Distressed Apartment Properties: A New Wave of Deals is On the Way


Brian D. Milovich

Managing Principal, Calvera Partners

Distress for apartment properties during the Great Financial Crisis (GFC) looked a lot different than they do today. During that period, I was working on acquiring distressed loans with the purpose of foreclosing and taking ownership of the underlying property. San Francisco, where I was based, was ground zero for this scenario. Some apartment owners were able to finance their acquisitions with 100% debt, or even more in some instances. With any drop in rents and a slowdown in the ability to improve the rent roll in a rent-controlled property, the over-leveraged owner had no way to remain current on their loan payments. Too much leverage is always the main cause of distress.

Today, distress originates from a number of causes. The pandemic caused once high-flying markets like the San Francisco Bay Area to suffer significant job losses and demographic flight to lower-cost markets, both causing a sharp decline in rents. In places like downtown Minneapolis, as few as 60% of downtown workers are back in the office. With considerable new apartment supply that came online during the past two years– and fewer reasons to live downtown– rental demand has been meager in downtown Minneapolis. In a handful of markets,the pandemic hangover is real.

While not over-leveraged, many apartment properties acquired in 2019 through 2021 were bought with floating rate agency (Fannie Mae or Freddie Mac) loans. These loans have a requirement for the borrower to purchase an interest rate cap. Back then, an interest rate cap for three years on an approximately $25 million loan would have cost $30,000. Earlier this year, that same cap would have cost around $1 million. That’s a problem because the non-institutional property owner either 1) doesn’t have an extra $1 million on hand, 2) doesn’t want to ask their investors for it, or 3) cannot refinance the property because the new loan amount is less than the original amount. Often, the best option is to sell.

In the previous example, though stressful for the owner, a good deal for everyone was more than likely executed. Properties purchased in 2020 or earlier have seen rent rolls increase 20-30% because of rampant inflation, particularly in Sun Belt markets. Higher net operating income served to offset any increases in cap rate (i.e., lower valuation) and we’ve seen those deals perform well. They were simply sold earlier than the owner might have liked. The real pain will be felt by groups who used bridge debt to purchase properties in 2021.

Bridge debt by non-bank lenders was something we discussed as a company but could never get comfortable with. Wells Fargo or JPMorgan Chase aren’t in the business of owning apartment buildings. They’re in the business of traditional lending and highly leveraged apartment deals aren’t their bailiwick. Debt funds are in the business of making highly leveraged loans because if they must foreclose and take the building back, they don’t mind as it’s all about the eventual investment return. The bigger issue we had was more basic; how can we rationally come up with a business plan that pays back the bridge lender after three years, the normal term of a bridge loan? In 2021, I consulted other lenders in the industry because I was befuddled. How can a group buy a building at a super low yield (~3.0%), lever it up with 80% debt, and then refinance it three years later after knowing that the Fed wanted to raise rates? Every financial model we put together showed that if everything went right in the business plan, those deals could not be refinanced with new debt at 4.5%. With loan rates now at 5.5%, that can mean only one thing: they will be sold when the owner can no longer hang on.

I don’t believe we will see much lender distress in the apartment market. Yes, there are numerous loans on the books with debt coverage ratios (net operating income divided by debt service) below 1.0x., but that doesn’t mean that the debt should or will be sold at a discount. I believe we will see numerous owners who have their equity positions either totally wiped out or are forced to sell for a miniscule profit. Rescue capital like preferred equity will buy time for these owners by financing the new interest rate cap or helping with a cash IN (not “out”) refinance. However, that owner is waiting for values to increase significantly to make their numbers work. We don’t think that will happen in the short term, and they don’t have the luxury of time. We are waiting for a wave of deals to hit the market where debt-stressed owners and their limited partners say enough is enough.


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