May 12, 2023

By: Evan Polaski, Investor Relations Managing Director

Evan Polaski:  

Hi, I’m Evan Polaski with Ashcroft Capital. Today for our acquisition update, revisiting quarter one and our outlook for quarter two and beyond, I’ve got Scott Lebenhart, Ashcroft Capital’s chief investment officer. Hi, Scott.  

Scott Lebenhart:  

Hey, how’s it going? I’m sure you all know me by now, Scott Lebenhart. I’m the CIO here at Ashcroft. I joined up with Ashcroft in 2018, and it’s been a fantastic ride. I love working here. We’ve bought a lot and done a lot of great things. I’m excited to share with you guys what I’m seeing out in the markets right now.  

Evan Polaski:  

I appreciate it. As we’re recounting, this is our fourth or fifth quarter now doing our interviews. I’m looking forward to continuing these. You can find his full bio on our website if anybody’s looking for a little more detail on Scott’s background. 

Looking back at Q1, it was a pretty disruptive quarter on a macro level, not for Ashcroft, but globally. Why don’t you give us a high level of what we’re seeing and what steps we took to try to get through that quarter.  

Scott Lebenhart:  

On the acquisitions–transaction side, deal flow was extremely slow to start the new year. Every January, toward the end of January is multifamily’s largest conference, called NMHC (National Multifamily Housing Council), which was held in Vegas this year. 

The timing couldn’t have been more perfect to put thought leaders in the same room—buyers, sellers, lenders, brokers, and everyone else. We had a big conversation about the current market, and it was almost like a therapy session. What are you feeling? What are you going through right now? What are you seeing with your portfolio? What are your hopes, visions, and plans for 2023?  

I think that helped calm some of those in attendance. To understand, “Hey, there’s a lot of money out there. There’s a lot of equity that is looking to invest in multifamily.” Whether it be domestic money, but also a ton of international money looking to invest in multifamily in the United States, everyone feels strongly about the fundamentals of multifamily. We’re dealing with capital market challenges right now.  

The overall concerns that everyone shared with each other were about the capital markets and interest rates: “What are interest rates going to do? If and when there is a recession, what’s the impact; how long is that going to be?” Those were the main themes of the conversation.  

From the lender side, lenders are as eager as the equity groups are to put money to work and have loans in multifamily. Because again, it performs very well, it stays occupied, and it cash flows as opposed to [sic]. If you lose a tenant, you can’t necessarily find someone else to move in the next day. It doesn’t work like that—same with retail and industrial. Therefore, lenders are still eager to put money out there; it’s tough to buy deals right now.  

Refinancing on the lender’s side is extremely difficult as well because of high interest rates. If you’re looking to refinance now, you’re likely going to be refinancing with a higher interest rate than the loan you currently have. As a result, people are waiting.  

A good theme that we got from that conference was that lenders are working on getting creative and coming up with new debt products. To meet this higher interest rate environment, they’re offering fixed-rate loans with the ability to buy down the interest rates, providing flexibility to get out of those fixed-rate loans at a certain time. Where we used to love floating-rate loans because they are super flexible, now lenders are starting to figure out how to be flexible with their fixed-rate product as well.  

After NMHC, having those conversations helped calm concerns that industry leaders had, and more deals came to the market for sale. These are typically more core-plus in profile deals, most of them built after 2000, and even the majority of deals we saw were probably 2015 and newer. Loan assumption deals became very popular in Q1, where the existing loan was able to be assumed by the next buyer.  

This got a lot of interest because it takes the volatility of the debt market out of the equation.  

Overall in Q1, some of these deals will actually trade and sell. Some of them didn’t hit their projected pricing and were pulled from the market. And there are a handful of deals put under contract and getting awarded, but they’re not closing, which is rare for the past 24 to 36 months. Ultimately the buyer is dropping out because of interest rate volatility, the capital markets change slightly, or the inability to find equity.  

So overall, Q1 was a quarter that was filled with continued uncertainty, but there is some optimism as data points start to come out on where deals are ultimately priced. I know we’ll get into Q2 later, but we do see things opening more from here.  

