Before a clear path forward emerges, commercial mortgage brokers and their clients must be patient as the pieces begin to reassemble in the capital markets and in the larger marketplace. They must also weigh the past and future actions of the Federal Reserve. All of these factors add up to a time of uncertainty for the economy as well as the structured finance sector.

“Initially, there was a move by many bank depositors to shift their money from smaller banks to larger ones, specifically those that are considered ‘too big to fail.’”

Currently, market participants are seeing expectations being reset and bond yields declining due to a changing outlook in the Fed’s rate-hike trajectory, as well as a flight to safety. Should banks pull back further on their lending activities and the economy suffers, the Fed may pause or reverse hikes in the near future.

A commonly held view early in 2023 was that the Fed would continue hiking rates until something broke. Clearly, something did break in the banking sector.

Crisis takes shape

The beginning of the crisis occurred this past March when Silvergate Bank became the first institution forced to liquidate, largely due to the collapse of its cryptocurrency banking operations. A few days later, Silicon Valley Bank (SVB) became the largest bank to fail since the 2008 financial crisis. Two days after that, Signature Bank collapsed.

More recently, JPMorgan Chase acquired most of the assets and assumed the deposits of First Republic Bank, which had been taken over by the Federal Deposit Insurance Corp. (FDIC). These failures sent shockwaves through the ranks of the country’s local and regional banks, which hold about two-thirds of all U.S. commercial mortgages. At many banks, real estate loans remain the largest component of the balance sheet.

According to Fitch Ratings, commercial mortgages account for 33% of the loans held on the books of banks with total assets of $1 billion to $10 billion. The exposure is even greater when looking beyond the 25 largest domestically chartered banks, as the Federal Reserve estimates that commercial real estate loans comprise 43% of the assets at these institutions.

With the recent news of declining values across commercial real estate, it is yet unclear how these smaller banks will be impacted. But compared to the financial crisis of 2007 to 2009, banks today are lending a smaller percentage of their capital, so there’s less concentration in real estate. Thus, there’s less exposure and potential opportunity for growth.

Fueling the fire

While various factors played into the failures of these banks, one factor that they all had in common was increased pressure from the Fed’s interest rate hikes that began in 2022. The higher rates weighed heavily on digital assets. When deposit bases are drained, banks get squeezed.

The lack of depositor diversification can push banks past the limits of solvency. Pressure is placed on banks since depositors have other options, such as money market accounts or government bonds, to hold their cash.

SVB is a telling example. With a focus on venture capital-funded firms and startups, the bank got in trouble when these companies spent down their cash balances, draining the bank of deposits. Because SVB was poorly diversified, it had to sell government bonds to raise cash, and it did so at a loss of $1.8 billion. Ultimately, trust in the bank was lost and its shares declined. Companies panicked and pulled cash out in what amounted to the fastest bank run since the Great Depression. This forced regulators and the FDIC to take control of the bank.

The Fed likely realized the implications of rate hikes on banks due to the securities they held but believed there was liquidity elsewhere in the system due to high levels of cash and the ability to borrow from the Federal Home Loan Banks. While this is true, the fundamental problem was the volume of securities, the size of the unrealized mark-to-market assets and the implications of holding them until maturity.

When large depositors acted at the same time, the runs created big problems for banks. The result was a modern-day electronic bank run that had not been seen before but has been revealed as something to keep a closer eye on in the future.

Now the spate of interest rate hikes may be nearing a pause. The Fed has expanded its balance sheet to provide additional support to banks. But the crisis makes a soft economic landing even more unlikely and many experts believe a recession is unavoidable.

Impact on lending

Initially, there was a move by many bank depositors to shift their money from smaller banks to larger ones, specifically those that are considered “too big to fail.” But there’s also a shift by the government to protect smaller banks. Depositors must believe the money they deposit in banks is safe. With the current banking crisis, the FDIC acted to shore up medium- and small-sized banks by quickly making an exception at SVB and Signature Bank to insure deposits above the usual $250,000 limit.

A common view is that economic conditions will deteriorate for the next few quarters and commercial real estate will most likely suffer too. The consumer housing market is in the midst of a major correction and average mortgage rates have increased from 3.22% at the start of 2022 to 6.57% as of May 25, 2023, Freddie Mac reported. The Fed is trying to backstop liquidity risk, but there is underlying credit stress that also can be found in the commercial real estate capital markets.

Banks are currently looking to boost liquidity by asking for greater depositor relationships. Because the largest banks saw a major inflow of deposits following the regional bank failures, many lenders are willing to give better rates to borrowers who provide meaningful deposits. There are also numerous lenders that are shifting their resources from originations to asset management. In some cases, banks are sharply reducing their lending levels.

