The Lender Letter 05: RTL On The Rise and Multifamily Madness Has No Cure

RTL On The Rise Amidst Sad CRE Backdrop

Earlier this month, Rithm completed a $500mm rated securitization of RTL Loans, the second such rated securitization since Toorak completed the first rated RTL securitization earlier in Q1. RTL loans refer to “fix and flip” loans, typically of short <18 month duration which are utilized to acquire and improve a (typically SFR) property, often with high leverage levels 80%+.

Getting a rating from an agency means that the asset class opens up to a new class of institutional fixed-income investors via these securitized products. This kind of positive development indicates a maturing industry with continued investor appetite, despite decreased volume of overall activity in the market from post-pandemic peaks.

Once upon a time, the only way to get financing for these types of loans was through a bank warehouse line, similar to ones used by mortgage bankers to originate and sell traditional consumer mortgages. A space I worked in for several years.

This is interesting coming at a time where CRE debt is trading at the biggest discount since the GFC, there is wide concern for a lack of appetite for the US’s debt, and consumers are showing signs of economic stress. Seriously, most days the news cycle in RE finance is filled with stories about increasing commercial foreclosures, new multifamily rents decelerating, and multifamily transaction volumes dropping an additional 25% to start off the year.

Lastly, because RTL loans deal with the SFR space, 30-year mortgage rate spreads over the 10-year treasury remain ~50% higher than the 10-year average. This is a result of pricing dynamics, prepayment speeds, duration, etc but still an interesting comparison against a new asset class gaining rating status.

I’m not necessarily a doom and gloom person, although I feel that investors had gotten over-excited about rate cuts, and that the distressed CRE opportunity in multifamily isn’t going to occur in the way some had anticipated. I had thought the RTL news was a nice bit of green shoots to reflect on amidst the chaos.

Multifamily Madness Has No Cure

Naturally as a bridge lender, I spend a lot of time being asked to refinance other bridge loans. There are no shortage of unique scenarios people find themselves in. Aside from office, most of the chatter in the market about distress has been about the Multifamily sector. Transaction volumes exploded in 2022 as seen below. For Q1 2024, transaction volumes for Multifamily are down another ~50% from the 2019 pre-COVID benchmark.

Obviously, much of the concern has been over floating rate debt, which can itself quickly result in default due to the increased cost of servicing debt. We are now in the era of higher-for-longer-for-longer-er, where fixed and floating rate bridge AND permanent debt is coming due and cannot be refinanced at current interest costs. The result? The wall of maturities has now become the wave of modifications, with lenders across all types from private debt funds to CLOs, banks, CMBS, all facing the choice between forcing a sale, foreclosing based on maturity accelerations clauses, or extending the loan to buy time for the buyer to be in a situation to refinance.

The market response? A massive rise in formation of “opportunistic funds” which seek mid-teens to 20%+ returns on their invested capital, poised to enter as bailout capital for these troubled assets and sponsors. My issue? I don’t think these funds solve the most fundamental investor problem.

Real estate assets are facing an asset deflation crisis while simultaneously an operating leverage crisis. While the value of real estate has fallen, its ability to service debt has fallen similarly far. These numbers are anywhere from 25-40% roughly. The lower the initial cap rate, the worse the damage.

In order to pay off and refinance their maturing debt, a borrower can choose to extend the loan (if allowed, typically with the payment of some fee or the funding of a reserve account) or pay off the loan via cash-in refinance. If the sponsor is unable to come up with the cash to fulfill these options, they must raise additional capital in the form of subordinate debt or preferred equity. The problem? Returns.

There may well be enough paper equity in a deal for opportunistic capital to place funds in the capital stack with an equity cushion, however, where is the return to come from? On a stabilized asset, especially in a market with rent control, there is no way to achieve the cash flows to pay a 15-20% return to the investor when the asset already needs cash-in to obtain financing.

Even without rent control, rents are widely reported to be softening which puts pressure on any value-add business plan. At the end of the investment window, the asset will likely need to be sold in order for the investor to recognize their accrued return.

In my view, the only way these investments can be successful on a stabilized market-rate asset without requiring later sale is for one thing to happen: interest rates must fall. These investments will be essentially options that rates decrease enough to enable the property cash flows to pay back all the accrued capital, because cash flows are so constrained by debt. I wouldn't confidently bet on long-end rates falling substantially.

This analysis takes into no account situations specific to a sponsor which may enable them to pay back the investment with outside cash, or the situation where an asset is under-managed and can benefit from a new operating plan/capex.

But does it really make sense to invest in a business plan in a subordinate position rather than be a direct investor on a new asset? Maybe for those who look to be passive, but in that case, what is the net benefit to the sponsor to write a call option against their future equity? I’m not sure sponsors will be convinced of the net benefit of this financing arrangement instead of selling assets and walking away, even if that means a loss.