As a result of continued strong demand for multifamily acquisitions in the U.S., capitalization rates being paid by investors can easily be equal to or less than debt constants on multifamily agency loans. For example, if you are purchasing a property in a high demand market you might need to acquire the property at a capitalization rate at or below 5%. In today’s interest rate environment (June 2019), your debt constant for a market rate non-green certified property could easily exceed the purchase capitalization rate by 1% (5.75% to 6.00%). If interest rates increase as the loan application is being processed, each basis point increase in the loan interest rate can decrease loan proceeds. This situation is particularly frustrating if an investor is purchasing a property. Prior to rate locking a loan, an increase in the loan interest rate will necessitate a larger equity raise. Consequently, investors desire to lock their interest rates as soon as possible.
If a transaction involves a refinance of a stabilized property, once a Fannie Mae or Freddie Mac loan is under application, the borrower can lock both the interest rate spread and Treasury index by posting the loan application fee and a 2% rate lock deposit, which is refunded at or shortly after the loan closes. However, if a property is stabilizing and the borrower is refinancing a construction loan, it might make sense to wait to lock the interest rate until such time as the lender has completed their loan underwriting, or utilize one of the agency lease up financing programs.
An occurrence that can be particularly problematic is a purchase transaction whereby the property gross rents or collected rental income decline within 30 to 45 days of closing, and the loan is debt coverage constrained. Within this timeframe, buyers may have signed off on their due diligence of the property, received a loan commitment and locked an interest rate (and therefore waived off on a financing contingency). To protect yourself in this type of situation, ask the seller to agree to a property performance clause that preserves the debt amount once you have locked the interest rate. If rents or income decline in the period between rate locking and closing, and the debt coverage constrained loan decreases, the seller might agree to take back a small unsecured note, instead of the buyer having to scramble for additional equity proceeds prior to closing to rectify a situation that is out of their control. Also for a purchase transaction, be cautious of any immediate or future real estate tax increases that might impact a lender’s final loan underwriting, but was not reflected in the property’s offering memorandum or historical operating statements.
Before executing a loan application, ask the lender to detail property performance or economic events that could alter loan proceeds up to closing, and then work with the seller and lender to mitigate potential negative events which can, at times, drastically increase the cash equity required at closing.