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The (Surprisingly Quiet) Storm: Multifamily Distress
If you had asked me two years ago what the multifamily market would look like today, I’d have confidently predicted widespread foreclosures and a surplus of discounted properties ripe for the taking. After all, borrowing rates were hovering near historic lows, property values seemed to be marching ever upward, and everyone knew that couldn’t last forever. A dramatic correction felt inevitable.
Yet here we are, and the carnage many expected just hasn’t materialized—at least not in the way headlines suggested. Instead, the real story is playing out behind closed doors, as lenders and operators quietly work out their issues through a series of “operator replacement” deals, credit bids, and creative financing structures designed to avoid outright foreclosure.
Why the disconnect? How did we go from forecasting a full-blown meltdown to navigating an environment where traditional “distress” is surprisingly rare? Let’s take a look under the hood.
Background: Where Did All the Distress Come From?
Rapid Rate Hikes: Over the past 18 months, the Fed’s aggressive interest rate hikes abruptly changed the cost of capital, putting pressure on those who had financed with short-term, floating-rate debt. Suddenly, cash flows were squeezed and debt service coverage took a hit.
Softening Fundamentals: At the same time, many markets (notably sunbelt markets where the bulk of transactions during mania phase occurred) experienced rent stagnation or even declines. Coupled with inflation-driven expense growth—everything from labor to utilities to insurance—owners saw their operating expense margins increase by 10-25%.
Shifts in Sentiment: Investor confidence also waned. Many institutional and private equity players who were once bullish started tightening acquisition criteria or focusing on well-located assets that weren’t necessarily “distressed” in the classic sense. Furthermore, the once flush retail investors are feeling the pain and without the liquidity that once was.
As values dipped below some outstanding loan balances, you’d expect a wave of foreclosures. Instead, lenders—especially those holding large loan books—have favored negotiated workouts to protect asset quality and future upside.
The Textbook “Distress Deal” Example:
Example: In January 2022, ApplePath (AP) acquired a well-located, value-add multifamily in Houston at roughly $200K/unit total project costs. They financed with a 75% loan-to-cost mortgage, with a three-year term and extension options tied to debt yield tests, or $150k/unit. Since then, rents have softened, expenses have climbed, and interest rates are +400 bps greater. Fast-forward to today, and the property is now valued closer to $140K/unit—below the outstanding loan balance.
Under “normal” circumstances, a short-term bridge or debt fund loan gone underwater would lead to a quick foreclosure or a fire-sale listing. But what’s actually happening is more understated and largely happening out of view:
Investment Sales Attempt: The owner or lender hires an Investment Sales broker hoping to find a buyer that can pay to cover the debt balance.
Quiet Negotiation: Failing that, the lender or existing GP/LP often opts to replace the sponsor (the GP) rather than foreclose, especially in prime locations. Lenders #1 goal is receiving 100% par value of loan, and sometimes another shot at deploying fresh capital into a new entity. Sponsors with in-demand assets and loan balances not far from market value know what they have. Some are looking to source a new operator with capital so they may receive a hope note on the new entity.
Behind Closed Doors: This leads to private deals that rarely hit the broader market, involving restructured loan terms, new equity capital, and fresh operational expertise.
The Multifamily Market’s “Orderly Resolution”
The trend is clear: distressed situations exist, but they’re being handled discreetly and methodically. Banks and agencies prefer GP replacements (and similar strategies) to seizing and dumping assets at a loss. By incentivizing a stronger operator to step in, lenders stand a better chance of recouping their principal or even riding the eventual market rebound.
Throughout 2024 and into 2025, this approach has only gained traction, with industry estimates suggesting billions in loans getting a second life via:
Standard Replacement GP Structures
A/B Note Splits
Let’s explore each.
1. Standard Replacement GP Structure
Basic Property Snapshot:
Current Loan Balance: $50M
Current Value: $45M
NOI: $2.75M
Situation: Original GP in default, unable to cover debt service.
The lender on this deal will kick-out the exisiting sponsor from the deal. Most debt funds and banks aren’t set up to asset management at the level required for best operations. So, they source a new operator who is willing to step into the new capital stack with an accretive loan. The lender will extend term, perhaps fix the rate, and in return, ask for a small paydown and fresh capital for stabilization.
