Crunch Time: The Working Capital Puzzle in the Challenging Commercial Real Estate Market

Working capital can be thought of as the reserves you raise up front on a deal acquisition.

I recommend this number being equal to 6 months of your expenses in addition to what the lender requires for their replacement reserves.

After the money printing during Covid, there was a massive increase in rents. In many markets, this increase was close to 20% annualized rent increase. Because of this, it was almost impossible to predict where rents were going with historical natural increases of around 3%.

What was the result? Prices of assets were being sold much higher than the value of the current operations to account for this upside potential.

The Fannie Mae and Freddie Mac agencies make their lending decisions based off of current operations, not pro forma numbers. If you wanted to buy a deal during those couple years, almost all loans were made on floating rate, short term bridge debt. Agencies were barely lending money.

So where's the working capital problem?

Interest rates now have risen at a pace of one of the fastest in history. If you bought a rate cap on your bridge loan, it almost certainly got capped out. If you bought an extension, one year is often priced at $1M+. Before the rate increases, I remember seeing rate cap extensions priced at $35,000 to $50,000.

Debt service payments and rate cap extensions became much more than anticipated. What we're seeing now with deals that are in trouble is that this unexpected cost had to be paid out of the working capital budget until it ran out and then into renovation budget.

Deals in trouble are the ones who now have no working capital reserves left, couldn't complete their renovation project to improve NOI, are now underwater because values have dropped around 20% in the past year, and have their floating bridge debt expiring very soon.