For the last decade, investors have enjoyed the benefits of ZIRP, or a zero-interest rate environment, where asset prices were one-directional. But like any good buzz, there is a price to be paid in the post-bender aftermath and we could be paying it for many years. Commercial real estate assets and all relevant stakeholders partied at the ZIRP; heck, it’s been a gluttonous feeding frenzy with properties acquired at yields well below the cost of capital (i.e., remember the days of cap rates under 3%). One well-established NYC broker earned the nickname “Joey 1 Cap” because of his uncanny ability to sell properties to willing investors at such low yields. And why not as, in those days (pre-2019), investors could often double or triple the rent roll in short order, turn a 1% cap into a 6% cap, and cash out all equity through refinancing. This was the way it worked until the music stopped and yesterday’s ZIRP heroes are tomorrow’s unfortunate losers. Buying a multi-family property at a 2% cap in 2018 with 3% financing gets a whole lot uglier five years later in a world of 6% cap rates and 7% interest rates. As the proverbial tide recedes, we are starting to see those that were swimming naked.
So what’s going on and why are increasing interest rates wreaking havoc on commercial real estate and why is the issue particularly acute in NYC? Perhaps a hypothetical Class B office building acquired in NYC in 2015 best illustrates the point and let’s assume for the sake of the example that interest rates were zero at the time. The office has a net operating income of $1 million and, because any intelligent office investor demands a sensible yield, he acquires the property for $25 million, or a 4% capitalization rate. And because the real estate game is all about leverage, the investor cuts an equity check of only $5 million and borrows the remaining 80%, or $20 million. Things go well for a while as ownership increases the rent, and operates the asset more efficiently, and by December 2019, the net operating income increases to $1.3 million (and assuming the same 4% cap rate, the property is now worth $32.5 million). Of course, the prescient investor sells right at this moment and takes home a tidy profit for herself and her investors but, in this hypothetical as in real life, few are so prophetic to see the pending doom around the corner. The pandemic hits, New Yorkers flee their apartments and office space sits vacant, tenants walk away from their lease obligations, and those tenants that do stay, re-negotiate their rents lower. The mayhem subsides just a bit and it’s now 2023, the office building is 70% occupied, rents are reduced from their peak, the net operating income is a mere $800,000 and it’s time to refinance that $20 million loan. Uh oh, you see the problem? The value of the office has been decimated and not just because the net income dropped $200,000 but cap rate creep from 4% to 8% during the hold period has further eroded value. The bank determines the value is now around $10 million but you owe the lender $20 million. For those more visual, the charts below illustrate this discussion:
What does a borrower do whose asset is worth substantially less than what they paid and it’s time to refinance? Depending on what that shortfall is and whether ownership is willing to cough up additional equity to cover that gap, the bank may restructure the debt or agree with ownership to sell at a loss. Ownership may simply stop mortgage payments if a turnaround of the asset is unachievable and hand over the keys to the lender. In fact, RXR may be doing just that with two of its office buildings in NYC, Brookfield did so with two Los Angeles towers but surely these aren’t the only groups impacted…expect more headlines in the coming months. In NYC as with other major cities, the pandemic and work from home was the initial kick in the stomach for office landlords while the interest rate hike is likely to prove to be the knockout left hook to the face.
There will be a similar reckoning of multi-family property owners in NYC with a healthy mix of rent-stabilized tenants. Again, it isn’t just the elevated interest rates when owners go to finance that is problematic, the valuations for such properties declined from 35% to 40% in June 2019 when the laws involving rent-stabilized apartments changed in a draconian way. Prior to the change, these buildings were “value add” plays with juice in the rents or meat on the bones as investors back then referred to them because investors could—often through buyouts—convert rent-stabilized apartments with nominal rents into fully free market apartments within a year or so of acquiring them. To illustrate, take a 25-unit rent-stabilized building with a net operating income of $250,000 purchased in January 2019 for $6.7 million at a 3.75% cap rate. That same asset today (assuming that the net income hasn’t declined which is probably not the case as taxes and other expenses likely would have increased while the rent roll plateaued) likely underwrites at a 7% cap rate, or $3.6 million. With refinancing on the horizon, many of these owners face a similar challenge that the office owners do. They can only pray for a change in the rent laws, a dramatic fall of interest rates, or execute a steep capital call to inject additional equity into the asset to hold on to it. This author’s view is that the sharks are currently making their way to the Hudson River for the feeding frenzy on the horizon. Are you the shark or the prey?
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