By the Numbers
Managing multifamily credit in a negative leverage environment
Mary Beth Fisher, PhD | August 19, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Property price appreciation in most commercial real estate has increased faster than rents, dragging some capitalization rates lower. The sharp rise in interest rates in 2022 has led to underwriting of some CRE loans with negative leverage—loans with coupons higher than the unlevered rate of return on the property. Some recently issued agency multifamily deals contain a significant proportion of negative leverage loans. Although these loans are riskier, underwriters can maintain robust credit quality by adjusting other lending standards, which is what the GSEs have done.
The evolution of the multifamily market over the past several years comes through clearly in the credit metrics of two standard, Freddie K deals (Exhibit 1):
- The K074 deal, issued March 1, 2018, and
- The K147 deal, issued July 1, 2022
Both deals were about $1.2 billion in size at issuance, but the K074 deal had nearly twice as many loans as the K147 deal because the average loan size was almost 60% smaller. Not coincidentally, multifamily property prices have appreciated 60% since December of 2017, according to data from CoStar.
Exhibit 1: Credit comparison of two standard Freddie K deals
The weighted average coupon on the K074 deal was 4.23% at issuance with an average capitalization rate of 5.52%. That made the leverage, or the difference between the the rate of return on the property and the average cost of financing, equal to 1.29%.
The rapid property price appreciation during the pandemic has not quite yet been matched by equivalent rent growth. One result has been that capitalization rates have fallen. This is evident in the more recent K147 deal, which has a weighted average cap rate of 4.42%, or 110 bp below the 2018 deal. The average financing cost is only 21 bp lower at 4.02%, which has pushed leverage down to a narrow 0.40%. In fact, looking at the leverage loan-by-loan across both deals, it’s evident that roughly half of the loans in the K147 deal have leverage numbers at or below zero (Exhibit 2). By comparison in the the K074 deal, only 4 of the 81 loans had flat or negative leverage.
Exhibit 2: Leverage analysis by loans in K074 and K147
Is the growing preponderance of negative leverage loans an indication that the GSEs and other lenders are financing high risk loans and that the credit quality of agency CMBS has deteriorated? The warning bells are summed up succinctly in an excerpt from a recent WMRE article Does Price Growth Justify Negative Leverage?
Negative leverage is when a property’s cap rate falls below the cost of debt on the property. Some argue that this behavior is irrational and reminiscent of the risk-taking that preceded the Great Recession. Others believe the negative leverage is justified when rent and price growth expectations are high, as they have been recently.
It’s increasingly likely that higher interest rates, negative leverage and the increasing dependence on future growth may lead to a reversal in the 20-year decline in cap rates in the second quarter.
Huge sectors of the market – investors primarily – would like to see cap rates rise. In fact, there is already evidence that they did rise in the second quarter, as projected by the WMRE article. Just as importantly, despite the lower to negative leverage, CMBS deals did not necessarily get riskier.
Shifting underwriting standards in a low leverage environment
The problem with that definition of leverage is that it’s not really apples-to-apples. The capitalization rate measures of the rate of return on the market value of the property, assuming an investor pays cash:
Capitalization rate (%) = Net Operating Income (NOI) / Market Value of Property
Lenders don’t typically allow borrowers to finance 100% of the value of the property. In the K074 deal, the average loan to value (LTV) was 69%, so the borrowers were only paying the financing cost on 69% of the market value. The debt service coverage ratio (DSCR) is typically higher than the leverage ratio, since it measures how well the NOI covers the debt payment.
DSCR = NOI / Debt payment
The DSCR for the K074 deal was 1.42 at cutoff, meaning on average the annual NOI was 42% higher than the annual debt service payments on the loan.
In the K147 deal, the weighted average LTV was 10% lower at 59%. The loans with flat to negative leverage have lower LTVs to keep the DSCR stable (Exhibit 2). The average DSCR of the K147 deal was a bit higher at 1.46. Perhaps the most important metric for the B-piece buyer is the debt yield.
Debt yield (%) = NOI / Loan Amount
The debt yield is a variation of the capitalization rate, but it shows an investor how well the property’s income covers the amount of the loan. That is most relevant for banks or other first-loss investors in a position to foreclose on the loan. The inverse of the debt yield (100 / debt yield) indicates how many years it would take to recover the loan amount from the NOI of the property.
In both the K074 and K147 deal the debt yield is 8.00%, implying it would take 12.5 years to cover the average loan amount from the property’s NOI, all else being equal. The underwriting standards have effectively shifted – requiring lower LTVs – to accommodate the low interest rate and low cap rate environment while maintaining the debt yield and DSCR at standard levels. The credit metrics of the Freddie K deals have not deteriorated due to the negative leverage environment; however, borrowers are arguably more dependent on future rent growth and further property price appreciation to achieve targeted returns.