two most common.

Agency Loans:

Agency debt is debt that is secured through either Fannie Mae or Freddie Mac. Fannie Mae and Freddie Mac are federally backed home mortgage companies created by the United States Congress. Neither institution originates nor services its own mortgages. Instead, they buy and guarantee mortgages issued through lenders in the secondary mortgage market. The two entities virtually monopolized the secondary mortgage market until the 1990s. That’s when growing federal regulation and new legislation that allowed banks and other financial companies to merge sparked more competition from conventional companies.

Still, Fannie Mae and Freddie Mac continue to dominate the secondary mortgage market. Together, these agencies make the mortgage market more liquid, stable, and affordable by providing liquidity and guarantees to thousands of banks, savings and loans, and mortgage companies. Agency loans traditionally have lower leverage or loan to value (LTV), depending on the debt service coverage ratio, than private loans. The interest rates tend to be lower than private loans. Agency loans can only be used to purchase stabilized assets (90% occupancy or above). There is usually a penalty for paying the loan off early.

Bridge Loans

A bridge loan is a short-term loan used until a person or company secures permanent financing or removes an existing obligation. It allows the user to meet current obligations by providing immediate cash flow. Bridge loans, also known as private debt, are funded by private institutions as opposed to agency loans.

Life insurance companies are a common source of funds for bridge loans. Bridge loans tend to have higher leverage or LTV than agency loans and often are what we refer to as loan to cost (LTC), which means that some of your capital expenditures can be included in the debt and not just the purchase of the asset. The interest rates are typically higher than agency debt because the risk is higher, and the term is shorter. Typically, bridge loans are for a three-year term with two, one-year options to extend.

How does all of this affect the deal flow and cap rate of the multifamily market? Agency and bridge loans go back and forth as the best option for multifamily operators. Sometimes the leverage on an agency loan is high enough that the lower interest rate makes it the most effective from a cash-on-cash perspective.

However, sometimes the higher leverage bridge loans make more sense. The balance between leverage and rate is a key factor. Loan money has a lower cost than private equity, so the lower the amount of private equity, typically the better the cash flow.

However, there is a tipping point where, regardless of the leverage amount, the overall loan rate becomes too high. The Treasury, LIBOR (London Inter-Bank Offered Rate), and SOFR (Secured Overnight Financing Rate) all affect the rates and are constantly changing. When bridge debt rates get too high, it can cause problems if you are looking to purchase pre-stabilized assets since you cannot use an agency loan. This will affect how many pre-stabilized deals will come up for sale during that cycle. The higher rates will also affect how much buyers can pay for a deal, which will expand the cap rate. You could make the case that interest rates are directly related to cap rate compression and expansion, along with supply and inflation.

During the initial COVID-19 shutdown, all bridge lenders stopped lending money and only agency loans were available with extra COVID-19 reserves. This restricted what could be purchased during that year. That created a backlog of both deal flow and capital that could not be placed.

Once bridge loans began to open back up, they had to make up ground from not placing any loans, and rates became very competitive. This, coupled with the backlog of capital, caused cap rates to compress in 2021. Now, as interest rates rise slightly at the end of 2021, we are seeing a return of agency loans.

However, we are seeing cap rates continue to compress despite the rising rates. This is because of increased housing demand and inflation. Both factors have led to high rent growth, especially in the Southeast as people continue to migrate from the North to the South to lower expense states such as Florida and Texas.

So, as we are underwriting hundreds of deals per year, how are we keeping track of capital markets and how do they affect our deals? We get capital market reports from various brokerage firms on a regular basis. Our team is always tracking news regarding market shifts and relevant information.

However, the best way that we keep up with the debt market is by being in constant contact with debt brokers. Since we underwrite so many deals, we are on the phone verifying debt terms multiple times per week. This is honestly the best way to keep your finger on the pulse of the debt market. Once you listen for a while, you can start to predict trends and patterns.

While you cannot control everything in life or multifamily, you can mitigate risk, understand patterns, and be able to adjust quickly to the new status quo. At PassiveInvesting.com, we are very skilled at adapting to an ever-adjusting real estate landscape. We are always prepared for the next opportunity