The largest area of concern in the second half of this year is in extension of credit. The expectation is that commercial real estate borrowers will be hard-pressed to secure loans, unless they are willing to accept low leverage, higher rates and more stringent underwriting standards. Banks are unlikely to fully retreat from real estate, although they are expected to be even more careful about the loans they do make going forward.

Opportunity will knock

As the crisis progresses, developers and value-add investors are being forced to ask for extensions from lenders. Some sponsors are having to make capital calls to cover cost overruns because construction lenders won’t provide more capital or interest reserves have been expended. Lenders will not be able to provide extensions indefinitely because they need to be repaid to make new loans.

Large national and regional banks have a much lower concentration of real estate today. There is opportunity for them to expand, even if it is only a 5% increase from what they have been doing. Industry experts believe the transactions that can be executed today will be among the safest loans possible given the low levels of leverage. The balance of this year could be a prime opportunity for banks that remain active during turbulent times to build relationships with brokers and borrowers.

As the year progresses, expect to see more distressed deals. These are transactions in which the borrower cannot meet the project’s financial obligations. These deals typically involve partially built developments but they occasionally happen with projects that have entered the lease-up phase. If materials and labor costs turn out to be higher than anticipated, the developer may need to find other capital sources to meet their needs.

The process ahead to recover from the recent banking issues will likely require a relaxing of federal regulations, in particular those relating to troubled debt restructuring. This refers to the renegotiation of terms between a debtor and creditor in an effort to reduce or delay repayments while avoiding bankruptcy. Changes to troubled debt restructuring will require guidance from the Fed and the FDIC.

In the interim, borrowers could discover a bit of flexibility coming from banks, which may be more amenable to making deals. Other elements that could serve as solutions are additional collateral and more cash in properties to backstop loans. Banks will likely need to add people with experience in handling troubled loans (such as brokers, consultants, attorneys, or experts in commercial real estate and receivership) to work through the turmoil that may be on the horizon.

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Many real estate and finance experts view the banking issues that emerged in the spring of 2023 as more akin to a crisis in confidence. Eventually, the situation should stabilize and reveal a market that is fundamentally in a better place. Commercial real estate may suffer in general, but some markets will fare better than others. Many high-growth markets are still undersupplied in housing. Supply and demand will continue to drive success.

How thin the capital markets are will be clear when funds are truly needed for some projects. Distress obviously impacts supply, and when the floodgates open, it could be a feeding frenzy as those with dry powder jump in. The stress being felt in the mortgage markets will be a negative drag in the short term. But in the medium to long term, there are expected to be opportunities that smart investors can capture.

The sound advice for mortgage brokers and their clients is to stick to the fundamentals, use moderate leverage and include conservative underwriting assumptions. If they adopt this approach, they’re less likely to be caught without a chair when the music stops. ●

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Single-source dangers

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Speed and efficiency

Experience and transparency

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What can be done with a growing inventory of failing hotels? One answer could be to convert these properties to a higher and better use — specifically, multifamily housing.

A June 2020 McKinsey & Company hotel-industry study suggests that recovery to pre-pandemic levels could take three years to achieve. For many hotel owners, that’s just too long to wait, and some will be forced to sell their properties at a steep discount or hand the keys over to their lenders.

Unlike hospitality, however, multifamily is in high demand, and that’s especially true of workforce housing. Many apartment developers have largely focused on Class A properties where premium rents can justify the higher construction costs. Meanwhile, affordable-housing options have dwindled. There is ready-made demand for workforce housing that a vacant or failing hotel could fill.

Provided that the hotel property is the right fit for a conversion, a few different sources of capital will finance these projects, including banks, debt funds and local private money lenders. Whatever the source, the lender will scrutinize the sponsorship team’s past experience and financial strength to determine if the project is viable. Lenders understand, however, that a conversion from a struggling hotel to multifamily makes a lot of sense under the right circumstances.

Anatomy of a deal

Let’s say, for example, that an investor discovers a three-story, garden-style, limited-service hotel that has recently lost its flag. The property is comprised of 180 rooms, mostly studios and one-bedroom units. The complex has a pool, fitness facility, small business center and a breakfast area near the lobby. The property is running at 20% occupancy and producing no positive cash flow.

In this hypothetical situation, the asset can be acquired in an off-market sale at a steep discount of $8 million, or $44,444 per room. The investor believes they can spend about $2 million to convert the site to multifamily. Their plan is to combine many of the existing rooms to create 100 new one- and two-bedroom apartment units.

The lobby area will be converted to a leasing and management office along with a community clubhouse, while residents will use the existing fitness and business centers once they are freshened up. After consulting with a zoning attorney, the developer confirms that 100 residential units will comply with the density and parking regulations that are currently in place.

The plan is to shut down and renovate the property during the first six months following the close of escrow, and then lease 10 units per month for 10 months. This strategy provides a 16-month timeline for construction and lease-up.

