The Fed raised rates again for its 11th time.
This marks the 22 year high in interest rates
and what we're going to see next.
A credit crunch and loan defaults.
In this video, we're going to talk about what these rate increases
are going to mean for both residential and commercial real estate.
So what is going on with the Fed?
They've raised rates 11 times.
Single family housing is not going down.
However, commercial real estate is going down hard.
Why is there such a difference?
So, as we all know, inflation got out of control last year
and the Fed is adamant in raising rates to try to lower that number.
So after 11 rate increases, both the price of housing
and the price of rent has not gone down.
has gone down are the values of the commercial properties,
which we're going to focus on now
So the first slide we're going to talk about is the office market,
which represents about 15% of the $20 trillion commercial real estate sector.
So the office market right now does account for about 80%
of the commercial loan delinquencies.
So everybody's talking about this right now,
which makes a lot of sense because many of these office buildings
are suffering from work, from home and the landlords are getting killed
because the vacancies are supporting both the expenses and the debt.
one thing to note here is that much of this office
building is suburban with the urban core, the class-A properties.
They make up less than half of all the United States office space.
but for purposes of this video, I want to focus on multifamily.
So multifamily represents about 18.45% of the $20 trillion
commercial real estate market,
So multifamily is the largest category, exceeding even office
there are three things that happen in the multifamily market
that many of you may or may not know.
Number one, there were a lot of loans originated
in 2020 and 2021 when rates were very, very cheap.
Number two, Many of these loans were either bridge loans or construction loans,
which means that these loans are temporary or bridges
that they were short term and they reset in 2 to 3 years
and they're all going to be facing higher rates.
Number three, the majority of these loans are with small
and regional mid-sized banks, which originated over 50% of all of these loans.
So multifamily is in a much different scenario than office, where
all offices is suffering from vacancy.
Multifamily is not what multifamily is suffering from
are these loan maturities that are starting to hit this year.
What you're going to talk about next in this chart, we talk about debt
maturities, specifically for the apartment industry or multifamily.
These are commercial mortgage backed security loan maturities
that have already started yet are really going to hit in Q4 of 2023.
And you could see how they roll out through most of next year
into 2026 and 2027.
Why is this important?
it's important because the Fed is continuing to raise rates.
And every single one of these lines represents and a part of a community
that has a low interest rate from prior to 2021.
and when these mature,
many of the values of these properties
are not going to be worth the loans themselves.
So I'm calling Q4 of 2023 Red October,
when you can see here, which I circled, there's $8
billion of multifamily commercial mortgage backed securities or CMBS
which is expecting to come due starting the second half of this year.
This is exactly why I'm telling you guys to hold on
to your dry powder, build your reserves and get ready
because this $8 billion year is largely going to go back to the lenders.
lot of these syndicators and a lot of these landlords
are not going to be recapitalizing these properties
and they have no chance to refinance these properties
The values of these properties
in many cases are actually worth less than the loans themselves.
This is going to be very disruptive the banking system
and it's going to ripple through to the single family.
And of course, at the same time, we have many of these commercial office
buildings that we mentioned earlier, also defaulting around the same time.
and what's what's really important to understand here,
guys, is somebody holding this debt now might be a live company,
it might be a pension, it might be an insurance company,
it might be a regional bank, but somebody owns this debt.
and when that debt matures, they're going to have to
right size this low, which means that much of the equity
in a lot of these properties that existed just one or two years ago
is going to be gone. So let's take a deeper dive here.
And so many of you might have heard about debt service coverage ratio or DCR,
but a debt service coverage ratio simply measures the ability of a borrower
to repay its debt. That's all it is.
And the debt service coverage is widely used in commercial loan underwriting
and is a key formula that lenders use to determine the size of a loan.
So if you're getting a loan, typically what a letter will do
is they'll have a debt service coverage ratio in the loan document.
In other words, the debt service coverage ratio is of an insurance policy
for the lender.
So these debt service coverage ratios are going to be talked about a lot.
And debt service coverage is simply
the annual net operating income divided by the total debt service.
we all know that total debt service has gone up.
in this equation, the debt service coverage is actually going down
because the debt service has gone up, not necessarily
because the net operating income has gone up or down.
That's all because of the debt service,
because the price of debt continues to go up.
So these debt service coverage ratios are actually out of balance.
If you're a lender and they're concerned, of course,
and they're asking the borrowers to put up more cash or more reserves,
and some of these borrowers are deciding that's not a good idea right now
because the value of our properties are less than the actual loan themselves.
as you can see in this slide, the debt coverage ratio below
one means that the property does not generate enough revenue
to cover the debt service, while a debt ratio over one means the property
should in theory, generate enough revenue to pay off all the debts.
So it's very common for lenders to have a requirement
of a debt service coverage of one point to 1.25 or 1.3 or more.
But in many situations we're starting to see
that these debt service coverages are actually below one.
So this is the canary in the coal mine.
What's happening is as these properties get right
sized and as these loans mature,
the lenders are going to rely on the debt service coverage ratios.
So even if the syndicator or the property owner is meeting the net
operating income number, total debt service is for sure much higher
because rates have gone from say 3 to 5 or 6%
and therefore the debt service coverage ratios are below one.
So what happens when a debt service coverage ratio goes below one?
well, the lender is going to land last.
In other words, the borrower or the syndicator is actually going
to have to do a cash in just to hold the property.
Because a refi right now, as you all know, does not exist.
Nobody's going to refinance from 3% to 6%
without some kind of a cash refinance.
this,
of course, is
going to be the biggest issue facing many of these commercial real estate asset.
So those of you who are in residential, you may not care about this,
but what this is going to do
is actually going to spill over into the residential market.
Because big, big banks that service residential like Wells Fargo.
Like Chase, like U.S. Bank.
They all do business in the commercial real estate sector
and they do business in the residential real estate sector.
Toxic debt in one part of the bank is going to contaminate the entire bank.
It's going to affect all the underwriting and it's actually going to be tougher
and tougher
and tougher on the real estate industry, no matter what sector you're in.
while multifamily is actually performing from an OAI standpoint,
it's not performing when you're looking at the cash on cash reserve
because the debt service has gotten so high much of that
cash that originally was projected, does not exist today.
What it really means is that if your loan is maturing,
based on the longer charity's by month through 2025 or 2026 and rates
don't go down significantly, then most of these real estate
assets are not going to be worth the value of the low
therefore most of the equity could be completely gone or eliminated.
if you're in a position where you don't have a loan maturity
for the next couple of years, you very well could be fine.
but today, if you are maturing and the loans are at five or six
and your rate was at 3% and your debt service coverages are less than one,
which in this particular case they would be
that means that the bank is going to give you less of a loan
on the refinance and you're going to have to write a check
for the difference of the old loan versus the new loan just to keep the property.
So this is the ripple effect for when the Federal Reserve continues to raise rates,
it actually increases the cost of debt, lowers
the debt service coverages and will put many of these assets into default.
and wiping out everybody's equity and even potentially taking a
loss for the bank itself.