It is Memorial Day weekend. It is important that we remember those who have fought so hard to defend our country.
The stock market has been doing well despite “higher for longer” interest rates. It feels like the current pricing of stocks is already based on future rate cuts and projected very healthy earnings growth. As a result, the stock market looks fully valued or probably even overvalued. Let me not stop at stocks: junk bond prices are up, and yield spreads over US treasuries are heavily down. Investors are perceiving lower risk in these assets and are willing to pay higher prices. Gold, Silver, Crypto—everything is up too. It is the Everything Rally. How wonderful!
But this is where we enter the “danger zone.” Complacency is high, momentum investing is high, and risk perception is low. Many investment portfolios are becoming overweight with these appreciated valuations. Now is the time for investors to return to the principles of prudent diversification and also look at what is “cheap now” or what’s trading at a steep discount.
Compare and contrast stocks and other assets that have rallied heavily recently to the relative value of the Commercial Real Estate (CRE) sector, which has seen asset valuations soften quite a bit since the FED moved the rates to a highly restrictive level. The current “higher for longer” interest rate policy has forced valuation corrections down by about 20% on average from the peak of 2022 in the multifamily real estate sector in the USA. Some regions and assets are down 25-30%, while other areas are only down 10-15%. All real estate is local, of course.
From a value investing perspective, Commercial RE, especially multifamily, feels like it is trading at a big discount to construction/reconstruction costs. Some markets have seen an oversupply of new multifamily assets, while other markets are still significantly short on housing units, especially affordable housing. On average, it is one of the most attractive asset classes today, given its steady, predictable cash flows and significantly discounted valuations driven by the FED’s aggressive interest rate hikes.
The Commercial Real Estate market heavily depends on the cost and availability of financing. Currently, bank financing is incredibly tight. Banks want to lend money only at 55-65% Loan-to-Value (LTV). Banks used to loan at 75-80% at the peak of the market, but now the pendulum has swung the other way, and credit is super tight. This makes it difficult for buyers of Commercial RE assets to close purchase transactions as they have to bring more equity to the deal.
Raising common equity dollars has gotten much harder in this environment, as many existing investors want to get their previously invested capital out and are hesitant to write fresh checks until they see the outcome of past investments. As a consequence, many new acquisitions are considering injecting “Preferred Equity” as a gap between bank debt and common equity capital. Alternatively, some projects resort to bringing in “Mezz Debt” or “Bridge Debt” to help them close on new purchase transactions and work to back-fill raising common equity capital over time. We will cover both of these opportunities later in this article.
Furthermore, there are many existing projects, especially value-add deals, that require additional capital due to the much higher interest rates and other factors such as higher insurance costs and the overall cost inflation of the last few years. A wide majority of the “value-add” projects borrowed using variable rate loans when interest rates were low. Now, many of these projects are experiencing tremendous pressure from a liquidity perspective and require additional capital infusion to survive and ultimately thrive.
Additionally, there are many properties that originally borrowed with fixed low rate loans that are facing loan maturity and interest rate resets in 2024 and beyond. In residential Real Estate, 15-30 year fixed interest rate loans are very common. However, in commercial RE, the majority of loans have a fixed rate only for five years and must either refinance or have their interest rate reset to the current market rates at the expiration of the fixed-rate period.
Today, there are many conversations in the industry about the “maturities cliff,” reflecting the fact that many commercial RE loans are resetting to much higher interest rates or simply maturing. Owners of these properties face problems similar to value-add projects: they too need further capital injected into these projects to meet bank requirements for loan extensions or refinancing.
This state of the commercial RE market is creating a tremendous opportunity to inject “Mezz Financing” cash into new and existing assets that have fundamental potential but are short on cash. “Mezz Financing” can come in the form of Mezz Debt or Mezz Equity (Preferred Equity is another name for it). Properly underwritten projects provide investors in Mezz Financing with “equity-like returns without equity-like risk”!
This sounds great, but what does this really mean?
Let me offer an example of a real deal called Riverbend Apartments in Indianapolis that we financed from Tempo Advantage Fund LLC, the premier fund of Mezz Financing. The property was bought right after COVID in June 2020 at a steep discount. It has been heavily renovated and is rapidly moving toward 90%+ occupancy, looking to achieve full stabilization soon.
It has seen strong rent growth in a great steady-eddy market. However, the property is not yet ready for sale, and it needed a $7M Mezz Debt loan behind $117M of senior bank capital. We looked at the asset’s current “as-is” value and determined that it is worth $180M today, but we discounted that in our underwriting to $165M. If you do the math, $7M of our money behind $117M capital senior to us puts us at a $124M break-even price. But the property can sell for $165M today. That’s over $40M of equity behind us. The LTV (124M / 165M) = 75%. And if we use the appraised $180M, the LTV looks like 124M / 180M = 69%. There is a very significant margin of safety securing our $7M investment.
Now, let’s look at the rewards of making this $7M loan. The loan carries a 20% annual interest rate with 11% current pay and 9% deferred. We are charging the borrower 2 points and getting a small equity upside in the deal. The borrower is providing us with 1.5 years of interest reserves at an 11% annual rate. He is also providing a personal guarantee. Overall, the loan has most certainly “equity-like returns without the equity-like risks”: We are generating returns that are typically reserved for equity investors, but taking much lower levels of risk than equity investors.
We are focused on providing Mezz Loans / Bridge Debt from Tempo Advantage Fund LLC. Other players in our space are offering Preferred Equity. The big difference between the two strategies is that we like debt with fixed maturity dates, certainty of defined high interest rates, and friendliness to self-directed IRA investors (interest income is the perfect type of income for self-directed IRAs).
The Preferred Equity strategy can be a bit more friendly to working with 1st lien lenders (banks) that may not allow subordinate debt. In any case, both strategies solve for the same need: liquidity shortage, critically needed on new and existing projects that can offer investors high returns that are typically reserved for common equity investors, but without the risk of being in the common equity position on the capital stack.
The key point here is that I don’t know if the stock market will continue its happy march forward, and I have no clue when and if Bitcoin will hit $100,000 or gold will reach $3,000. But on a relative basis, these asset values appear to be high, while Commercial RE, especially multifamily housing, pricing is trading at a significant discount.
Prudent diversification theory says that portfolios should be rebalanced, and now may be the right time to consider doing that. Furthermore, I am not advocating writing common equity checks into Commercial RE deals today. Instead, I believe there is a tremendous opportunity to generate great risk-adjusted returns by investing in multifamily projects and other commercial RE strategies via Mezz Financing, taking on a lower level of risk than common equity while targeting returns that used to be reserved only for common equity in the past.
Another really important point to consider is the forward path of interest rates and how it might impact Commercial RE. The FED is maintaining its “higher for longer” interest rates and has openly acknowledged that the current interest rates are very restrictive, but the inflation is sticky too. So, their plans to start cutting rates are getting delayed into the later part of 2024 and into 2025.
Eventually, the rates are likely to come down with inflation, and that will be a massive tailwind to many Commercial RE projects. It will be welcome news for the stock market and other asset classes too, but Real Estate trades on leverage, and leverage is low and credit is ultra-tight today. Once rates start coming down and credit loosens, prices of commercial RE could take off.
In conclusion, there is a generational opportunity now to invest in commercial RE, especially the multifamily asset class, but do it via Mezz Financing (Mezz Debt or Preferred Equity), taking on a lower level of risk than common equity while targeting outsized returns for this level of risk.
