Private Debt Is Multifamily's Hero For The Day, But It Will Have To Prove Its Mettle As A Long-Term Savior

Borrowing from a debt fund can be risky business, but multifamily owners are starting to take the leap as refinancing options grow scarce.

Demand for alternative and niche funding sources is on the rise as the ongoing CRE credit crunch sidelines most banks. Cue private lenders like debt funds that have stepped into the void, offering short-term loans that allow investors to close a capital gap while they try to secure more permanent financing. 

As interest rates remain elevated, some owners with maturing debt are finding themselves in the same position they were when the loan originated. And how a debt fund reacts to a potential default will vary based on the health of the property and the borrower. 

Yet one thing has become increasingly clear: As banks recoil from their exposure to CRE debt, alternative lenders are seizing the moment to prove themselves a stronger partner.

“When you really look at it, a conventional bank lender is not really suitable for a lot of the real estate deals out there today,” said Daniel Lebensohn, co-CEO of BH3 Management, a firm that specializes in shoring up distressed debt in capital stacks. “Why wouldn’t you be better off with a fund that can actually do something with a nonperforming piece of paper?” 

Multifamily lending is expected to total $339B in 2024, a 25% increase over last year’s estimate of $271B, according to Mortgage Bankers Association data reported by CoStar. Private funds, real estate investment trusts and other specialty lenders are expected to become more popular as liquidity from banks remains limited.

The worldwide private debt market has been in growth mode since the Global Financial Crisis, increasing from about $375B to about $1.6T in 2023, according to Preqin data reported by Brookings. BlackRock projects the market will exceed $3.5T by 2028.

Demand from CRE borrowers has never been as strong as it is today, particularly among multifamily owners who took out floating-rate financing when debt was cheap. Soaring interest rates mean many of those borrowers are unable to service their loans, and a growing number of banks are unwilling to cover the shortfall. 

“Multifamily was the golden asset right after Covid. Between that and industrial, it was very sought after,” said Paul Jhung, a partner in the Assurance Practice of CohnReznick’s New York office and a member of the firm’s commercial real estate industry practice. 

“But a lot of the operating income issues we are seeing in terms of inflation just don’t support the debt service coverage ratio. The banks see that, and they find that the risks are too steep given where rates are.”

A private debt fund can be a good short-term option for owners who have failed to access bank debt or raise additional money from investors, said Dee Estep, a principal in CLA Dallas’ Real Estate Group. The hope is that the loan acts as a stopgap while they wait for interest rates to come down.

“Because of the health of a lot of these assets right now, there is not enough interest from an investor standpoint to invest additional dollars,” she said. “Going to a debt fund shores them up for the next 18 months with the expectation that there will be an upswing in the market.”

The Federal Reserve began raising interest rates in mid-2022, and while it has hinted at three rate cuts this year, decreases have yet to materialize and hopes have dimmed. Overdue debt fund loans usually carry higher interest rates, so if an owner is unable to pay them off in time, they land in a more precarious situation than they were before, Estep said.

In some cases, owners are better off short-selling the property than attempting to recapitalize, she added.

“They are accumulating all of that unpaid interest and it’s compounding,” she said. “It puts you in an almost worse situation if you don’t try to sell it for what you can get it for. At the end of the day, if you can hang on, it’s hard to catch up.”

Property short sales are paving the way for cash-rich, institutional-grade buyers to scoop up properties at a bargain. In some cases, prices are discounted as much as 20%-30% below market value, said Ryan Chismark, partner at Dallas-based Meritax Advisors.

“Rapid interest rate hikes turned market economics upside down in the most accelerated Federal Reserve intervention we have seen since the 1980s,” Chismark said in an email. “Equity evaporated overnight and those who took on the most risk when the market was hot, primarily multifamily syndicators, are going to be offloading inventory in the back half of 2024.”

If Chismark’s prediction is correct and the market is flooded with institutional buyers, that could be a good thing for the overall stability of multifamily, Estep said. 

Many syndicators purchased value-add properties with the intention of upgrades, but as costs accelerated they were unable to make good on those plans, leaving many properties in the state of deterioration they were in before.

