How Rising Interest Rates May Influence Your Next Apartment Deal

Another day another rate increase.

On July 27th, the Federal Reserve revved up the overnight borrowing rate (Feds rate) for a third time, taking its benchmark rate to a range of 2.25%-2.5%. So, what does this all mean from an apartment investing standpoint?

2.25% - 2.5% | The federal funds rate target range as set by the FOMC at its July 2022 meeting. The committee decided to raise the rate 75 basis points from the 1.5%-1.75% target set in June.

To understand this, let's look at some specific impacts and how they play out amongst investors and others. Without a doubt, having a better understanding of "the Fed" and its changes will help you make better decisions in an ever-changing economic environment.

So we'll start with explaining the most talked about rate in the news, the federal funds rate.

What is the Federal Funds Rate?

I'll try to keep this simple. Let's say you deposit a large sum of money at Bank of America.

As a business, Bank of America needs to make money, so it takes your money and lends it to someone trying to buy a house or car at a specific interest rate. But Bank of America cant lend out all the money it holds because the federal reserve has a particular reserve limit that designates a certain amount that each bank should have at all times.

Now, some banks have higher reserves (more deposits or cash on hand) than others. Again, let's say Bank of America has lent out most of its money below its designated reserve limit.

And let's also say that another bank like Chase has a large amount of excess reserves. Bank of America can then borrow money from Chase overnight but has to return the money by the next business day with interest.

This interest rate is called the overnight rate, or the federal funds rate. It's a target for the interest rates big commercial banks charge each other for overnight loans.

How does it affect us?

Well, it directly affects monetary and financial conditions, which in turn has a profound effect on critical features of the US economy like employment, growth, and inflation.

The rate also indirectly influences short-term interest rates for everything from credit card rates, home loans, auto loans, and commercial loans for apartment investments. Here are some significant moving pieces changing the multifamily residential market based on changing interest rates.

Different Impacts on the Multifamily Apartment Real Estate Market

Higher Cost of Debt Capital

First and foremost, the change in the federal interest rates means debt becomes more expensive.

When people amortize financed investments, they see higher premiums or scheduled payments. The rationale is to reduce the money supply in the economy, reduce borrowing and lending and increase saving. Consequently, these increased costs are passed down to the limited and general partners.

Tighter Underwriting

Higher costs in terms of borrowed assets mean lenders and borrowers will engage in more stringent underwriting.

"Multifamily investors have recently become more selective in their acquisitions amid ongoing market volatility, increased debt costs, and global economic uncertainty," states Matthew Vance, Americas Head of Multifamily Research at CBRE.

Consequently, the Fed has stated that more interest rate hikes are coming down the line. As a result, astute investors will need to accommodate for these hikes in their long-term projections.

Lower Investor Yields

Lower loan-to-value due to tighter lender underwriting standards has caused operators to bring more equity to the table, hurting investor yields because of higher debt.

Fortunately, robust rent growth in several markets could help offset the impact of rate hikes on debt service payments to borrowers.

Freddie Mac's 2022 Multifamily Outlook reports that rent growth is expected to increase by 10% for the year, outpacing inflation entirely.

Changes in Cap Rates

Let's spend a bit of time here as cap rates have historically been a confusing topic for beginning and even astute investors. Regardless, it is a significant number to understand.

So what is a cap rate? Briefly, a cap rate is simply a formula. It's the ratio of a rental property's net operating income to its purchase price:

Cap rate = Net Operating Income/Purchase Price

The formula can be used on the level of an individual property by looking at its net operating income compared to its value. But can also be used on the level of an entire market by taking average cap rates for a large group of properties.

Beyond a simple math formula, while several factors can influence a cap rate, it is best understood as a measure of risk. So, in theory, a higher cap rate means an investment is more risky and vice versa.

For example, Property A in a pleasant and developed A-level neighborhood may have a cap rate of 3%. On the other hand, property B in an "up and coming" C neighborhood, still a bit on the sketchy side, may have a cap rate of 9%.

What does this mean, though? Cap rates can also be a measure of potential returns on investment. So as your risk tolerance increases, so do your potential returns.

If we look at the formula, your cap rate will increase if you can find some way to increase the NOI via increased rents or reducing expenses at Property B. But something could happen that may obstruct that, hence the increased risk.

So, what is a good cap rate? Well, that depends on each investor's personal investment criteria and preferences.

Regarding rising interest rates, its relationship to the cap rate is complex as a change in interest rate does NOT always mean a change in cap rate.

In this case, after reaching their lowest levels in Q1 2022, average underwritten cap rates for prime multifamily assets increased by 39 basis points (bps) to 3.76% in Q2 due to rising interest rates.

Still, Taylor Jacobi, Director of Strategic Investment Consulting at CBRE, expects cap rates to hold steady amid increases in long-term interest rates due to robust demand and rent growth.

Apartment investors keep buying, even as rates rise.

Despite all these changes in the US monetary policy, the multifamily apartment real estate market is as strong as ever.

Lawrence Yun, the chief economist for the National Association of Realtors, shows no real worry or concern for the rising interest rates as the housing supply issue and increased demand are much stronger factors than creeping interest rates.

"Any short-term price adjustments, if they occur, will be less consequential compared to the immense longer-term housing affordability challenges we face as a country" - Lawrence Yun

This shortage and increased demand are driving rent through the roof, especially in the Sunbelt markets.

For example, some markets have noted rent increases up to 25-30% in Florida. Eight of the Top 10 markets are in Florida based on year-over-year rent increases.

Moreover, the CBRE stated bluntly in their multifamily outlook report, "The multifamily sector is set for a record-breaking 2022 amid solid fundamentals and heightened investor interest. With tremendous liquidity and a growing range of debt options available, multifamily pricing will be as strong as ever."

This is supported by several factors such as increasing occupancy rates in suburban and urban markets, higher vaccination rates, a growing willingness to use public transit, the reopening of college campuses, and more workers returning to the office.

"The multifamily sector is set for a record-breaking 2022 amid solid fundamentals and heightened investor interest."

Further, investor appetite for multifamily is still strong. In 2021, US multifamily investment volume reached a record of nearly $213 billion.

"For 2022, we expect at least a 10% increase from 2021 to $234 billion," stated Vance.

In summary, an environment marked by higher interest rates and inflation will require a reassessment of risk for all investors. Tighter underwriting and more selective acquisitions by apartment operators and syndications are necessary this season.

Despite this, don't forget that real estate is STILL the perfect hedge against inflation.

Rents are rising at record levels, vacancy rates are falling, lender appetite for multifamily is still healthy, and investor appetite for multifamily is still as robust as ever. As a result, in my opinion, and based on these facts, Multifamily Real Estate is still one of the best investments in the world.

What other things could potentially influence the multifamily apartment market in the coming future? Let me know in the comments below!!

Tochi Ajiwe, MD is a Houston native who began his career in medicine as an Emergency Medicine Physician. He completed his BS at Baylor University, received his medical degree from the University of Texas Southwestern in Dallas, and is currently practicing at Baylor College of Medicine in Houston. After learning about the power of real estate investing in medical school, Dr. Ajiwe has been an active buy-and-hold investor and currently has over 3M AUM. He is passionate about informing and inspiring busy professionals about the power of multifamily investing and financial freedom. He most notably desires to encourage more minority professionals to take advantage of this space!

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