There is a lot of talk about interest rates lately. We started with 0% interest rates this year. We are now at approximately 1.5% interest rates in a matter of months. This has sent shockwaves into the financial community. It may not seem like much, but a 1.5% increase in interest rates can have significant impacts on the cost of debt.
Our economy over the last several decades has seen an explosion in debt from government spending, stimulus, cheap money, student loans, ease of credit, etc. The ability to take money from the future and pay back at near zero interest rates has caused a debt bubble. This has likely led to asset inflation which we are now seeing the air let out in the stock market.
Interest Rates
To help better explain the affect that interest rates have on debt it would be beneficial to look at a multifamily property bought with a bridge loan. Last year bridge loans were readily available, and lenders were willing to offer 80% leverage with a low floating rate. Say you purchase a $25MM property that has an NOI of $1,000,000 per year. You bought the property at a 4% cap rate which is not uncommon in the last year.
Now, let us say you took a $20MM loan out to purchase the property or 80% of the purchase price. A typical bridge loan has floating rate debt where you pay interest only. That means each year you pay your loan amount times your interest rate. Divide that by 12 and that is your monthly payment. With a sudden increase of 1.5% in interest rates, you now owe an additional $300,000 per year to pay for the debt depending on if your rate is capped or not.
You can now see a small rise in interest rates has a significant effect on leveraged assets.
Leverage
Moving forward, leverage is not going to be as high with this amount of uncertainty and a Federal Reserve that is signaling rate hikes until inflation comes down. The bridge lenders are looking for higher debt yields going in and higher debt yields on year 3 for a safe exit. The going in debt yield is now around 6% or higher and the exit debt yield on year 3 is 8% or higher. The lenders are looking for these debt yields so that you can successfully meet a 1.25 DSCR on year 3 to exit into permanent financing.
The bridge loans gave the market the leverage to increase the asset prices and now that the leverage is being taken away and the cost of capital is increasing, the valuations are taking a temporary pause or drop in some cases.
Cap Rates
Cap rates were burning below 4% in Q1 of 2022. It seemed like a race to the bottom as more buyers were competing in the marketplace to get deals. The 10-year Treasury was well below 2% so there was still a decent spread between the cap rate and the 10-year. Now the 10-year has doubled since the beginning of the year, and it looks to move higher with increased rate hikes.
What does this mean for cap rates? Historically cap rates for multifamily need to be above the 10-year treasury because there is risk for owning real estate. The 10-year treasury on the other hand is what is considered a risk-free rate because it is backed by the faith of the US Government. The only way cap rates will continue to compress is if buyers are willing to pay the same prices that they have been paying.
My guess is that with increased costs of capital, rate caps, taxes, expenses and insurance, buyers will not be able to afford multifamily at the sustained levels at the beginning of the year. This means that cap rates will likely have to move up for the returns to be worth the risk.
Rent Growth
With all the increased costs, rent growth continues to be strong. There is still double-digit percent rent growth on average across the country. This helps with the NOI hit those properties are going to take with the rise in interest rates.
Hopefully, the owners and operators of multifamily properties can hold on long enough to increase the NOI to overcome current struggles or the properties have appreciated so much that they are still in the money if needing to sell or refinance.
Buyer’s Market?
The good news for anyone that has wanted to get into multifamily or wants to continue buying, the market has been shifting in favor of the buyers. As lenders start requiring rate caps, lower leverage, and higher spreads, the buyer pool has started to shrink. There are less Confidentiality Agreements being signed to look at properties, less property tours, and less buyers on best and final.
This means there is a window for buyers to acquire some nicer assets if willing to take on risk in the current environment. The calculations being done now have to be based on all the increased costs. You will need to factor in about 60% to 65% leverage with a going in debt yield around 6%.
The interest rate used on a fixed basis currently lands between 5% and 6%. The floating rate spreads can be anywhere from the high 2’s with Freddie Mac for nicer assets to the mid 4’s and above on older assets using a bridge lender. Depending on how much rate cap you buy, you will have to factor in the all-in rate which could be 6% to 7%.
Conclusion
Rising interest rates have a significant impact on a levered economy. Debt that does not cost money to carry inflates the price of things. Now that it is reversing, the cost to carry that debt begins to affect values. Expect interest rates to continue to rise as inflation worsens. If inflation starts going down and the Fed starts backing off, then we will see a reversal with a lowering of interest rates.
It is important to understand the costs of capital and the overall expenses when operating a multifamily property. Those who can operate well and increase NOI while limiting expenses, should continue to do well. Things can also change quickly so always be prepared. At the beginning of the year no one thought we would be at 1.5% interest rates right now. Deals will continue to get done if buyers buy based on cash flow.