Evan Polaski:  

I appreciate that. I was reading yesterday a Wall Street Journal article stating that commercial multifamily transactions were down 74% in Q1 relative to Q1 2022. So obviously everybody is seeing it. I’m sure there are a lot of the same impacts affecting the single-family home market. People who have long-term fixed-rate loans don’t want to sell. Why (assuming that there’s no other distress in the property or other issues coming up)?  

I’m talking with investors and saying, “Yeah, we would love to see that great core-plus with value-add upside type potential in a loan assumption, but unfortunately so does everybody else.” Every other buyer wants that; you’re not getting any type of discount in today’s market because of that financing. 

Jumping kind of from the macro level to Ashcroft specifically, we didn’t close on any deals in Q1. How many deals were we realistically underwriting? How many offers did we have out there throughout Q1?  

Scott Lebenhart:  

We’ve looked at probably a hundred deals or so in Q1, which is a good amount. It’s not a light amount; it’s not the highest quarter we’ve had looking at deals, but a lot of those deals have not traded or won’t trade. 

Realistically, about a third of the deals that we looked at went through the full process and were awarded to somebody, whether or not they actually closed. We looked at a lot of deals, and the common theme that we saw was a large bid–ask spread, where the sellers think the property is worth X. And we’re coming back and saying, “That’s great that you think it’s worth that, but it’s worth Y.” Then the seller ultimately says, “Well, I’m not a seller at that price; I’m going to hold it.” We’ve had a lot of conversations, and a lot of those hundred deals were deals where we had these types of conversations. People were testing the water to determine, “What does the market think it’s worth? What do I need to do to get the price that I want on it?” 

That led to the limited number of transactions out there. Property holders do want to sell their deals, and they don’t want to sell them at prices that don’t make sense. But of a hundred or so deals that we looked at and had conversations about, we submit LOIs on 10. As you mentioned, we did not get awarded any. Although we’re upset, we’re here to transact; that’s what we like to do. We’re comfortable with this result because we submitted prices that made sense for us.  

Ultimately, the deals that we didn’t win, that we heavily pursued, we got outbid. Whether or not that was relationship-wise or pure pricing-wise, we did see that there were some more aggressive sources of equity out there in Q1. 

We saw 1,031 buyers being extremely aggressive. Because, again, for them there’s not a lot of deals right now, and they need to put their money to work within a certain time. Therefore, they got aggressive in Q1. We also saw certain buyers coming up near the end of their funds, and it’s either use-it-or-lose-it money. You either spend the money and invest it, or you’ve got to give it back to your investors. We saw some groups that had a time clock on their equity. 

Conversely, a lot of buyers were more private family-office-type buyers that were buying deals purely for cash-on-cash returns, not looking at IRR, and planning on holding the deals 10 plus years or more. When you’re dealing with someone who’s pricing a deal that way, where we are both cash-on-cash-return focused and IRR focused, it’s tough to get to that same price point that someone who’s purely cashflow-focused is concerned with.  

Evan Polaski:  

That’s good to hear. And it’s always particularly good to hear deal results from your perspective, as the acquisition guy and the acquisition group, as to why we were not able to acquire anything. One thing I appreciate about Ashcroft and the broader view that Frank and Joe have set out, which is obviously coming through within the organization, is that it is better to do no deals than bad deals. And if it works out, it works out. 

As an investor myself, that is definitely something that is good to hear. There’s almost value in knowing that we’re not buying anything. 

Let’s jump into Q2 and what we’re starting to see coming forward. Some of these questions obviously go Q2 and beyond, but what are you starting to see? You had mentioned lenders getting into some creative structures. Why don’t you dive into a little more detail on that?  

Scott Lebenhart:  

We are continuing to talk to our relationship lenders, as well as new potential relationship lenders and our peers, asking, “Hey, what are you doing with this type of loan? What are you doing with that on that deal? How did you finance that?” 

