Jamie Dimon, CEO of JPMorgan Chase in a recent press conference said the 10-Year Treasury could reach as high as 7%. That puts agency financing around 8.5% to 9%.
Anyone buying a multifamily property seeking positive leverage will require a 10% cap rate. However, there will be no sellers at that cap rate.
I made a graphic over 6 months ago showing cap rate sensitivity. It shows asset prices as cap rates expand or compress based on $1,000,000 of NOI.
If cap rates start to expand past 6%, the equity in deals bought in late 2020 and beyond is going to be wiped out completely. The originator of the senior debt will also take a hit if they expand much further.
A deal with $1,000,000 in NOI at a 10% cap rate would sell for $10,000,000. A deal purchased on 80% bridge money maturing in the next 6-18 months faces extreme pressure.
While 10% cap rates likely won’t trade, a 6% to 7% cap rate trade still has LP’s holding the bag as well as the lender.
Read More: Looming Multifamily Maturities in 2023 – James Wilson
Inflation Data
The FED’s favorite inflation data metric, personal consumption expenditures price index (PCE) rose 0.4% in April. It rose 0.1% in March, convincing investors the worst is behind us.
With inflation proving stickier, the next FOMC meeting is likely to see another 25-basis point hike. The FED needs positive real rates to fight inflation, i.e., the rates need to be higher than inflation.
PCE being 4.7% year over year means that we are barely in positive real rates because the Fed Funds Rate is only around 5%. If inflation rises any further the FED will have no choice but to keep raising rates.
The pause that everyone is hoping for likely will not materialize in the short term. This puts further upward pressure on maturing rate caps and rate cap escrows.
Debt Ceiling Agreement
The agreement between the President of the United States and the House Speaker suspended the nation’s debt limit through 2025. There is a lot of rhetoric back and forth but essentially it means they are going to keep spending.
This really does nothing to help inflation and leaves the FED with an uphill battle. It also leaves investors in a bind because they cannot cut rates if inflation keeps rising.
Survive to 25’
“This is not your grandfather’s inflation.” Real estate was properly priced in the 1980’s. There’s been 40 years of financial distortion. Real estate has been pushed to the max by lower interest rates.
To bring inflation under control, real estate values are going to be under tremendous downward pressure. Go back to the cap rate sensitivity chart above. If you bought at a low cap rate and must sell at an expanded cap rate, there is no hedge.
The only hedge is if you can hold real estate for the long term. This is where the survive to 25’ mantra comes into play. The way things are shaping up it could be survive to late 25’ and maybe 26’.
2023 seems like a slog of an inflation fight and 2024 looks like another 100+ basis point cap rate expansion if not more.
Conclusion
If you own real estate, you should sell now while cap rates are reasonable or be prepared to hold for the long term. Start making every effort you can now to shore up the balance sheet of your assets and get into longer-term financing.
Real estate is an inflation hedge, but not if you must sell during an inopportune time. I could be wrong, but I would not expect a drop in rates any time soon. Be prepared to win in a rising interest rate environment and benefit when they start going down.
