Heading Into Fall, It’s NOI or Interest Rates?

Multifamily is currently 'the darling' of commercial real estate finance, observes Gantry's Blake Hering.

Blake Hering

As we approach the waning days of summer, one of the key questions for apartments owners is: Which falls faster: interest rates or net operating income? Certainly, the hope is that interest rates will begin to pull back. Unfortunately, however, with rents moderating and expenses on the rise, the dip is most likely to occur sooner and more noticeably in net operating income.

2010 to 2020 was the longest sustained period of economic expansion in U.S. history. And it was the Golden Age for commercial real estate. Money poured in from sources far and wide, saturating the market with equity and debt. Values were fueled by strong demand, solid property performance, ever-lowering interest rates, and a steep descent in the perception of risk and, thereby, capitalization rates.

CRE became a ‘must-have’ in investment portfolios, and even former dabblers were soon scaling their operations and creating tremendous wealth. What was not to like?

Covid precursor

Covid sent shock waves through the market. What exactly was a Global Pandemic? Who and what survives? Most of us headed home and refrained from human contact. Not a good proposition for businesses, nor the commercial real estate that houses them.

But money was plentiful and low cost. In March of 2020, the Fed funds rate was 1.50 to 1.75 percent. The Fed then cut rates twice that month. By April, the Fed funds rate was 0.05 percent. Our physical health may have been at risk, but Uncle Sam bolstered our financial immunity with cheap capital.

And plenty of it. On the 15th of March, the fourth round of quantitative easing began with monthly purchases of $80 billion of agency debt and $40 billion of mortgage-backed securities. This was a significant infusion of capital to the marketplace. When all was said and done, the Department of the Treasury spent over $1.6 trillion alone. Additionally, the SBA spent $963 billion, and the Department of Labor spent $701 billion on Covid-19. It was almost two full years of full-spigot spending to the tune of roughly $3 trillion.

The buck stops

By early 2022, it appeared our collective financial well-being was sound. And with the market awash in capital, not surprisingly, the cost of goods and services had gone up. And costs were now rising at a healthy clip. To avert runaway inflation, the Fed initiated their first rate increase of 25 BPs in March of 2022, then +50, then +75 four times, then +50, then four more at +25. At July’s Federal Open Market Committee meeting, the Fed raised rates to a new 22-year high of 5.25-5.50 percent.

But that’s not all. Quantitative Tightening, the extraction of funds back out of the system, began in early 2022 as well. The Fed has been reducing its balance sheet by roughly $90 billion per month. How long this will last is anybody’s guess, but this appears prudent as the Fed’s balance sheet had gone from from $1 trillion pre-GFC, to $4.5 trillion by 2016, then ballooned to $9 trillion during Covid!

Bank woes to boot

After we’d begun to regain our footing from Covid-19 and braced ourselves for a steady climb in interest rates, we then experienced the third largest bank collapse in US history. Silicon Valley Bank ($209 billion) on March 10, 2023, followed two days later by the fourth largest bank failure in US history in Signature Bank ($110 billion). Shortly thereafter, First Republic Bank ($212 billion) began to list sideways before failing on May 1st as the second largest bank failure in US history.

These collapsed financial institutions signaled two important messages: short-term deposits don’t belong invested in long-term assets, and longer duration bonds and Treasuries aren’t liquid enough when cash is needed at the speed of a modern bank run.

The sustained rise in rates had slowed and muted markets. These collapses revealed how dramatically asset values had changed. The fact that these were the second, third, and fourth largest banks to fail within a 90-day period, means that the world of banking will now be very different. At minimum, reserve requirements will go up, regulations will increase, and the tolerance for risk, or longer-term investment, will diminish meaningfully.

What does this mean for CRE Lending?

Luckily, this is an article about multifamily lending. Because frankly, the picture for office lending is bleak. Urban retail is not much better. Industrial is mostly positive. And apartments? Well, in the CRE space, they remain a darling.

Sure, there are some blemishes, but by and large, housing is much needed across the country. And apartments, because of their diverse income streams, rapid mark-to-market lease terms, and because housing, for most of us, is not optional, remain perpetually viable.

Generalizing about apartment performance is impossible because all markets, submarkets, and individual assets have their own characteristics. However, big picture trends reflect that occupancy remains solid despite the emergence of concessions in many markets. Rents are leveling off from the growth trends of recent years though not losing ground rapidly. Operating expenses appear to be the impediment to the project’s bottom line as categorical growth appears to be stubbornly resilient especially for utilities, turnover, R&M, and landscaping.

How to approach the market

Roughly $2 trillion of multifamily loans will be maturing in the next 18-24 months. Start early. Approach your existing lender/relationship first. There’s an old truism in this business: It’s a relationship business. We may have veered from this during the boomtimes, but it rings true now. From there, find the right mortgage banker. This would be the person you feel comfortable with, who listens and understands what you’re after, and has the network and experience to address your needs. It is this person who will help you establish your next relationship. Spend the time asking questions, answering theirs, and filling in the gaps. CRE debt is no longer a commodity.

What to expect

The universe of lenders is smaller. Banks, as mentioned, are less active. Same for credit unions. The agencies, Fannie Mae and Freddie Mac along with the life insurance companies remain the most active and reliable multifamily lending sources in the market.

Loans today are constrained by debt-service-coverage: a maximum of 80 percent of a property’s underwritten NOI can be applied to cover the debt. Deploying that sizing strategy means that, if rates go up, loan amounts go down. Since a property’s value is increasingly difficult to measure, the standard “loan-to-value” metric is harder to correlate. That said, I’d ballpark today’s LTV max at 60 to 5 percent.

As for rates, we’ve entered a new normal. With US Treasury yields currently in the 4 to 4.5 percent range, then loan rates equate to high 5 to 7 percent. This is not welcome news for most. But it is the world we operate in currently.

So, this brings me back to the original question of which falls most meaningfully: interest rates or net operating income? If you have debt needs in the next 12 to 24 months, this is a strong question to consider. Sure, we all hope interest rates will come back down. But what if property performance sags first? A lower NOI will result in a lower loan amount just as a higher interest rate will.

This is a time for thoughtful decision making on property performance and debt strategy. Bring in an expert to help navigate this new landscape—one who has your confidence—and trust the process.

Blake Hering is principal, Gantry.

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