Right now, the real issue with lenders and the entire capital market perspective is that interest rates are so high, meaning debt service coverage ratios on deals are low, debt yields are low, and there is uncertainty on where devaluation is going to end up for these properties. This is leading to lenders lending at less proceeds, meaning lower LTVs. Typically, right now, it’s more in the 55 to 65% loan-to-value range. Where we weren’t taking it up to 80% LTV two years ago or so, you could have gotten loans in the 75, 80% range back then. 

That’s pulled back, which is creating issues for people who need to refinance or people who want to buy but don’t necessarily have that larger equity piece that you need, call it 35%, 35 to 45% of the capital stack with equity as opposed to 20, 25% of equities.  

One of the unattractive parts about a fixed-rate loan is the lack of flexibility to sell out of it early. Typically, there are larger prepays on that and the fees, costs, and yield maintenance to unwind the securities that are backing that loan. Because it’s more debt-fund focused, we’re seeing more balance-sheet lenders. This means that these lenders are using their own money, lending it out, and waiting for it to come back, as opposed to lending it out and then selling off that loan to a different holder, where they’re buying that loan for the cash flow expected of it. That is where the issue is being created. A lot of these groups that have debt funds are lending their own money, which means that they can do what they want because it’s their own money.  

We’ve also spoken with certain lender relationships on the insurance side that have preferred equity groups within their shops. They give you a typical bank loan up to 60% or so, and then they go from 60% to maybe 70, 75% with their preferred equity product. But to the borrower, it looks like one loan of up to 70% or so. It’s just the higher interest rate, but you’re able to get proceeds that way. 

Again, we’re continuing to see the lenders try to react to the environment that we’re in today. All this happened very quickly. People didn’t have money raised to accommodate the summer of last year when interest rates started to hike. Now they’re taking a step back. They’re able to go to their investors and their investment committees and say, “Hey, this is what we need to do to fill the gap in the hole.”  

There are still a lot of products that are not out yet that are launching in Q2 or Q3 based on the timing of setting up the fund documents, etc. I am optimistic that there are better solutions on the horizon for us on the lending side.  

Evan Polaski:  

From that standpoint, it sounds a bit like the lenders are running the show and causing some pause in the acquisition market. Clearly, if people could still borrow at 2%, a lot more deals would be transacted at the prices that sellers still want.  

Is that accurate? I know this is a bit of a crystal ball comment, but what are you seeing start to thaw that market to get more transactions so that those bid prices can start coming down?  

Scott Lebenhart:  

I hate to say that one person controls the fate of our industry. But in reality, until Jerome Powell and the Feds start to signal an end to the interest rate hikes, that is going to start the thawing process. We’ve started to see that with his March statements talking about the peak interest rates. Since then, we’ve seen treasuries come down significantly. The yield curve flattened and has started to decrease a lot sooner than originally anticipated.  

If he starts to signal that, I think that will be more promising. If he signals when rates may start to decrease and what rates may look like in 2024, that’s going to help even more. Ultimately, once people can start to get a better understanding of what their cost of capital is going to be, people are going to be excited and willing to be more aggressive on deals.  

Evan Polaski:  

To overly simplify modeling a multifamily deal, it is a simple math equation. As you noted, if you don’t know what you’re subtracting, what the number that you’re taking out of the bigger number is, you don’t know whether that’s going to be a positive or negative spread. I completely understand where you’re coming from there.  

Using that, and particularly with the forward curve end of Q4, going into early Q1, there was a lot of talk about the wave of distressed loans that are coming due in the second half of this year, particularly people who took out bridge loans that maybe got aggressive on assumptions on the front end and bought in 2020, 2021, 2022 on short-term types of loans. Are we still seeing that? Is there still an expectation that there is going to be some of that coming later this year?  

Scott Lebenhart:  

Yes, I believe that truly distressed deals will be here by the end of next year. Like you said, the floating rate environment started post-COVID in early 2021. That’s when all the debt funds came back to the table and got aggressive with their floating-rate product. Those are the loans that are starting to come up for their two-year anniversary, where people need to buy rate caps. 

You start getting tested at that level. Certain deals were only two years, with one-year extensions. We typically did three-year initial terms with two one-year extensions. So thankfully, we’re not running into that issue. 

