Interest rates play a major role in how much it costs to acquire a property. The more expensive a property is to buy, the less profitable it becomes. Understanding interest rates is important for both active and passive investors, because interest rates impact the demand, prices, and profitability of a multifamily property.
That is why investors are concerned about rising interest rates. Rising inflation has resulted in monetary policy that drove interest rates to increase. Interest rates are the amount a lender is charging a borrower as a percentage of the principal amount loaned.
In this article, we’re breaking down what is causing this rise in interest rates. We’re also going to dive into how interest rates rise, the impact rising interest rates have on multifamily real estate, the historical context of interest rates, and the benefits and consequences of interest rates on real estate investors.
What is Causing Interest Rates to Increase?
During the COVID-19 pandemic, the Federal Reserve decreased interest rates in order to mitigate the impact the pandemic would have on the economy. In recent months, rampant inflation has been causing the price of most consumer goods to rise. According to Pere News, the annual growth rate in the Consumer Price Index has increased to a new 4 decade peak of 9.1% as of June 2022. There were multiple causes of this spike in inflation, including the excess of currency injected into economies around the world as a result of the COVID-19 pandemic, and the 2022 Russian invasion of Ukraine that led to a drastic increase in the price of oil and commodities. Over the last year, energy prices have increased by almost 42%. This is the biggest increase in prices since 1980. Despite Jerome Powell, Chairman of the Federal Reserve, and other economists claiming that inflation was transitory, it has been clear that this is not the case. As a result of persistent inflation, the Federal Reserve has changed their tune.
Who Controls Interest Rates?
The Federal Reserve is the US central bank whose job it is to control inflation. According to Investopedia, the Federal Reserve explained that it is choosing to increase its target federal funds rate in response to strong job growth, a low unemployment rate, and high inflation. In June 2022, the Fed announced a 75 basis point hike to the federal funds rate. To clarify, the federal funds rate is the interest rate banks charge each other to borrow money overnight. Although the Fed doesn’t directly control the mortgage rates of real estate, its monetary policy does heavily impact these rates. As a result of the Fed’s latest actions, interest rates in the real estate space have increased. The Fed is expected to continue increasing their target range for the federal funds rate with the goal of controlling inflation. This means that interest rates in the real estate space are likely to continue rising.
How do Higher Interest Rates Impact Demand for Multifamily?
As interest rates increase, demand for multifamily has also increased. This has been caused by multiple factors. For one, as interest rates increase, less people can obtain financing to buy a home. Mortgage rates have increased from 2% to over 6%, and this has resulted in an increase in the monthly payments buyers are making on their mortgage, as explained by Pere News. This phenomenon has resulted in an expansion in the renter pool. The more people there are looking to rent a unit, the more demand there is for the same number of multifamily units. Due to the persisting supply shortage of houses in the U.S., people will still need to rent, and the fixed number of rentable units remains in high demand. This is especially true in highly sought after markets, and urban areas where housing costs are more expensive and there is a higher concentration of people. It’s also important to note the trend among young, single people who are becoming increasingly more likely to rent an apartment than to buy a home, even if they can afford one.
There has also been an increase in the amount of institutional buyers moving into the single family space. As a result, single family prices have been driven higher. This pushes out many aspiring homebuyers, and they end up renting apartment units as a result. According to Blue Lake Capital, $77 billion of institutional capital was spent on single family properties between December 2020, and May 2021. This means that less people will be able to afford a home, and more of them will need to rent.
Interest rates play an interesting role in the demand for multifamily properties among multifamily investors. Interest rates determine how much an investor will pay for a given property, and thus, impact the value of real estate. In a low interest rate environment, demand for real estate tends to increase, as the cost of borrowing becomes cheaper. The opposite is true in a high interest rate environment. High interest rates tend to decrease demand for real estate, and as a result, gives more negotiating power to prospective buyers.
Historical Context of Interest Rates?
Despite interest rates being higher in 2022 than they were in 2021, they are still lower than they have been historically. In the early 2000s and 2018, interest rates were higher than they were in early 2022. In the 1980s, interest rates hit double digits. Data from Freddie Mac shows that the record high 30 year mortgage rate was 16.64% back in 1981. So, the rates of low to mid 6% we’re seeing in August 2022 is not bad in comparison.
The state of the multifamily space shouldn’t be judged solely by interest rates and inflation. For example, the level of job creation in a given market and the housing supply shortage continues to preserve the strength of the multifamily space.
With rising interest rates, investors must now focus on managing the cost of leverage. Sponsors who are looking to acquire more assets can adjust their underwriting assumptions to account for the changes in the debt market. They may implement stress tests relating to interest rates, inflation, and cap rates to draw out different paths to achieve the desired projected returns.
Impact on Returns
As financing becomes more expensive as a result of higher interest rates, returns may be impacted. The rise in debt costs can eat into the total profitability of a property. This means that less money may be returned to investors.
In a high rate environment, some investors are hesitant to invest because they are fearful of having to pay higher interest rates and receiving less profit as a result. This can lead to more opportunities for the investors who choose to remain in acquisition mode.
Returning to Bonds
In high interest rate environments, there is a trend of real estate investors turning to bonds. Some investors believe that bonds will be able to generate higher returns than real estate. Higher interest rates are thought to interfere with a property’s ability to generate a strong return on their investment. However, bonds can have low returns over extended periods of time. Investing in bonds is not a guarantee that an investor will receive higher returns than in real estate, and real estate offers more control over the asset’s value while bonds do not.
How Can Investors Mitigate Changes in Interest Rates?
To account for changing interest rates, investors can adapt and make the most of the current investment environment and the opportunities available. Rental increases are a good option to mitigate the impact of rising debt costs.
Also, adjusting their construction projects and planned renovations to account for the changing price of leverage may allow investors to absorb the changes in NOI caused by rising interest rates. Cutting back expenses is a good way to adjust and pivot in a rising interest rate environment.
Most importantly, it’s important for investors to buy right. The increased cost of debt means that investors need to create a higher return or purchase the property at a lower price. An investor has more control over the purchase price of the property than the renta revenue the property will generate, the sale price of the property, or the cost of operating the property.
Depending on the market the property is located in, multifamily assets continue to see rising rental premiums.
Even if interest rates increase dramatically in the coming years as the world resumes normalcy post-COVID and the Federal Reserve takes their foot off the gas, evidence suggests that multifamily will remain in a strong position.
Rising interest rates is a concerning issue for most investors. It is normal to be uncertain with the way things are changing in real time. However, historical trends and the strength of multifamily presents a strong argument for why multifamily real estate will be able to mitigate the impacts rising inflation and interest rates will have on the asset class as a whole. Interest rates have changed throughout history, and will certainly continue to fluctuate throughout different economic environments. This is why it’s so important to understand this aspect of real estate.
While rising interest rates is something investors should continue to monitor as changes continue to unfold, investors will need to lean into the fundamentals and ensure that the investment opportunities they are acquiring are strong assets that align with their conservative underwriting criteria.