After two years in which the Federal Reserve expanded the U.S. money supply by an astounding 410 percent and kept interest rates at near zero to prop up the economy, the U.S. central bank is striving to battle inflation that has hit a 40-year high. That raises a pivotal question: Will those inflation-fighting efforts help or harm multifamily lending, investment and development?
In mid-June, the Fed instituted its third rate hike of the year, a 75-basis-point increase that was the biggest since 1994. That followed the June 1 start of the Fed’s plan to reduce its $9 trillion balance sheet, which had grown from $4.2 trillion over the past two years.
The Fed’s tightening, which began in March, had little effect on the red-hot multifamily sector in the first quarter, when buyers sank $63 billion into apartments, a 56 percent year-over-year increase and the strongest first quarter on record, according to CBRE. But since then, lenders and investors have become more cautious.
“To go back to a 10-Year Treasury yield of 3.5 percent or 4 percent should not be problematic for the economy or real estate business,” he said. “But when you’re going from near zero to those levels in two or three months, it’s going to create shockwaves and a lot of uncertainty.
“Is it going to get worse before it gets better? Probably. But the point is we’ve got to clean up what was a highly unusual response to a highly unusual shock.”
Volatility as the Norm
In previous periods of rising interest rates, lenders typically kept the cost of capital relatively stable by narrowing the spread above whatever benchmark rate was being used, noted Eddy O’Brien, co-founder of Blaze Capital Partners in Charleston, S.C. Today, however, lenders either have moved to the sidelines or are pricing more risk into deals.
“The magnitude of interest rate increases, the threat of a potential stagflation scenario and general stock market jitters are causing a little bit of a different reaction this time,” said O’Brien, whose Southeast-focused firm has a $400 million pipeline of acquisition and development deals. “There is a good bit of volatility in the loan pricing environment right now.”
That volatility has also been felt in the collateralized loan obligation (CLO) market, from which many bridge lenders draw their capital, said Shlomi Ronen, founder of Dekel Capital, a Los Angeles-based real estate merchant bank. The Secured Overnight Financing Rate (SOFR) ballooned from 0.05 percent to around 1.5 percent between January and the end of June, and CLO spreads have widened as buyers of the securities demand higher yields.
“In conjunction with the rate index increases, the volatility in the CLO market caught some investors off guard,” he added. “Everybody in the multifamily space has been running on what feels like full tilt for the last 12 to 18 months, and it appears that there’s a healthy reevaluation happening to determine whether assumptions going forward are still relevant or need to be adjusted.”
Rent Growth Hopes
At midyear, cap rates have yet to materially adjust to the rise in interest rates. As a result, buyers have become more cautious. Seller-friendly contract terms are disappearing as buyers reject demands for truncated due diligence periods and hard money the day a contract is signed, O’Brien said.
Still, transactions in which a borrower’s mortgage interest rate is higher than the capitalization rate of the asset being purchased are now occurring, observers say. The only way those negative leverage deals work out, they add, is if rent growth continues on an upward trajectory.
U.S. multifamily rental rates grew at a year-over-year clip of about 18 percent, Nadji said. While that pace of growth is unsustainable, rental housing demand should remain strong considering demographic trends and the fact that would-be home buyers are facing higher mortgage rates and median home prices, added Nadji, whose firm is forecasting cooler but still sturdy rent growth of 10 percent this year.
“I think there are reasons to be optimistic about apartment rent growth, especially when homes are becoming less affordable,” he stated. “Even if the Fed causes a recession, apartment demand and rent growth should stay very strong.”
Altering the Approach
In many cases, multifamily investors have changed strategies to account for the hiccup in the capital markets. Before this year, DB Capital Management, which owns a $500 million portfolio of primarily value-add assets in infill markets in Texas and the West, was selling properties well before the end of its average hold period to take advantage of a rapid rise in values.
But in acclimating to market uncertainty, CEO & Co-Founder Brennen Degner now anticipates keeping the assets for a more typical three- to five-year hold period. Additionally, instead of seeking bridge loans for 70 percent to 75 percent of cost, the investor is looking for leverage of around 60 percent and using SOFR swaps to reduce interest rate risk. And because bridge loan spreads offered by debt funds have increased, he’s also tapping bank financing.
“I’m still very bullish on all of our markets—people are always going to need an affordable place to live,” Degner said. “But we wanted to shift our debt strategies. For us, it has been a flight to quality in terms of debt structure.”
Developers looking for construction financing are adapting to changes, too. Design-build firm Ryan Cos. has seen financing increase significantly since SOFR has risen, reported Christa Chambers, senior vice president of capital markets for the firm. The company typically adds interest reserves to its financing packages to counter further rate increases, and it is keeping an eye on older loans to see ifthe SOFR increase will cause a shortfall.