I personally don’t think the distress in the market is going to be as robust as other people do. The distressed sellers on deals are going to be those owners of properties that have been poorly operated and poorly capitalized and basically have their lender forcing them to repay that loan. 

At that point, they’ll have two options. They could either sell at perhaps a loss, which would create that distressed environment, or refinance into a new loan, which, as we talked about, is very difficult in this environment. If you didn’t complete your business plan and grow NOI substantially, you’re likely not going to be able to refinance out your proceeds. As a result, you’re taking a loan for less than what your original loan balance was, meaning you must come up with equity or some type of preferred equity to come into the deal. That is not always the best solution for a deal. This has been an extremely heavy focus of Ashcroft and NARS (National Association of Realtors). When we’re not buying deals, this is what we’re working on. We’re in constant communication with our lenders, working to ensure that we’ll have no pressure to sell or refinance. 

Ultimately, based on conversations, I don’t think lenders want to foreclose on properties in mass quantities. They don’t want to become landlords. They don’t want to have what happened in 2008 and 2009, forcing them to figure out what to do with all the properties that they’re now owners of. Therefore, they’re willing to work with the borrowers with whom they have relationships and are executing business plans properly. 

I do think between working with known borrowers and the creativity that we’re starting to see in the loan space, some potential distress will be alleviated that we were originally expecting and kick the can down the road so to speak. This will also give owners and borrowers time to let the capital markets settle and then work through the payoff of the loan. They will wait for the capital markets to improve to sell the property or refinance. I think that the distressed deals are going to be more truly distressed deals that you’re buying from poor operators that haven’t executed the business plan.  

Evan Polaski:  

Taking all that you’ve shared with us and diving into Ashcroft, how are we evolving our discussion last quarter to take a more calculated approach, setting ourselves up to take advantage of the opportunities that will arise and will continue to come to market?  

Scott Lebenhart:  

We’re being extremely selective on the properties that we’re pursuing. To the point I mentioned before, we are focusing on the more core-plus profile deals that are coming out. Those are what we’re looking at. In times of uncertainty, you look at the markets. People flood toward gold, commodities, and other safe plays. Those core-plus type deals are more of those “safe plays.” 

High-quality deals, extremely strong locations, and good demographics are all things that we’re focused on. Given the lending environment that we talked about, we’re looking at deals with big straight loans. We’re trying to work within the flexibility of them, but we’re buying these deals with the mentality of, “Hey, we are going to hold it for at least five years or so.”  

In terms of the calculated approach, on the distressed side, we are taking a very targeted approach and doing a ton of research to find deals in submarkets that we like. As you suggested, we think that more of this distress will be on the outskirts and the B-locations. We’re trying to find that diamond in the rough, where there may be a distressed deal coming up with an ideal product type in an area that we like.  

We’re targeting and researching properties that were purchased in the last two to three years, looking at who the owners are and what their type of capitalization may be. We want to be in position on those deals when it is time for a seller to say, “All right, now I’m a market seller; I’ll take my loss, and I’m ready to go.” We are hoping to be that first call.  

Evan Polaski:  

At Ashcroft, as things have slowed down, our leasing agents are upping that salesmanship, where they didn’t necessarily have time to do so the last two years because tenants were flooding in, and they were getting five qualified tenants for every vacancy. 

Now we need to find these tenants. We need to follow up and make sure we’re getting them into units—to that end, on the IR side, being continually in front of our investors and making sure that we’re having those conversations. I appreciate all of this input. Any final comments that you might have that you’d like to share?  

Scott Lebenhart:  

I hope that in the next call, we’ll be talking about a deal that we actually got under contract. As an acquisition person, a deal junkie, it’s frustrating to not have any deals. But to your point, we are remaining hyper-focused on great deals and staying firm on our prices. We’re not looking to make a bad investment on the front end. We’re looking to find a safe investment in a market that we feel strongly about, with a business plan that we feel confident in—also building in, as we’ve always done, a conservative underwriting.  

At the end of the day, our expectation is to under-promise and overachieve. We want to make sure that we stay true to that. It’s frustrating, but we know that in the long run we’ll be just fine. 

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