After completing a market-rent analysis, the sponsor projects that the property could produce $1,275,000 in effective gross income upon stabilization, and can be operated at roughly $4,500 per unit for total expenses of $450,000. Therefore, net operating income (NOI) for the stabilized multifamily property is projected to be $825,000. Based upon a market capitalization rate of 5.5%, the projected NOI would garner a new property value of $15 million or $150,000 per unit.

The investor finds a nonrecourse bridge lender that agrees to provide a mortgage based upon 75% of the total project cost. The lender charges a 2% origination fee with an estimated $50,000 in additional financing costs. Since the property will be shut down for some time and not producing any cash flow, the lender will require a $400,000 interest reserve to be held back from the initial loan funds at closing in order to cover debt-service payments during the construction and lease-up phases.

This particular lender will incorporate their origination fee, financing costs and the interest reserve into their calculation of the total project cost, which is estimated to be $10.61 million. The total calculated loan amount is $7,956,853, with an initial funding of $5,556,853. The $400,000 interest reserve and the $2 million in renovation funds will be held in an escrow account and released as the sponsor completes their business plan. Based upon this scenario, if the investor’s acquisition cost is $10.61 million and the property is sold for $15 million, then a $4.39 million profit would be realized.

Preparing your pitch

A hotel-conversion project such as the one outlined above has a number of hurdles to overcome and financing is one of them. Lenders will want to know that the sponsor has experience in owning and operating multifamily properties.

The property-management company also will be of interest to many lenders since the management company usually plays a key role in the business plan. A qualified architectural firm and general contractor will be important members of the team as well. Bonus points are given if the entire team has previously worked together on a successful project.

Detailed construction plans, timelines and budgets will demonstrate that the sponsor has a well-considered strategy. Furthermore, projected rental rates and a stabilized asset value will need to be supported by current market data.

Oftentimes, a lender will require an interest reserve to be held back in an escrow account to cover the loan payments while the property is renovated and has no cash flow. In a traditional multifamily value-add conversion, the borrower can renovate the individual units as leases expire, helping to maintain cash flow and cover debt service. This strategy, however, is generally not possible for a hotel-to-multifamily conversion.

These projects, for example, usually require retrofitting mechanical and plumbing systems. Even if the renovation is light and these systems can continue to function without interruption, it’s generally not possible for tenants to occupy the rooms while the building renovation is ongoing.

To convert a vacant hotel into a multifamily property, it must be legally permissible, physically possible, financially feasible and maximally productive.

A nuanced strategy

The concept of highest and best use is an important one in real estate investment, and it is guided by four key rules. To convert a vacant hotel into a multifamily property, it must be legally permissible, physically possible, financially feasible and maximally productive.

First, a former hotel property may require a change in zoning, or variance, to allow for residential use. The developer would need to work with a zoning attorney to have a complete understanding of what the current zoning permits and forbids. Some properties may be able to avoid any zoning changes. But the current zoning may limit any residential leases to less than one year, which may be an issue for some tenants.

Furthermore, nonconforming zoning could negatively affect the value of the newly renovated asset, causing investors to demand a higher cap rate than more traditional multifamily properties in the market. In addition, such things as title or deed restrictions also could prohibit a redevelopment opportunity.

Whether the hotel can physically be converted into an apartment complex is another important question. The size and shape of the property can affect the feasibility of the conversion. For instance, the property may not allow for enough parking spaces for the number of proposed units. It may not offer enough visibility or privacy that is in line with the developer’s vision for the new property.

Another issue to investigate is financial feasibility. Investors must assess the total project cost to determine if the conversion makes financial sense. If the value of the finished property is greater than the purchase price, plus hard and soft costs, the project may be viable. Given current construction costs, locating an existing property that can be converted may be the most cost-effective solution for producing more workforce housing.

Something else to resolve is whether the property will produce the highest net return possible. Considering the state of the hospitality industry, it is likely that a multifamily conversion will turn higher profits for the foreseeable future.

Furthermore, multifamily properties trade at lower capitalization rates than hospitality assets, so each dollar of income will produce greater value. For instance, a multifamily asset producing $1 million in NOI might trade at a 5% cap rate while a hotel project in the same market and producing similar NOI might trade at a 7.5% cap rate. The differing cap rates would provide a value of roughly $20 million for the multifamily property and only $13.3 million for the hotel.

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Let’s not sugarcoat this: Converting a hotel is no easy task. You’re taking a building with a specific business model and repurposing it for another use. The unfortunate reality is that there is no clear end in sight for the economic distress caused by the pandemic. With some kitchen-area retrofitting and combining of rooms to increase square footage, a conversion could be a viable solution for your investor clients hunting for yield in today’s commercial real estate market. ●

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Contrary to popular belief, however, gradually rising interest rates are likely to continue strengthening the multifamily sector and also benefit investors with exposure to this asset class — along with commercial mortgage brokers who are involved in lining up financing. The single-family housing market has been in a slump and there is no sign of anything changing in the near term.

