If you’ve been paying attention to the financial news in the last few months you have probably heard a lot of discussion about rising inflation and plans for the federal reserve to raise interest rates.
Rising interest rates and rising inflation? That is a double whammy!
Is there any investment that can perform well during such an environment?
Or should we just join the investors that have decided to pack up and sit on the side lines for the foreseeable future?
What happens to commercial real estate during inflation?
As a quick recap – real estate is traditionally seen as a hedge against inflation. If there is an investment class that you want to own during an inflationary period, then real estate should be at the top of your list. Hard physical assets like real estate stand the test of time. As an investor you will benefit not only from increased asset value but increased cash flows that grow in line with inflation.
We’ve already looked at how real estate performs during times of high inflation but what about rising and high interest rates?
Are commercial real estate interest rates rising?
Many of the headlines that are shown on national and local news are related to single family home mortgage rates. These headlines talk about the traditional 30-year mortgage that is obtained by first time home buyers to purchase their primary residence. You may have seen these rates rising and automatically assumed that commercial real estate rates are also rising but is that true?
Do commercial real estate rates have to rise because single family home mortgage interest rates are rising?
Well, it depends. Yes, typically if there is a rise in the residential mortgage rates then similar factors will likely impact and lead to the rise of interest rates for commercial mortgage loans.
There is more to the story than only this, however. Changes in residential mortgages do not always correlate to changes in commercial real estate mortgage rates.
We focus primarily on multifamily apartments and this asset class does correlate more closely to rates seen in primary residences, but rates are not always the same. Given the fact that investment real estate has larger scale and more lending options you may find instances where large commercial investment properties will have a lower interest rate than what you may be able to obtain for the purchase of a primary residence.
Additionally, when considering the faction that interest rates have been at historical lows for an extended period of years, an alternative view may be that interest rates are not just rising but rather they are returning to normal.
What happens to multifamily apartment real estate when interest rates rise?
Interest rates impact multifamily apartments in many ways depending on which viewpoint you are looking through. There is the impact on Operators, active investors, who are purchasing apartments, and passive investors that are providing funds to invest in multifamily apartments. There is also the view from the renter standpoint as interest rates impact renter demand and ability to pay (we will talk more about this later). The future sentiment (i.e., a person’s view about what will happen in the economy and world in the future), macro-economic, regulatory and policy changes all impact what people are willing to pay for apartments.
Based on the mix of factors impacting the change in interest rates and the specific type of property and location you are investing in there could be an increase or decrease in multifamily apartment values during an increasing rate environment. Generally, if outlooks are positive real estate values will rise and if outlooks are negative values will decline but there are several key factors that we should look at to get a deeper understanding of how values are impacted.
What factors affect commercial real estate multifamily apartments value?
Pricing for multifamily apartments (and other commercial real estate) are primarily based on a few key factors which all ultimately impact each other: Cap rates, Net Operating Income, Returns on Investment.
Return on investment (ROI) can be broken down into several other more accurate and granular metrics. For the purpose of this article (and to understand the view of what may be most important for a passive investor) we will use ROI as an overarching term for what returns a passive investor can expect to get by investing in a multifamily apartment.
Net income is not directly connected to interest rates but there may be indirect impacts to rising interest rates on rental prices.
Results for returns on investment is a combination of how the two previous factors interact (assuming consistent operation of the property during ownership) so we will focus on the first two items mentioned.
How do cap rates change in a rising interest rate environment?
Cap rates are an important topic as the cap rate is one of the major inputs into the valuation of a multifamily apartment community. Lower cap rates usually indicate higher property valuations and price premiums while higher cap rates typically indicate cheaper properties and lower valuations. Further, lower cap rates will be applied to lower risk, higher quality assets and markets while higher cap rates are used for higher risk, lower quality assets and markets.
Depending on whether your investment strategy is to invest in distressed, turnkey or value add multifamily apartments then current market cap rates may have more (or less) impact on what is considered a “good deal” in accordance with the techniques of that investment strategy. Cap rates are really intended for stabilized assets and would be most applicable to turnkey property investors. For other investors, such as value add investors, properties will often be bought at lower cap rates than the current income justifies based on the investors opinion on the future profit and valuation they can obtain for the property.
That leaves us with the big question, will cap rates increase in a rising interest rate environment?
Investors tend to try and get a cap rate (i.e. expected return value as a percent) that is greater than the cost of borrowing (i.e. interest rates). As you may already know real estate is a supply and demand equation and highly local to each real estate market. Perhaps when looking at numbers on a national average if interest rates rise there will be a correlation in rising cap rates. In certain markets supply for multifamily apartment investments remains low compared to current demands. There are many factors that can continue to keep demand strong, cap rates low and values high.
Commercial assets also benefit from international, 1031 and other investor demand where lower returns from U.S. real estate markets benefit them more than their other investment options. Cap rates may not rise as much as expected; buyers may choose to settler for lower returns; demand will continue to be present. Consistent demand could keep cap rates low or at least dampen an increase that would be in line with interest rate increases.
Further many people may favor the security of real estate in high inflationary periods versus stocks or other investment assets. The view of real estate as an inflation safe haven could be a factor that helps to keep demand steady.
To be more concrete, based on quarterly data from the NCREIF (National Council of Real Estate Investment Fiduciaries) over the last 20 years there have been periods where cap rates declined despite increasing rates. This contrary movement occurred in the late 2000’s before great recession and late 2010’s. A savvy investor would want to invest in the safest asset for the amount of return they can earn so in this case if the cap rates are lower for multifamily than the interest on a 10 yr U.S. Treasury bond (debt instrument most correlated to mortgage rates) then investors may see the Treasury bond returns (also called the “risk free rate”) as the better investment as it has least risk given the “guaranteed” return from the US Government.
How do interest rates affect rental prices for multifamily apartments?
As mentioned earlier rising interest rates are most often discussed in relation to single family homes. This brings up the question of whether it is better for a prospective renter to buy a primary residence or to rent. There are many influences that impact the answer to that question but one thing we will focus on primarily is affordability.
Affordability is often what forces individuals that want to buy a personal home to be priced out and not able to afford to buy a single-family home or those that can afford one decide to delay purchasing. As interest rates increase, purchasing power decreases; potential homeowners end up with an incrementally higher on-going mortgage payment and may no longer qualify to buy the type of home they wanted because their loan approval does not cover homes in that price bracket. This leads to more individuals staying in the market for rentals and bolstering the demand for rental units.
Interest rates may not have a direct impact on rental prices but indirectly via the increase (or retention) of demand within the rental market there is likelihood that rental prices will remain consistent or increase.