Navigating a Turbulent Interest Rate Market: Identifying Multifamily Real Estate Opportunities

We have just recently, as in the December 2023 Fed meeting, officially made it to the top of the fastest interest rate-raising cycle in the past 50 years. It was dramatic. 

Looking forward to 2024, per the Fed’s dot plot, we see ~3 rate cuts this year. The market doesn’t believe the Fed and is closer to ~6 rate cuts this year. It will be interesting to see where it lands.

Fundamentally, though, we believe one thing is true.

Interest rates will be coming down in 2024.

So, what do we do with that information? As multifamily investors, how can we take advantage of the turbulent interest rate market?

History tells us that investing now, when capital flows are low, interest rates are high, and the market is uncertain, has generated outsized returns over a 5 to 7-year holding period for thoughtful investors. 

It’s Buffett’s classic quote, “Invest when others are fearful.”

But why? What are the features of the current market that create future opportunities?

Let’s look at six key areas: 

• Inflation, more specifically, the response to too much inflation
• The Fed and Interest rates
• “Risk-free” rate of return vs. market investment
• Multifamily debt costs and leverage
• Supply
• Cap rate expansion/compression

Inflation… too much of a good thing 

First, inflation, the gradual increase in prices of goods and services over time, is not inherently bad. The problem is too much and/or too rapidly increasing inflation. 

The Fed targets an annual inflation rate of ~2.00%. And, as the graph shows, the inflation rate was at or near that target for most of the decade before 2021. But, starting in 2021, inflation spiked as a response to COVID-19 stimulus (e.g., excess money supply), resulting in the worst inflationary environment in over forty years.

Source: Federal Reserve Bank of Minneapolis

We all know this story. The Fed initially thought inflation would be transient. Then, it reacted later than it perhaps should have to start using the tools they have at its disposal and increase the Federal Funds rate. 

Remember that the Fed has a dual mandate—some would say it is a three-part mandate—maintaining price stability, maximizing employment, and ensuring financial stability.   

Inflation skyrocketed. The Fed responded. 

The Fed and Interest Rates 

The Federal Reserve’s primary weapon in combating inflation is managing the Fed Funds rate—the interest rate that U.S. banks pay one another to borrow or loan money overnight (e.g., overnight rate). The ripple effects of moving the Fed Funds rate are significant, with varying immediate and lagging impacts on almost all sectors of the U.S. and International economies. 

In response to the inflationary surge between 2021 and 2023, the Federal Reserve implemented eleven consecutive interest rate hikes over eighteen months.

Source: Federal Reserve

After this historically fast move, the Fed Funds Rate currently stands at its highest point in over two decades. 

And it’s working. Inflation, the rate of price growth, is coming down. The economy is showing signs of slowing down. By how much, we don’t know yet. 

Risk-Free Rates of Return vs. Market Investments

Without going into a deep dive into the US T-Bond market, we want to note that most investment professionals consider US Treasury bonds to be risk-free because the US Government backs them. So, a 10-year T-bond with a coupon rate of 5% (if held to maturity) would deliver a risk-free annual rate of return of 5%. 

Before the current interest rate cycle, US Treasury yields were anemic. Investing in bond funds or pursuing bond yields made very little sense because you were receiving less than the average inflation rate of 2.5%. So, to deliver yield, investors would look across a basket of asset classes to provide current income and growth—commercial real estate is one of those asset classes. 

As the Fed Funds rate increased, so did bond yields, making these products more attractive to income-sensitive investors (pensions, insurance companies, sovereign wealth, etc.). Thus, commercial real estate demand slowed down as a function of macro-level risk-adjusted return decisions. 

There’s more to this, but the takeaway is that money flows move out of the traditionally very stable Core/Core plus real estate assets when the market’s risk-free rate increases. This occurred in 2022/2023. 

On the other hand, money flows move back into Core/Core plus real estate when the market’s risk-free rate decreases. We could see this as the Fed Funds rate decreases and the economy slows.

Multifamily debt costs and leverage

Another obvious and significant impact of the Fed Funds rate cycle is increased debt costs and leverage. 

Floating debt costs increased, and fixed-rate debt costs increased. Loan-to-value (LTV) ratios across both products went down. 

Debt is less available and more expensive. 

A $70M project that would have received a 65% LTV loan ($45M in debt/$25M in equity) proceeds a fixed-rate loan at 3.5% in 2021 can only get a 50% LTV loan at 5.75% ($35M in debt/$35M in equity). 

Initially, the ripple effect of the increased debt cost is that loans are smaller and more expensive. This reduces the beneficial impact of leverage and lowers the overall rate of return on commercial real estate investments. More equity is required per deal, constraining the number of projects commercial real estate firms can acquire. 

The downstream, but not necessarily long-term, negative impacts are apparent. 

New Supply

New multifamily construction takes time. 

You have to identify the land, secure the land, ensure or modify the zoning, get approvals for the project, begin construction, get close enough to completion where you can start the lease-up process, etc. It can take upwards of 3 years to bring a new project online and start generating income. 

A lot of new projects started three years ago. 

Depending on the submarket, a historic amount of new supply will come online in 2024. But it all started years ago when rates were lower. 

Another critical impact of increasing interest rates and, to no small extent, regional bank stresses is that construction financing has all but disappeared. It’s either too expensive or unavailable. 

So, the new supply trends this year and a little bit next year will reverse 2-4 years from now, when very little new supply will be coming online. 

Hopefully, you’re getting a sense of why we believe there’s a significant opportunity to be a net buyer today. 

Cap rate expansion/compression

We’ve covered in detail how Cap Rates work. 

For our purposes here, remember the key idea: As a buyer, you want the highest cap rate you can achieve (keeping deal and market quality at or above standards). As a seller, you want the lowest cap rate you can achieve on sale. 

Usually, there is very little movement in A/B cap rates over a 2—to 3-year period. They typically move slowly based on long-term demographics, money flow trends, asset desirability, etc. 

But in rapid interest rate-raising cycles, they can move significantly like today’s. 

As cap rates increase and debt costs increase, values usually decrease. 

The Current Opportunity

Multifamily demographics continue to hold up. Rent growth has slowed, but finding or buying a home is still challenging. Essentially, resident demand is still strong. 

So, if you currently hold multifamily assets, wait out the turbulence. Wait for cap rates and debt costs to decrease before any disposition plans. For example, our portfolio has no loans due until 2027. 

As a buyer, though, based on the critical factors noted above, today’s pricing is a significant limited-time opportunity to acquire quality projects at a significantly lower basis. So, as interest rates come down, LTVs increase, and cap rates start to compress again, we can be well-positioned to generate attractive risk-adjusted future returns using the current market turbulence as an opportunity…

…buying when others are fearful.