How DLP Capital is Navigating Interest Rate Challenges & Mitigating Risk

Over the last few years, interest rates have had a significant impact on everyone from real estate operators, to investors, to homebuyers.

In this edition of our Impact Series, we’ll take a look at a question we get often: how has the current interest rate environment and recent interest rate hikes affected DLP Capital both as a whole and at the individual fund level?

While we are no more immune to the ongoing interest rate situation than anyone else, we are, fortunately, well positioned to weather the storm. Despite the economic headwinds, we believe that we are prepared to continue delivering what our investors rely on us for: trusted real estate investments offering passive income streams that can help grow their wealth and build a financial legacy for future generations.

In this article, we’ll take a look at how the interest rate environment has affected each of our funds, as well as how we’re mitigating risks and pivoting our strategies as needed to continue delivering consistent performance for investors.

The DLP Lending Fund 

The DLP Lending Fund operates as a short-term bridge and construction lender to real estate sponsors.

In the current market, we’ve faced a few challenges for this Fund, including the higher cost of leverage and diminished loan proceeds due to higher interest rates. We’re fortunate that only about half of our capital is leverage from banks, which is on the lower end within the industry. Here are some other mitigating factors that have helped us maintain the performance of this Fund in the current interest rate environment.

• We’ve capitalized on the opportunity to make bank quality loans to successful and experienced real estate sponsors, who are facing a dearth of options for financing and exorbitant costs for traditional bank financing. The lack of available financing has increased demand, affording us the chance to earn higher yields on these loans.

• Our average loan to stabilized value is in the low 50% range, which means that in most cases, our borrowers are still able to pay off our loans via permanent or take-out financing.

• Interest rate hikes have worked in our favor for these funds, with the average rates for the loans we provide climbing over the last year from the low 9% to the low 12% range. This has allowed us to offset the higher cost of leverage while continuing to generate double-digit returns for our investors. As our existing loans come up for extensions, we will increase these rates accordingly.

• When rate increases eventually level off or even decrease, we will still be in a position to benefit, as our portfolio wide average yield should stay around where it is now, potentially increasing returns for our investors.

• Our team is more hands-on than ever in the asset management of our portfolio, mitigating risks and driving loan payoffs.

The DLP Preferred Credit Fund

Similar to the DLP Lending Fund, with the DLP Preferred Credit Fund, DLP operates as a short-term bridge and construction lender to real estate sponsors.

In the current market, we’ve faced a few challenges for this Fund, including the rising interest rates and their effect on the overall market. As a result,
we’ve seen a dramatic decrease in the volume of transactions and faced challenges obtaining permanent debt, which is often the repayment path
for loans made in the DLP Preferred Credit Fund. At the same time, the rising interest rate environment has created an excellent opportunity for the Fund’s strategy:

• On average, senior mortgage leverage has decreased by 10-15%, providing an opportunity for the Fund to invest as a junior/ mezzanine lender at a much lower place in the capital stack, more likely behind a 60% loan-to-value senior loan versus the 70-75% loan- to-value we saw prior to the rate increases. This reduces our overall risk.

• The increased cost of senior debt has narrowed the gap between senior debt and subordinate debt, allowing the the Fund to be
  more competitive.
  

• The demand for the type of capital the DLP Preferred Credit Fund provides has grown substantially due to the dramatic decrease in
  the availability of capital.

• We are able to be competitive for the business of the highest quality borrowers, especially when capital from the DLP Preferred Credit Fund is coupled with senior lending from the DLP Lending Fund.

The DLP Building Communities Fund

The DLP Building Communities Fund provides capital to real estate sponsors to build new rental communities designed to be affordable for working families across America. Depending on the deal, we may act as a preferred equity provider, a lender, or a land banker.

In the current market, the challenges we’ve faced with the DLP Building Communities Fund are driven by higher rates on both permanent and construction financing. Permanent financing refers to long-term mortgage loans that replace construction loan financing once a project has been completed. These loans can range from 20- 30 years. With higher interest rates in place for this type of financing, it is harder to find deals for the fund that make sense and can generate positive cash flow. Higher construction financing costs are driving higher total construction costs, which can cut into returns. Higher rates in general are also creating a need for more equity due to lower leverage.

Here are some examples of how we’ve mitigated these challenges and maintained the performance of our real estate funds:

• The increase in the cost of capital has brought down land prices, affording us a better basis price on land.

• The increased cost of capital has also slowed many developer and builder’s construction pipelines, improving the pricing of materials and labor anywhere from 3-10% with increased supply amid lower demand.

• We’ve sharpened our focus on investing in the best markets for our strategy, with a significant focus on investing in areas where the rents can support the costs short term & long term. We’re targeting a 7%+ yield-on-cost, which can still generate positive cash flow, in a 5% long-term rate environment.

• With the significant decrease in the availability of capital to develop and build new housing communities, the DLP Building Communities Fund is able to be very competitive in providing preferred equity to strong experienced developers.

The DLP Housing Fund

The DLP Housing Fund focuses on preserving rental housing that is affordable for working families through investments in existing communities.

In the current market, acquiring properties has been a challenge as they are increasingly being sold at cap rates that create negative yields due to the increased interest rates. Cap rates are used in real estate as an estimate of potential return on an investment, as well as the time it may take to recover the capital invested in a property. A lower cap rate indicates it could take longer to recoup an investment because of a lower return, while a higher cap rates means the potential to recover your investment sooner. We believe that cap rates will steadily increase, which would lead to lower property values and may create some strong investing opportunities, especially in distressed or rescue capital situations

With these challenges in mind, we’ve pivoted our strategy in a few ways to mitigate risk.

• In 2023, we deployed capital in a lender position for development and value-add projects. Depending on the buying opportunities, this may remain a significant portion of the strategy in 2024.

• The majority of the properties in The DLP Housing Fund portfolio (58 out of 65) have fixed long-term debt at an average of about 3.5%. This locked-in low rate shields our borrowers from rising interest rates, making it easier for our borrowers to consistently pay on their loans, leading to fewer delinquencies.

• Out of the 7 properties within our portfolio that have floating debt, 6 have rate caps in place. We’re in the process of refinancing two of these properties with fixed debt at a high 5% interest rate, while another property is under agreement to sell.

• In 2024, we expect to deploy more capital in preferred equity positions, behind low leverage and ahead of significant sponsor equity. Doing this will give us the opportunity to achieve strong cash flow while filling a financing gap for real estate sponsors.

As we said earlier, we believe DLP Capital is well positioned to weather the storm of interest rate changes and to capitalize on opportunities created by the resulting market volatility. We expect to focus our capital deployment on lending bridge and construction capital to experienced real estate sponsors on high-quality projects, while providing preferred equity in situations that allow equity level returns at debt level/close to debt level risks, while looking for distressed opportunities. As the markets evolve, we’ll continue to keep our investor community updated both through our Impact Series and our regularly scheduled webinars.

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