Floating-rate loans have become very popular over the last few years as interest rates dropped to record-low levels.
Unfortunately, many investors started to think the rates would stay low forever.
As a result, properties acquired with floating rate debt have become some of the most at-risk deals in the entire real estate market
The biggest reason is that a 30-day average SOFR rate (interest rate index used to benchmark many floating rate loans) has jumped from less than ten basis points in March to almost 300 basis points.
This change could create a significant amount of buying opportunities for real estate investors in 2023, as they did back in 2008.
Let me explain:
First, what is a floating-rate loan?
In a FRL(floating rate loan), the interest rate payments change monthly to reflect changes in this variable index over time.
The index rate of a floating rate loan is generally the 30-day average secured overnight financing rate (SOFR).
Investors often prefer this because the initial rate on a floating rate structure is generally lower than comparable fixed-rate loans.
But they fail to look into the future and believe that rates will stay the same or even decrease during the loan term.
As a result, they do not want to tie into a fixed rate if the rates might come down = wishful thinking.
On top, the floating rate loan becomes even more attractive with an option of an interest rate cap, which essentially provides insurance that the floating rate on loan won’t exceed a specific preset figure for a set period.
But these interest rate caps have a fee, and with interest rates rising so quickly in 2022, the cost of these recaps has also increased much over the last ten months.
The borrowers are paying 3-10 times more now than in 2021.
Here is a surprising fact - only a fraction of floating rate loan borrowers buy a rate cap in the first place, and most recaps will expire within a two to five-year timeframe.
This risky move is leading to a potential source of distress in the real estate market, especially on deals acquired in the last 18 to 24 months and at cap rates between 3% and 4%.
I came across a deal from June 2022 running into this exact problem.↓
This property was purchased for
- $10 million with a 4.2% going-in cap rate
- A floating rate loan with a 65% loan amount.
- Rate of 3.85% above the 30-day average SOFR rate,
- A two-year rate cap to limit the variable component of the loan to no more than 300 basis points,
- This resulted in an interest rate ceiling of 6.85%, with interest-only payments owed for the entire five-year term.
Now back in June, the 30-day average SOFR rate was around 50 basis points.
So the rate at acquisition was just 4.35%.
The property was generating $420,000 in annual NOI and paying out roughly $280,000 in annual debt service,
So the cash-on-cash return was 4%
The COC return is less than what I ideally recommend = 7%, but still not a massive concern because the rents were under market.
Here is the challenge though:
The 30-day average SOFR rate recently jumped to ~ 3% as of October 28, putting the all-in rate on the deal just six months later almost at 6.82%.
And let’s assume the owner increased the rents by 5%, which is a lot given the costs also increased due to inflation.
The annual NOI would now sit at $441,000, with annual debt service at $443,000, putting the investor in a negative cashflow position.
At this point, a common Plan B is: refinance into a fixed-rate loan to avoid further damage, but that would most likely mean more equity investment.
Let me illustrate why:
Commercial real estate lenders size fixed-rate loans based on a minimum debt service coverage ratio or DSCR value.
Last I checked, this ratio requirement was 1.2, and the rates were 6.75 for a DSCR loan.
So even if we assume a lower 6% interest rate on a fixed rate loan with a 30-year amortization period and a 1.2x minimum DSCR constraint with that same $441,000 and NOI, the maximum loan you could get is $5.1 million, or $1.4 million short of the initial loan amount.
This means that to refinance, you would need to come up with more equity investment from investors - almost 40% of their initial capital contribution on the deal.
Not good!
This will result in a lot of angry investors, but sometimes it’s also not even possible based on investor liquidity.
What if you can’t refinance?
You won’t be able to service your debt without consistent capital calls, especially if you did not maintain the reserves for the long term.
And then an expiring rate cap would cause debt service payments to go even higher in the future.
You can see how the domino starts to fall here.
This is why the sellers are likely to sell the properties at a significant discount to what they bought them for if not hand the keys back to the lender if loan covenants are breached.
I could see this cycle playing out on a large scale because the market has been on a bull run since the 2010 and many investors made a lot of assumptions.
This could result in considerable distress in the market bubbling up buying opportunities like we haven’t seen since the early 2010.
If you recognize this and position yourself to scoop up any deals, meaning:
- gain the knowledge,
- set a team up to divide and conquer
- define processes to move fast,
- have capital ready
you can be set for life!
That’s a wrap - I hope this helps.
