The multifamily real estate sector, once a darling of investors due to its resilience during economic downturns, is now facing mounting pressures that could lead to a prolonged period of distress. In August, special servicing rates for multifamily properties hit 5.71%, marking a nearly nine-year high, according to Trepp. Although still lower than the office sector's rate of 11.91%, this sharp increase signals deeper challenges ahead. Mark Silverman, partner at Locke Lord and head of their CMBS special servicing team, warns that this distress is only the beginning of what could be a tough three-year cycle.
The Roots of Multifamily Distress
Silverman points to several factors that have converged to create the current multifamily dilemma. The first is the aggressive lending cycle between 2013 and 2017, when low interest rates and favorable leverage made multifamily investments highly attractive. Many investors took advantage of non-recourse loans—loans in which the lender's recovery is limited to the collateral property and not the borrower's personal assets—which allowed them to borrow without personal liability. As Silverman noted, “Interest rates, leverage, and non-recourse made it hard to refuse in that pre-pandemic window.”
However, the situation started to shift dramatically with the onset of inflation and the Federal Reserve's response. To combat rising prices, the Fed initiated a series of interest rate hikes, pushing the cost of borrowing higher. For multifamily property owners, many of whom took on adjustable-rate debt, these higher rates compounded the financial strain just as other expenses—such as maintenance, insurance, and utilities—were also on the rise.
The result? A growing number of multifamily owners are now approaching loan maturities without the capital reserves necessary to service their debt or cover increased operating costs. As Silverman bluntly put it, "It’s a big airball if you don’t have the reserves or funds. How do you increase your money in if you can’t massively increase rents?”
Challenges Ahead: More Distress Before Relief
While many sectors of commercial real estate are experiencing distress, the multifamily sector is particularly complicated. One key difference is that multifamily properties are homes for tenants, making foreclosure and eviction processes fraught with legal, operational, and public relations challenges. As Silverman explained, “Multifamily can be a lot harder to solve. There are different rules and requirements for foreclosing on multifamily assets, and no one wants to kick tenants out of their homes.”
Unlike the office sector, where companies can vacate a building and losses can be absorbed, multifamily properties involve people's homes, complicating efforts to reset property values or reestablish rents. Moreover, multifamily operators face the delicate task of determining whether rents should be increased or decreased, or if they should shift their properties into government-subsidized programs to stabilize income.
Silverman believes that the current multifamily distress is just the beginning of a longer, three-year cycle. “I think it gets worse before it gets better,” he said. He foresees higher rates of special servicing, where loans are transferred to specialists for workout or foreclosure, as more borrowers default on their obligations.
The Importance of Early Communication
One of Silverman’s key recommendations for multifamily property owners facing distress is to avoid burying their heads in the sand. Many borrowers fail to communicate effectively with lenders when they run into financial trouble, often waiting until it's too late to explore creative solutions. “Once you get up to maturity or shortly before maturity, it may be too late to come up with creative solutions,” Silverman cautioned.
Instead, borrowers should begin reviewing their options several years before their loan matures. By doing so, they can work with lenders to explore refinancing options, restructuring, or other strategies to avoid default and the potential for foreclosure. However, refinancing is becoming increasingly difficult, with Silverman noting that “the ability to refinance something at maturity is looking particularly slim.”
Who Will Weather the Storm?
Silverman is optimistic that sophisticated multifamily owners—those with experience and resources—will be able to navigate the challenges ahead. These larger operators are more likely to have the capital reserves needed to address rising costs, as well as the expertise to work with lenders on restructuring their loans.
However, smaller property owners, particularly those with just one or two multifamily properties, may find it much harder to weather the storm. “I don’t see how you solve that problem if you’re a single owner of a single multifamily property and you don’t want to put in more capital, or may not have more capital,” Silverman said.
For these owners, non-recourse loans may offer a temporary reprieve, as they allow borrowers to walk away from the property without personal liability. However, Silverman warns that these loans often come with carve-outs, or exceptions, that lenders can use to pursue borrowers for additional payments. Violating loan provisions, such as comingling funds or failing to provide financial information, can trigger these carve-outs and leave borrowers exposed.
The Path Forward
As multifamily distress continues to rise, property owners, lenders, and investors will need to navigate a challenging landscape. Early communication, creative financing solutions, and a willingness to adapt to changing market conditions will be key to surviving the next few years of increased distress. For many, the road ahead will be tough, but by planning ahead and working closely with lenders, some multifamily owners may find ways to emerge from this cycle in a stronger position. Ultimately, the multifamily market may face its biggest test yet, and for many owners, the stakes have never been higher.
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