Rising interest rates, along with rapidly increasing construction costs, will continue to be headwinds for the owner-occupied housing sector in general, keeping the demand for rental housing strong. As interest rates climb upward, so do mortgage payments, making homes increasingly less affordable for consumers. This causes some would-be homeowners to remain renters for longer periods of time because they can no longer afford the home they want to purchase.

In addition, higher mortgage payments can negatively affect an existing homeowner’s debt-to-income (DTI) ratio, making it more challenging for them to qualify for financing on their ideal home. DTI constraints have been especially prohibitive for a millennial generation saddled with more student debt than any other in history.

Housing-market constraints

A research paper published by Freddie Mac last year stated that the “increasing interest rate environments we identified are almost always accompanied by reductions in mortgage originations, home sales, and housing starts across the board.” In addition, a tight supply of single-family homes has helped boost property values over the past several years, placing the dream of homeownership even further out of reach for many first-time buyers.

According to a recent report from the National Association of Realtors, the median price of a single-family home is $50,000 more than it was in 2016. Fewer home sales generally warrant lower levels of new construction, keeping supply constrained and encouraging values to remain elevated. Homebuilders are fighting increased costs of materials, along with shortages of qualified trade workers, with no immediate end in sight.

In fact, delivery of new properties across all asset classes remains below historical averages, even as the overall population continues to grow. Conversely, owners of commercial real estate are benefiting from exceptionally low vacancy rates and increasing rents — especially in the apartment sector.

Cap-rate increases

It is common knowledge among mortgage brokers and many others in the commercial real estate industry that rising interest rates force cap rates higher. There are numerous studies published every year, however, that show no correlation between increasing interest rates and increasing cap rates, at least in the near-to-medium term. (This is not the case when looking at longer periods of time spanning several decades.)

In fact, rising interest rates often coincide with an improving economy, which tends to benefit real estate performance. Melissa Reagen, head of research for the Americas at TH Real Estate, an affiliate of Nuveen (the investment-management arm of TIAA) articulated it nicely. “If interest rates are rising because of stronger economic growth, as is currently the case, real estate demand will also likely be growing,” Reagen said. “If interest rates are increasing gradually, and are likely to remain at, or below, long-term averages, as is currently expected, real estate would likely be well positioned to benefit in such an environment.”

Even if (or when) cap rates do begin to drift upward, the effects will likely be lessened from increased rent and net operating income (NOI) growth. Mathematically, a 5 percent growth in NOI will offset a 25 basis-point increase in the cap rate to maintain the same property value. A property with $1 million in NOI priced at a 5 percent cap rate, for example, offers a value of $20 million. If the NOI grows to $1.05 million and the market cap rate increases to 5.25 percent, the property still holds its $20 million value.

Demographics and financing

Positive demographic trends and consumer tastes have had, and will continue to have, a significant impact on the multifamily market. The estimated 75.4 million millennials as of April 2016 are now the largest generation in U.S. history, eclipsing the baby boomers by half a million people, according to U.S. Census Bureau data.

The millennial generation, based on the Pew Research Center’s definition, includes those born between 1981 and 1997. They are now hitting their peak spending and consumption years. They are holding off on marriage, having kids later in life and moving more frequently than past generations, all of which leads to a propensity to rent.

On another front, despite murmurs of possible moves to change how government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac are structured and operate, the gridlock in Washington, D.C., has proved challenging to garner any kind of momentum leading to actual legislation. This past November, the Federal Housing Finance Agency (FHFA) announced that multifamily lending caps for Fannie Mae and Freddie Mac will be set to $35 billion for each agency in 2019.

Furthermore, loans for properties meeting certain affordability or energy- savings metrics, will be applied toward the agencies’ uncapped production. These parameters are intended to further the strategic goal of the FHFA, which is to provide liquidity for the multifamily market without hindering the participation of private capital. In addition, there has been an uptick in market participation by other lenders — including banks, credit unions, life insurance companies as well as alternative lenders like debt funds, which are mainly involved in financing unstabilized or transitional assets.

• • •

The U.S. economy has been strong, with consistently positive quarterly numbers. Unemployment is at its lowest level in decades and consumer spending is on the rise. These are the positive trends influencing the rise in interest rates, and they are headwinds that bode well for real estate sectors such as multifamily, industrial and office.

With the GSEs providing relatively cheap, nonrecourse financing, and other lenders becoming increasingly competitive in the multifamily space, the foundation is set for continued velocity in the apartment sector, which should keep investors and other finance professionals — such as commercial mortgage brokers — busy for the next few years.

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