Short Sellers See Distress Emerging in Apartments as Borrowing Costs Surge

(Bloomberg) — Soaring rents and cheap funding made blocks of US rental apartments seem like a “can’t miss” investment during the pandemic. Developers piled in to take advantage by constructing millions of the multifamily units, while investors snapped up older complexes to renovate them.

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Since then, borrowing costs have surged, and now there are emerging signs that some borrowers will struggle to refinance, Fitch Ratings said on Thursday. Rents are stabilizing, landlords’ expenses have risen and competition has grown, which will cause the delinquency rate for the assets to double this year to 1.3%, exceeding the pandemic peak, according to the ratings company.

The warnings come as more than $1 trillion of multifamily debt is due to mature through 2028, according to data compiled by Trepp, potentially leading to increased defaults and losses for banks and bondholders. While the problems are not seen as systemic, short sellers are moving in to try to profit from the emerging distress.

“I expect a great deal of pain in multifamily as we adjust to a higher interest rate environment along with a lot more supply hitting the market in 2024,” said Daniel McNamara, founder of hedge fund Polpo Capital, which is betting against commercial mortgage bonds.

McNamara’s short positions are focused on offices, which have been battered by the work-from-home trend, but the derivatives he uses for those bets sometimes have some exposure to apartment rentals.

Viceroy Research, meanwhile, said in November that it was shorting Arbor Realty Trust Inc., a lender to US apartment landlords, arguing that the lender is burdened with distressed loans that were bundled into commercial real estate collateralized loan obligations. Arbor declined to comment.

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Multifamily assets valued at more than $67 billion are potentially distressed, the most of any property asset class, according to data compiled by MSCI Real Assets.

“There were a few unprofessional people getting over their skis,” said Jim Costello, chief economist at the data provider, regarding borrowers. While stories about the problems those debtors run into will dominate headlines this year, current price declines are bringing values back to pre-pandemic trend levels, he said.

Some companies are looking to reduce their exposure to the sector. Lennar Corp. is considering selling more than 11,000 apartments operated by a subsidiary, Bloomberg reported in December. Later that month, the homebuilder’s Chief Financial Officer Diane Bessette warned that its multifamily business is expected to lose about $25 million in the first quarter, more than double the loss in the previous three months. Lennar didn’t immediately reply to a request for comment.

The Federal Reserve Bank of Atlanta cited high-end complexes as an area of distress in a November report, while its San Francisco counterpart found landlords were battling lower occupancy in some downtown high-rises. Some projects in the St. Louis Fed’s zone have already been canceled or delayed because of higher interest rates.

Boise, Idaho, Phoenix and Austin are also among the markets seeing some signs of softening, said Alan Todd, a commercial mortgage-backed securities strategist at Bank of America Corp.

Distress will be isolated to a handful of markets that grew most quickly in recent years, Todd said. Some borrowers will have to inject more equity to help pay off their old loan because of higher rates and lower cash flow growth.

There are going to be pockets of stress in multifamily, said Chris Hentemann, chief investment officer and founder at 400 Capital Management, emphasizing that he doesn’t see the issues as systemic.

“Anything that is hitting a maturity event or has a variable form of financing is going to be under some stress, especially if they cannot keep raising rents precipitously in line with the cost of debt.”

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Week in Review

  • A sobering start to 2024 has wiped out hundreds of billions of dollars of value for credit markets caught in one of the worst cross-assets selloffs to greet a new year in decades.

  • Chinese shadow banking giant Zhongzhi Enterprise Group Co. filed for bankruptcy, cementing the rapid downfall of a firm that oversaw more than $140 billion at its peak before succumbing to the property crisis that has wreaked havoc on the world’s second-largest economy.

  • Bonds backed by consumer debt like car loans are close to their cheapest since the financial crisis by one measure, and investors like T. Rowe Price and Neuberger Berman say it makes sense to buy the securities as financial and political risks mount.

  • Private equity firms, eager to sell debt-laden businesses, are finding private credit firms increasingly willing to keep outstanding loans intact, even for companies that may soon have new owners.

  • Goldman Sachs Group Inc.’s asset management arm turned to a group of direct lenders for a $500 million debt package used to finance its purchase of DOXA Insurance Holdings.

  • JPMorgan Chase & Co. and Morgan Stanley expect US investment-grade bond returns to beat speculative-grade debt in 2024, for the first time in four years, as investors position for interest-rate cuts and slower economic growth.

  • Junk bond funds had their first outflows in nine weeks as 2024 arrived, according to Refinitiv Lipper, amid a $240 billion wipeout in global credit markets.

  • Humanigen Inc., a drug developer that raised money to treat severe Covid patients, filed for bankruptcy after its leading product was rejected by regulators.

On the Move

  • Lazard Inc. hired two managing directors, Jason New and Kevin Glodowski, for its restructuring practice as part of a plan to diversify offerings and boost the investment bank’s revenue.

  • ICG has appointed David Saitowitz to manage US investment strategies focused on syndicated loans and high yield bonds.

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