Rising Rates: Multifamily Impacts
At the time of writing this, rates have been on a steady increase. The Fed rate is currently at 3.75 - 4% with hints to continue rising until the inflation clams down further. Although there are signals of inflation slowing and the necessary adjustment taking place, it seems the rate increases are not done yet. The question is how this affects us as multifamily operators and investors.
Rate hikes are an increase in the cost of capital. Debt is one of the largest levers in a deal and when debt costs increase, prices tend to be inverse. This affects purchases, sales, and refinances. Purchases become trickier because operators have to account for increased costs currently as well as uncertainty in the future. The same applies to refinances. It's also difficult at the sale because increased debt means lower prices, and often operators selling will choose to wait until rates lower instead of accepting a lower price.
Cap rates are forced to expand to account for the higher debt costs. The cap rate controls the price of the asset. The cap rates expand which lower the cost of the asset which lowers the debt costs and allows returns to remain acceptable. If cap rates remained the same when rates increase substantially, cash flow and investment returns would drop to an unacceptable level. It would not make sense to purchase at the low cap rate with high rates, the investment would not perform.
Cap Rate 5%
Debt Service (4%, 25yr am, 25% down) $95,004
Cap Rate 5%
Debt Service (6.5%, 25yr am, 25% down) $121,536
Cap Rate 7%
Debt Service (6.5%, 25yr am, 25% down) $86,808
These aspects plus the headlines contribute to investor sentiment. The sentiment dictates how the market as a "whole" tends to view things. When rates are increasing rapidly, investors get nervous due to uncertainty and most pull back to see what will happen. Investors may choose to hold instead of sell which can limit supply.
There is also a lagging effect on pricing. Coming from a low cap rate environment bringing top dollar to a high cap rate environment bringing substantially less, sellers don't want to lower the offering price. At the same time, buyers are paying the current cost of debt (much higher) and their offers are adjusted accordingly (substantially lower) and so there is a stalemate.
Rate hikes affect us as operators and investors in several ways. It affects the cost of capital, the cap rate, and sentiment. All of these aspects are intertwined and contingent on each other. The only curveball is weighing in supply and demand. When there is a lack of supply in the market and a very high demand, cap rates/prices tend to fall much slower than in equilibrium. When supply is very constricted, some investors are willing to accept lower returns just to do a deal and so they still pay the higher prices. It feels like we are in a bit of a stalemate now with expanding cap rates, increasing debt, and an extreme lack of supply.