High interest rates are stressful. But don’t expect rising interest rates to break the bank for many apartment investors—even as some are forced to refinance lower interest loans with new, high-interest debt, according to economists.
“I don’t perceive there will be a ton of defaults,” says Dave Borsos vice president of capital markets for the National Multifamily Housing Council, based in Washington D.C.
Interest rates are now that highest they’ve been in years and they are likely to get a little higher as federal officials try to tamp down rising prices by making it more expensive to borrow money.
It’s already working in the apartment business. Investors are much less likely to buy new apartment properties as buyers and sellers argue about what cap rates should be with higher interest rates.
“Higher rates reduce the amount of leverage a property can support and thus squeezes return on investment to owners,” says Kelli Carhart, head of multifamily debt production for CBRE, working in the firm’s offices in Austin, Texas. “Although it’s not a 1:1 ratio, cap rates rise and values decrease over time with higher commercial mortgage rates.”
Federal Reserve officials hiked up their target for the short-term Fed Funds rates another 75 basis points in their September 2022 meeting, to a range of 3.25 percent to 3.0 percent. That’s up from close to zero during the coronavirus pandemic. And the Fed is not done yet—bond investors are betting on another 75-basis-point rate hike in November.
“The (Federal Open Market) Committee has said policy rates will increase further,” said Fed Vice Chair Lael Brainard October 10 in a prepared statement. But “we also will be learning as we go and that assessment will reflect incoming data.”
Interest rates will continue to rise until Federal Reserve officials like Brainard believe that the pace of inflation has sufficiently slowed. But the most recently monthly results still showed a year-over-year inflation rate north of eight percent.
“The Fed is primarily concerned about taming inflation,” says Carhart. “While a global or domestic disruption event could change the course of increases, right now the Fed is resolute on its position to continue the course of hikes throughout 2022 to the tune of 150 basis points.”
Fed officials have already transformed the interest rates paid by apartment investors.
Most long-term, fixed interest rates are based on the benchmark yield on U.S. Treasury bonds, which climbed to 3.83 percent for 10-year bonds on Thursday, October 6, down only slightly from 3.97 percent a few days before. That’s the highest the benchmark rate has been since 2008, and up from well under 1.0 percent for nearly all of 2020.
Accordingly, interest rates paid by many apartment investors for new fixed-rate loans are now higher than 5 percent for the first time in years.
“The last time the average 10-year fixed mortgage was north of 5 percent was 10 years ago,” says CBRE’s Carhart. “Though historically speaking, the current rate environment is not egregious. We have been the beneficiary of historically low rates.”
The good news for investors is that we may be approaching the end of interest rates hikes with some signals showing that inflation may be on the verge of cooling with leading indicators such shipping costs and commodity prices dropping in recent weeks.
“The economist consensus is that the 10-year will settle closer to 3 percent,” says Carhart. “With a recession likely in the first quarter of 2023, investors seek safety in the 10-year in a downturn… That is traditional behavior. If those forecasts hold, all-in coupon interest rates for apartment properties will hover closer to 5 percent.”
Refinancing can be hard, sometimes
Investors face the greatest challenges if they need to refinance loans with floating interest rates. “In the worst-case scenario, a floating rate loan matures, but the properties is not in a position to take on long term perm debt and has to do a new floating-rate loan,” says Borsos.
Several large, national banks have cut back on their lending to commercial real estate properties. Private equity debt funds that once filled in the gap for properties needing financing have also been much less able to make loans.
“Debt funds are now exceedingly expensive—now all-in interest rates are typically around 9 percent from a debt fund,” says NMHC’s Borsos.
Investors face much less difficulty if need to replace a permanent loan with new fixed-rate financing. Older loans probably have fixed interest rates similar to today’s. “Five or six or seven years ago interest rates were probably at the same level as now,” says Borsos.
Properties that, for one reason or another, need to refinance a more recent loan with a fixed interest rate are more likely to face an increase in their interest rates. But those more recent loans are also likely to be lower leverage.
“Over the last few years people have not been leveraging their properties,” says Borsos. In past, properties that fell behind in their loan payments often had high-leverage loans that covered 85 percent or 90 percent of the value of the property. “Most of my members have been taking out 55-percent loans,” says Borsos. “There is a lot of equity in there.”
Even if rates rise much higher than expected in the fight to beat inflation, apartment investments would probably survive, says Borsos. Investors are likely to hunker down and wait for the capital markets to get back to normal, he says.
“If Interest rates go to 9 percent, things are going to grind to halt,” says Borsos. “But people wouldn’t think that rates are going to stay there.”
The strong performance of multifamily properties is also likely to keep investors committed to their apartment properties.
“Underlying multifamily fundamentals are still strong and returns have been excellent. Housing is still undersupplied and the cost to own versus rent has never been larger,” says CBRE’s Carhart. “While we may see a temporary pause, as soon as market stability returns, investors will feel comfortable deploying capital in one of the best inflation hedge asset classes.”
Source: Wealth Management