Rising Rates & Multifamily
College student here. Would someone mind explaining how rising rates can / are impacting multifamily investors who bought within the last year and a half or so at extremely low cap rates? If someone could provide a simple mathematical example, that’d be very helpful as well. If you could touch on how this relates to exit caps as well, that’d be great. Probabaly naive, but not quite understanding why this seems to be such a cause of concern.
If you're trying to understand the "theory" of how why interest rates negatively impact multifamily, then I think the answer lies in the discount rate. So if you were to perform a DCF valuation on a property, the higher interest rate increases your discount rate, which lowers the valuation of your property. But I look at it in a much simpler way: real estate (multifamily) in this case is generally a highly leveraged asset. Investors can get loans of 50%-80%+ LTV. If interest rates go up, then the cost of owning real estate increases, but your rents don't necessarily increase. Since the cost of real estate increases, then the returns/positive cash flow decreases making real estate less attractive than other potential investments and less affordable. For example lets say you bought a $1,250,000 property last year and interest rates were at 4% interest only (for simplicity). Lets say that potential buyers will borrow at 80% LTV, which is a $1,000,000 loan. The new buyer's interest payment is $40,000/year. If interest rates increase to 6%, then that becomes $60,000/year. As the cost goes up, less and less buyers are able to afford the property at $1,250,000/are not happy with those returns, so demand for your property decreases. And lower demand = lower price. This is all assuming that the only thing changing is interest rates and all else stays equal.
Gotcha - thanks for that explanation. And how does this impact / relate to the low cap rate environment at which core investors are purchasing multifamily right now? My understanding is that cap rates are more so correlated with capital flows as opposed to rates. If so, why are people here assuming that cap rates have to rise for multifamily? What would happen if interest rates rise and cap rates don’t ?
Feel free to correct me, but yes, cap rates are directly related to a property's net operating income. The low cap rates are more from what I understand due to demand. Funds need to get money out no matter what so they are paying insanely high prices (low cap rates) to get the deals done. I'm sure you've seen some posts on here asking how people are getting multifamily deals to pencil aka make sense, people are asking that because at the prices multifamily has been trading (selling) at don't make sense. People are paying such low cap rates aka high purchase prices to get these deals done and if they lever up the deal they will not have enough cash flow for it to make sense in the long term. A lot of these funds are driven by fees, so the people working at these funds acquiring the deals are getting x% acquisition fees, management fees, etc while putting very little money in the deal and being backed by other people's money but they don't care since they're getting money up front and are the "savvy" investor while the group putting in a majority of the money doesn't know the industry and just needs exposure to the asset class and maybe something to make their investment books look nice.
I think the general consensus is cap rates have to rise because it's unsustainable. You see people paying 2.x% cap rates for these deals and they will not have the cash flow to support these deals and it will blow up in their face. They cannot support the debt/make a decent return and pay back investors at such a high basis if they're using leverage. It would also make no sense to buy all cash. We will see this blow up in the next few years when things play out, but the head of these funds don't care since they're getting fees now from these deals and it's not their money they are losing in the end, it's a life insurance company, pension fund, or high net worth individual.
Well it impacts the investors acquiring multifamily at low caps by reducing their returns which lowers demand for multifamily, which reduces capital flows into multifamily. Cap rates will rise for real estate across all property types because interest rates are not only rising, but rising fast. In the last 3 months SOFR has increased like 100bps and there's supposedly more rate hikes to come...i.e. the cost of owning real estate (interest payments) is increasing rapidly. This will inevitably increase cap rates (lower prices) because demand for real estate is not inelastic. People are very price sensitive towards real estate both at the investor level and homeowner level. If cap rates don't rise, then that means there are other economic forces at play that either balance out or outweigh the effects of rising interest rates. For example, maybe some cities are offering aggressive tax abatements that balance out the effect of rising interest rates on cap rates, but this doesn't mean that interest rates did not effect cap rates. In this example, rising interest rates prevented the city's tax abatement program from causing cap rates to compress even further. Imagine if rates weren't increasing and this city also offered aggressive tax abatement. Cap rates would compress more. But in my opinion, whatever forces are at play keeping cap rates low, I do not think they are strong enough to prevent some serious cap rate decompression. I signed a P&S to acquire a property 3 months ago and at the time I was underwriting at a 4.25% interest rate per my commitment letter...3 months later its at fucking 5.50%...and I'm a pretty conservative investor with a lot of margin of safety. The deal still works but fuck me my projected cash-on-cash return got cut in half. I see a lot of pain coming for everyone
Theoretically there would be a lot less buyers. If people are paying more for debt, and consequently able to put less debt (for DSCR covenants) those investments are less and less attractive.
Are housing interest rates always floating?
Floating until the loan is closed and then it's fixed for whatever term you chose (5 years, 7 years, 10 years, 30 years, etc...), so for example, if opt for 5 years and the benchmark rate your bank uses is at 3% and the spread is 2%, then your rate would be 5% at closing and fixed for 5 years. However, if the benchmark goes up to 4% before you close, then at closing your rate would be 6%. After 5 years, the rate will re-adjust to whatever the benchmark rate is in 5 years. Sometimes you can buy a rate cap before you close, so that you know your rate won't exceed a certain amount upon closing
Groups might be willing to accept lower returns just so they can put their capital to work. Right now the amount of dry powder, coupled with rent growth, is negating the impacts of higher debt costs. At least in multifamily. Starting to see/hear of more sensitivity to rising interest rates.
This is true. Lots of dry powder out there. Firms are increasing equity and reducing debt to make deals work. However, I see this changing once money markets, savings, etc adjust with higher rates. I believe there will be a point where its worth it to stay liquid.
Not might, are. There is no shortage of money buying deals.
One thing to consider though is that "rising rates" does not necessarily mean "high" interest rates. Yes, they may be higher than they were 6 months ago, but from a historical perspective they are still low and investors do know this. Look at where we were in 2017-2019 compared to interest rates now. We are coming out of a period that is an anomaly, not the norm.
Yes, but most of the people on these forums are in their early 20s and don't understand that just because things have been this way for 24 months, doesn't mean that the entire financial system collapses when rates go up 100 bps.
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