2023 was a year predicated on the belief of pending doom and gloom, but nobody knew when it would come. The pessimistic perspective was centered around wildfire inflation and a looming recession. Interestingly, it ended up being a year that magically saw the stock market rise by 40%, which very few predicted; at the same time, real estate values dropped by 30%.
Real estate was greatly impacted because property values are tied to interest rates. And to fight inflation, the Fed raised the Fed Funds Rate by 5% at a rapid pace. Treasuries also went up by a similar amount, as many sought safer investments with solid returns, in a period of high uncertainty. This caused owners in floating rate loans to see their interest rates 2x over the span of 12 months, as well as buyers to devalue new purchases by 30% to offset the rate increase, and refinances to halt as people did not want to get locked in to higher interest rate loans.
There was, and still is, the idea that this has created and will create distressed debt in commercial real estate. Distressed debt is when:
1. Loans have been defaulted on.
2. Owners cannot service the debt payments, leading to potential default
3. Property values are below the current loan amount so any new loan or sale will fail to payoff the existing loan
This first became apparent in office buildings. COVID led to the work-from-home environment which forced many companies to cancel lease renewals or extensions, leading to significantly higher vacancy. The income on these office buildings dropped so dramatically that it forced owners to do 1 of 3 things: bring on fresh cash to cover the loan, try to sell the property (but buyers weren't touching office buildings), or turn the keys back over to the banks.
There is a strong potential for this to hit the multifamily sector. The past 5 years saw capital pouring into apartment buildings that were purchased with high leverage loans at low or floating interest rates paired with a business plan to increase the income then refinance to pull cash out or sell for a quick profit. Well, rents in many areas have plateaued so owners have not been able to increase the income or the property value. Rates have doubled or tripled so many have to put cash in to refinance. If they look to sell, the increase in interest rates have offset any potential increase in property value so the profits have been wiped out. What do these owners do? There are 4 options.
1. Capital raise the investors to hold the building
2. Sell to hopefully recoup the original equity
3. In extreme cases, default on the property
4. Hope rates drop enough to be able to refinance and pay off the existing loan
At TGG, our focus has been and always will be to buy properties at amazing prices, prioritizing downside protection for our investors. Over the past 2 years, we refinanced or purchased the majority of our properties with 5-7 year fixed rate debt, which allows us to ride out the swings in the market. In the few buildings we have floating rate bridge debt hovering at 9%, we have been able to stabilize the properties, where the new gross and net incomes support loans that will cover the existing loan, pull additional cash out and positively cash flow.
Our strategy today and moving forward is based on being highly opportunistic to offset potential risk. The market has seen a shift, and everyone is adapting to the new norm of lower price points. We are aggressively pursuing properties that are devalued given the market conditions, ensuring we understand our worst case scenario, so we can continue to protect investor capital and achieve above market returns. Hindsight is 20-20 and nobody has a crystal ball. However, what we can do is assess the factors in play today and make decisions based on what we do know.
Comments