“There are advantages to larger groups coming in,” she said. “Some of these aging properties need millions of dollars in improvements … if you have the ability to put that money in, it’s going to make them healthier in the long run.”

Owners who aren’t ready to throw in the towel in some cases look to preferred equity as an additional stopgap, though Estep said finding those investors is often a harder sell than tapping into a debt fund. That’s because preferred equity investors are toward the back of the line in terms of who gets repaid in the event of a sale or liquidation.

“[Preferred equity] is going to be after bank debt, which is first in line, and if the property already has existing debt funds or bridge loans on their books, they’re going to be [third] in line,” she said. 

Tides Equities, a multifamily syndicator that snapped up $6.5B worth of Sun Belt apartment properties in 2021 and 2022, is reportedly on the hunt for preferred equity investments to shore up 30 of its properties, The Real Deal said in February. 

This isn’t the first time Tides has looked for alternative ways to recapitalize. Last summer, the group warned its limited partners that they would likely need to inject equity into its portfolio amid looming loan maturities that threatened dozens of properties. 

The capital call never materialized, as the Los Angeles-based firm was eventually able to extend certain loans and recapitalize others.

Other syndicators haven’t been as lucky. Nitya Capital was forced to sell off a number of its properties last year. And in March, debt tied to a 2,700-property portfolio landed in special servicing after the firm failed to pay off its $365M loan at maturity, according to TRD. 

For some groups, the crisis has spurred innovation. S2 Capital, a Dallas-based syndicator that bought $3B worth of apartments coming out of the pandemic, recently launched six open-ended vehicles ranging from REITs to allocator funds, according to Securities and Exchange Commission filings shared by CRE Analyst.

The group is likely attempting to protect its existing assets by creating perpetual sources of funding, CRE Analyst theorized. 

“Converting investors to an open-ended vehicle would provide S2 with a runway to secure relatively favorable financing,” CRE Analyst said in a LinkedIn Post. “If this is what happened, S2 just showed other syndicators how to survive until '25.”

S2 Capital declined Bisnow’s request for comment, but Estep said this may become more common among firms with the wherewithal and resources to shift their strategy.

“Those that are able to pivot are the ones that are going to survive and be successful,” she said.

BH3 launched its second debt fund last spring to help owners of distressed assets get their properties back to cash-flow positive. The fund has deployed loans across Chicago, New York and other major metro areas, and Lebensohn said BH3 is in talks with multifamily owners who need to recapitalize or reposition their portfolios.

“Even Class-A and well-built buildings in A locations are in some cases having issues simply because the credit market is tight and lots of conventional lenders are taking a pause,” Lebensohn said. “They are going to bridge lenders, funds like ours, looking for pref-equity positions or mezzanine loans because they are having trouble filling the gap.” 

Lebensohn is no stranger to downcycles. He and his partners, Greg Freedman and Eric Edidin, began acquiring nonperforming loans from banks during the GFC. In his view, private lenders are better positioned than banks from both a capital and mindset perspective to find solutions for properties in distress. 

“It happens to the best and brightest,” he said of owners whose properties become distressed. “What better situation to be in than when their lender can actually behave as a partner, as opposed to being obstinate and saying, ‘No, I have to fit within these four walls either because of regulations around me or because of how I’m structured.’”

Most investors agree that multifamily is a core asset with stable demand despite macroeconomic challenges, Estep said. But a calming of interest rates may not be enough to counteract the other headwinds that have wreaked havoc on the industry, Jhung said.

“Some of these multifamily assets in the secondary or tertiary markets that used to be hotbeds of activity are feeling rent pressure, and expenses are staying relatively high,” Jhung said. “I don't know if there's any remedy for that part.”

Whether alternative lenders are here for a good time or a long time is still to be determined.

Lebensohn is among those who believe the CRE capital stack forever changed after the bank failures of 2022. Others, like Estep, are less convinced.

“We are now seeing different strategies for putting deals together, and sometimes it makes sense to insert these types of vehicles,” she said. “But in a normal operating cycle, debt fund rates are not going to beat bank debt.”