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? How can we take advantage of the turbulent interest rate market as multifamily investors?
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
- Cap rate expansion/compression
Inflation… too much of a good thing
First off, inflation, the gradual increase in prices of goods and services over time, is not inherently a bad thing. It is too much and/or too rapidly increasing inflation that is the problem.
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 they perhaps should have to start using the tools they have at their 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 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 US and International economy.
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 on the US T-Bond market, we want to note that most investment professionals consider US Treasury bonds to be risk-free, in that they are backed by the US Government. 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. It made very little sense to invest in bond funds or pursue bond yields because you were receiving less than the average inflation rate of 2.5% of so. So to deliver yield, investors would look across a basket of asset classes to deliver current income and growth – commercial real estate is one of those asset classes.
As the Fed Funds rate moved up, so did bond yields, which made 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, obviously, 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. This is what we could see as the Fed Funds rate comes down and the economy slows down.
Multifamily debt costs and leverage
Another obvious and significant impact from the Fed Funds rate cycle is increased debt costs and leverage.
Floating debt costs increased. 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) fixed-rate loan at 3.5% in 2021, can now only get a 50% LTV loan at 5.75% ($35M in debt/$35M in equity).
The ripple effect of the increased debt cost, initially, 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, which then constrains how many total projects commercial real estate firms can acquire.
The downstream, but not necessarily long-term, negative impacts are apparent.
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.
And a lot of new projects were started 3 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 are lower.
Another key 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 of 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 how Cap Rates work (link to cap rate/NOI article) in detail before.
For our purposes here, just 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.
Normally, there is very little movement in A/B cap rates over a 2 to 3 year period. They usually 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 we have today.
As cap rates increase and debt costs increase, values usually decrease.
The Current Opportunity
Multifamily demographics continue to hold up. Rent growth has slowed down, but it’s still tough to find and or buy a home. Essentially, resident demand, as a whole, is still strong.
So, if you currently hold multifamily assets, just wait it out the turbulance. Wait for cap rates and debt costs to decrease before any disposition plans. For example, within our portfolio, we have no loans coming due until 2027.
As a buyer, though, based on the key 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.