Rent Regulation Is About to Shake Up Alternative Lending
Alternative lenders operating in New York City may be particularly vulnerable to the fallout from the recently passed Housing Stability and Tenant Protection Act of 2019. Because of increased competition over the last few years, lending standards have loosened in the alternative lending space. This has left some alternative loan borrowers in serious risk of default. The shakeout may force a significant shift in the lending marketplace.
For the past several years, increasing numbers of companies have entered the alternative lending space. The thesis was straightforward: With yields for equity investors compressing and building valuations setting investment bases significantly above historical averages, an investor could guarantee him or herself a moderate yield with little perceived downside risk by taking a debt position in the same assets.
The main downside to this thesis appeared to be that many individuals arrived at it simultaneously. The result was a boon to borrowers, but a dangerous milieu for note holders. Competition created incentives for more aggressive sizing and pricing. Average yields on bridge loans dropped precipitously from a standard 10 to 12 percent to between 7 and 9 percent. Simultaneously, newcomers to the space found themselves pushed ever-higher on the capital stack until transactions began to close north of 70, 80 and even 90 percent loan-to-value.
Further endangering the security of these loans was the fact that many of them were made on transitional assets. Transitional assets are often financed with alternative lenders because their lack of in-place cash flow prevents most banks from lending on them. The result is that the alternative lending corner of the market has a near monopoly on loans which were underwritten to projected rents based on destabilization of apartments. While these loans looked fairly safe, especially if the units to be deregulated were already vacant, they were subject to a regulatory risk which, in hindsight, was widely under-appreciated.
While market participants knew that the rent stabilization law—which governs rent-regulated housing in New York City—was up for renewal in June of 2019, very few anticipated the sea change that the revised regulation would bring about in the industry. The primary effect of the new legislation is to make it nearly impossible to deregulate a regulated apartment, or to even significantly raise the maximum legal rent for the unit within the regulation regime. Vacant rent-regulated apartments are now no longer convertible to free market apartments.
The result of this legislation is a significant impairment in value for stabilized apartments, with no clear path to recuperating that lost value. The most straightforward math is that if, as widely believed although yet to be confirmed by a significant number of transactions, values of certain stabilized apartments have declined 10 to 30 percent, then loans which were made at 70 to 90 percent of value or greater may now be underwater. Any alternative lender with a significant exposure to the New York City market with high-leverage loans is now facing a wave of potential defaults, or at the least workouts, as owners begin to recognize that their equity position has just been erased.
The alternative lending landscape is likely to change significantly in the coming months. Investors who thought they had found a safer, alternative path to investing in New York City real estate will likely now strongly reconsider the proposition. While some have already pivoted to commercial assets and a wider geographic dispersion, others will be significantly harmed by the recent regulatory shift. Additionally, the changing equity landscape is likely to thin the herd even further as yields on equity positions rise and converge with the compressed yields on legacy debt assets. Although one would expect alternative debt pricing to rise concomitantly, it wouldn’t be surprising to see many newcomers to the marketplace soured on the notion of debt as offering an excellent risk-adjusted return.
Because alternative lenders play a vital role in credit access for transitional assets, the marketplace will certainly suffer if the exodus is too great. A significant jump in bridge lending rates will further depress the value of assets which have already been impaired by the new legislation. With that being said, the need for bridge loans may also drop significantly as the landscape for value-add real estate projects is significantly altered by the new legislation. The only conclusion which can be reached for certain is that the alternative lending marketplace is on course for disruption and change in the latter half of this year.
Andrew Dansker is a first vice president of finance at Marcus & Millichap (MMI).