CREJ - Multifamily Properties Quarterly - February 2017
The 10-year Treasury rate ascended more than 70 basis points in the two months following this year’s presidential election. The Federal Reserve stated its intent to increase interest rates throughout 2017. Freddie Mac and Fannie Mae loan programs were created by Congress to perform an important role in the nation’s housing finance system – to provide liquidity, stability and affordability to the mortgage market. They provide liquidity (ready access to funds on reasonable terms) to the thousands of banks, savings and loans, and mortgage companies that make loans to finance housing. These two loan programs have had the biggest jump in their interest rates, as these two loan programs are directly connected to these long-term metrics. Many multifamily investors were once enamored by new low interest rates. Now, many multifamily investors have become desensitized and spoiled by interest rates under 4 percent. The days of interest rates in the low to high teens do not seem to be impending, by any means. However, the chances of interest rates being higher five years from now seems much more feasible, given the historical trends of interest rates. In the mid-2000s, we were in an interestrate environment that typically cost the investor in the mid-5 to low-6 percent range. These rates, although historically low for the time, seem to be the direction that the Feds want to incrementally achieve again. Multifamily assets have started to and will continue to be affected by rising interest rates. The question that remains in the minds of many multifamily investors is: When and by how much? We have seen, especially in the newer multifamily product, values dropping to as low as 8 to 12 percent just in the last 90 days alone. Investors are considering buying a 4.25 to 4.75 percent cap rate with debt levels above 4 percent. With the threat of increasing interest rates, the effect is to either retract their plans to purchase or, at the very least, rethink their investment strategy. Larger, more institutional capital with “patient money” could afford to chase smaller margin deals that only yielded 3 percent returns. Those returns continue to shrink and several institutional capital firms now are contemplating a holding pattern. Even if the holding period becomes a wait-and-see attitude to keep capital on the sidelines until there is more certainty, clarity or direction with the new administration to achieve some degree of positive leverage, cap rates must, at some point, fundamentally retreat backward. This could equate closer to a 5 percent cap rate, depending on the product and proximity to the core and transportation-oriented development areas for newer built product. To put that into perspective, this equates to about a 10 to 12 percent decrease in multifamily asset value! Recently built apartment buildings are realizing less and less rent growth as more competition comes to the market. Although demand seems to be steady, concessions are occurring in many new projects and a month (or two) may be the new norm. In the future, this translates to investors drawing back on what they were once willing to pay for an apartment investment property. The different apartment building classes will not experience these changes in the same way. When it comes to Class B and Class C apartment buildings, the effect may not be seen as immediately or dramatically as the Class A apartment buildings. One could make this conclusion because Class B and C apartment assets trade with higher cap rates due. In the current Denver multifamily climate, older multifamily product is trading in the low 5 percent cap rate up to the high 7 percent range, depending on the property’s location and condition. For example, a B product in the core could trade at a 5 percent cap rate or even lower in some cases. The strategy in this example is to buy, renovate and achieve not only rents that are more competitive than the A product but also a higher end yield than the A product purchases. In terms of B and C properties, the delta in interest rate to the cap rate ratio allows for the increase in interest rates to be absorbed without the dramatic increase to cap rates. Value-add types of multifamily product also feel pressure. Proforma rents are becoming more of an unsure measuring tool for stress testing the sufficient future returns on an older renovated property. At some point, the concessions for the A product trickle down to the B and C product to compete with the highly amenitized newer construction product. For example, if the rent for a one-bed, one-bath in central Denver that was built in 1970 pushes to $1,200 and has very little amenities, such as no parking and only a laundry room for a perk, that property could be competing against a one-bed, one-bath new construction that has parking, a dog wash, a lazy river and a balcony for $1,700 with two months’ free rent, yielding the tenant a net savings. That scenario transpires into the Class B building lowering rent, etc. This has happened before in our market, and we know history repeats itself. To conclude, Class B and C multifamily asset types will have a stronger outlook moving forward than the Class A product in terms of rent growth. Developers are simply unable to build what would rival Class B and C product due to available and affordable land, not to mention the development’s hard and soft costs. In the past, interest rates have allowed values to continue to climb upward at a staggering rate. This will continue to be a main point of discussion along with how values can be softened.