When the Federal Reserve raises interest rates by more in a year than it has in the prior decade, there is bound to be some turmoil. Owners keep asking the same question about those interest rates. Apartment portfolio values, rent growth, and sales volume all move when the cost to borrow doubles. This piece looks at what the Fed’s inflation fight has done so far, why multifamily is holding up better than home sales, and what to watch as 2023 approaches.
In an attempt to curb rapidly rising inflation and stave off a recession, the Fed dropped a hammer on the real estate markets. Both residential and commercial property felt a dramatic increase in the cost to borrow funds. The most recent increase was a 75 bps bump (CNBC). That brought the total to +3% in a 6-month period and +3.75% for the year (Forbes).
After over a decade of unprecedented value creation in real estate, it was beginning to feel like the party might never end. Before declaring “real estate” a troubled asset class, it is worth looking independently at the multifamily sector. The forces hitting home sales and the forces hitting apartments are related, but they are not the same.
The transmission is mechanical. Higher interest rates raise debt service on any new or floating-rate loan. Higher debt service lowers what a buyer can pay for the same net operating income. That pressure shows up first in sales activity and only later, if at all, in values. That is the link between interest rates, apartment portfolio values, and transaction volume. It also cuts the other way: less qualified homebuyers are generally a positive for keeping rents high and vacancy rates low.
Many multifamily buyers complained over the last year that low interest rates made it impossible to find deals. Now the signs point in a number of directions. As we attempt to plan for the year ahead, it is hard to know whether to feel cautiously optimistic or recklessly pessimistic.
The home buying market took the first and hardest hit, because mortgage rates track the Fed’s moves almost directly. In October, mortgage rates soared above 7% for the first time in 20 years (NBC) before pulling back slightly in November. The cost to borrow has doubled from this time last year. That most dramatically impacts affordability, which results in more inventory on the market and a longer time to sell.
Home prices are experiencing their fastest value deceleration in history. Prices are still higher year over year (Case Shiller Index), but they are rising at a lower rate. Deceleration is not decline. It means the gains are shrinking, not that they have reversed.
Several macro factors are significantly different from the last real estate downturn:
All of these suggest that home sales will struggle in many markets over the next +/- twelve months. A significant drop in home values nationwide is not anticipated. For apartment owners, the takeaway is that would-be buyers who cannot qualify tend to keep renting.
Market volatility and uncertainty are having some impact on the multifamily sector. The pain is concentrated in two places: rent growth is cooling, and sales have slowed to a standstill. Neither, so far, looks like a collapse.
Rents have begun to cool. They dropped in September for the first time in two years after climbing to record highs (WSJ), and then again in October. It bears noting that this is consistent with seasonal trends. Rent growth in 2022 continues to trend faster than in pre-pandemic years, with rent growth still at 5.9% YTD (Apartment List). Landlords polled say they still plan to increase rents in the coming months, albeit at a lower rate than previously planned (Realtor.com).
The first half of the year was strong. Overall national multifamily sales volume surpassed $101 billion in the first six months of 2022, a $34 billion increase year over year, with an average price per unit increase of 28.4% (Multifamily Housing News). Since the interest rate hikes began, many report that apartment sales have become “challenging” (Multifamily Executive), to say the least.
Buyers and sellers are now in a period of stasis with bid/ask disparity. The Mortgage Bankers Association (MBA) projects an overall 7% decline in multifamily lending for the year, reflecting a very different second half of 2022. Still, the current housing under-supply, coupled with a 9% year-over-year drop in construction starts (Fortune), suggests vacancy rates and cap rates will remain low in most markets for the immediate future (US News).
A bid/ask gap forms when sellers anchor to first-half pricing and buyers underwrite at second-half debt costs. Neither side is wrong about the numbers; they are using different ones. Deals that close in this environment are the ones where both parties trust the same operating data. That is the case for underwriting from actual property performance rather than broker pro formas, which our approach to acquisitions analysis is built around.
Views regarding the overall picture of 2023 seem pretty consistent: conditions will be largely dependent upon whether inflation is brought under control (Forbes). Beyond that single dependency, the forecasts split.
Regardless of whether an official recession is in the cards, most agree we are all in for some rough months ahead.
Planning under this much uncertainty is a matter of watching the right signals rather than picking a forecast. The signals that matter for an apartment portfolio in this environment are:
The playbook for the downside case is already written. Our five moves for preparing an apartment portfolio for a recession cover budgeting, loan audits, and local market tracking. Cautious budgeting in particular is covered in our multifamily budgeting strategies guide.
Higher interest rates raise the cost to borrow, which lowers what a buyer can pay for the same net operating income. In late 2022 that showed up as a bid/ask standoff and “challenging” apartment sales rather than a broad drop in values. That is the mechanism connecting interest rates, apartment portfolio pricing, and deal flow. Housing under-supply and a 9% year-over-year drop in construction starts suggest vacancy rates and cap rates will remain low in most markets for the immediate future.
Rising interest rates push would-be homebuyers out of the purchase market, which is generally positive for keeping rents high and vacancy low. Rents did cool in September and October 2022 after record highs, but that is consistent with seasonal trends. Rent growth was still 5.9% year to date, faster than pre-pandemic years, and landlords still planned increases at a lower rate.
As of late 2022, buyers and sellers are in a period of stasis with a wide bid/ask disparity, and the MBA projects a 7% decline in multifamily lending for the year. Deals that close are the ones where both sides underwrite from the same actual operating data. Whether to transact depends on loan maturities and local supply more than on a national call.
Forecasters disagree. Some have concluded a recession is not imminent (CoStar), some are less optimistic (Fannie Mae), and others expect a close call (Goldman). Most agree that conditions depend on whether inflation is brought under control, and that rough months lie ahead either way.
Rate uncertainty rewards the owners who can see rent trends, competitive set pricing, and loan exposure across every property in one place.
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