Below-Market Current Pay Rate:
Lender might offer ~3-5% fixed for 36 months.
Goal: Maintain positive cash flow and stabilize operations.
Accrual Component:
If they fix the loan, the lender could ask for 1-2% that accrues but isn’t paid currently.
Goal: Align incentives between lender and new GP for improved performance.
Promote Structure:
The replacement GP typically receives 75-100% of the upside above the loan balance depending on who sources the GP.
In the situation where an operator sources another, they may ask for a hope-note profit share of 10-30% after the new operator achieves some minimum IRR or MOIC.
Multiple tiers can reward outperformance.
Three-Year Projections:
After successfully stabilizing the asset, the new operator elects to exit. This is what returns would look like high-level (ignoring additional new equity injection).
Accrued Interest: $2.25M
Total Loan Balance: $52.25M
Projected Value: $55M
Net After Loan: $2.75M
Replacement GP’s Share: ~$1.9M (70% of upside)
2. A/B Note Split Structure
Another popular tactic involves splitting the existing loan into an A and a B piece.
Basic Property Snapshot:
Current Loan Balance: $50M
Current Value: $45M
NOI: $2.75M
Structure Breakdown:
A Note (“new” senior position):
Sized to current supportable debt (85-90% LTV).
Market-rate interest
Example: $40M at 4.5%, 2-year IO.
Common Equity:
Represents the last dollar of the senior note to the last dollar of the equity amount.
In this case, let’s say the asset needs $2M of capital for deferred, $500k to close the deal, and another $2.5M for improvements.
Common Position would be the $40M - $45M (this number can go over 100% of the market value… this is “risk”.)
B Note (“Hope Note”):
Represents the gap above the Equity.
Fully accruing, potentially convertible into equity.
Example: $10M at 2% accruing, convertible to 25% equity.
B-Note is $45M - $55M position.
Cash Flow Waterfall:
First: A Note debt service.
Second: Opex & reserves.
Third: Agreed minimum pref to common equity investors. At sale, likely receives some minimum MOIC (say 1.5x).
Fourth: Once return is met to common equity, B-note receives 2% accrued ($600k = 2% x $10M x 3 years) and any upside left to split between common and B-note.
Three-Year Projections:
A Note Balance: $40M
B Note Balance: $10.6M (with accrued interest)
Projected Value: $65M
Excess After A Note: $25M
Common Equity: $7.5M ($5M initial with 1.5x minimum)
B Note Recovery: $10.6M
Excess Proceeds: $6.9M ($25M - $7.5M - $10.6M)
The excess proceeds are to be split by the agreed upon waterfall between lender and new sponsor. This might be 75% going to Sponsor and 25% to Lender (B-Note participation).
$5.1M to common (total of $12.6M)
$1.8M to B-note (total of $12.4M)
Workouts in Action
Both the Replacement GP and A/B Note strategies help lenders avoid large write-downs while giving new operators a shot at turning the property around. For GPs stepping in, there’s a real opportunity to gain control of an asset at a favorable basis, provided they can stabilize and reposition it over the coming years.
Considerations:
Transfer Taxes & Structuring: Most deals are structured to minimize any tax implications and keep ownership transitions efficient.
Reporting & Transparency: Lender asset managers are going to be laser-focused on stabilizing operations and value. Lenders typically require thorough monthly and quarterly reporting to keep tabs on progress.
CapEx and Equity Funding: Lenders are generally not going to let a new sponsor step in at 100% LTC, it doesn’t reduce their risk. Therefore, lenders will ask for a buy down and likely additional capex needed to stabilize the asset.
Looking Ahead
While the “foreclosure wave” that many anticipated never really materialized, we’re not out of the woods yet. Rising interest rates, tighter credit, and fluctuating rent growth continue to pressure property owners—and plenty of deals are still limping along. But for now, it’s clear the market has found a way to dodge all-out distress, favoring quiet, behind-the-scenes workouts that maintain optionality for a future rebound.
Will these structured solutions become the new normal? Quite possibly. As we move further into this cycle, expect more innovation in financing, workout structures, and deal flow—all with the goal of minimizing high-profile foreclosures and maximizing long-term returns.
For those keeping an eye on opportunistic investments, the takeaway is clear: true “fire-sale” distress is rare, but behind-the-scenes deals and sponsor replacements are anything but.