The Cumulative Impacts of Higher Interest Rates
Stephen Sobin of Select Commercial Funding LLC on the outsized effects of the Fed's tightening.
Stephen Sobin
The Fed has raised rates 11 times and has indicated that there may be one or two more increases in store for us. The 10-year treasury rate (a benchmark for apartment lending) has jumped from 1.66 percent at the beginning of 2022 to over 4.60 percent at the end of September 2023. The Fed has further indicated that they do not see rates coming back down during the 4th quarter of 2023 or during 2024. They suggest that we might see a softening of rates in the spring of 2025. What is the effect on the multifamily sector and what are multifamily investors facing now as we near the end of 2023?
The level of sales activity in the multifamily sector has slowed drastically as the gap between sellers’ asking prices and buyers’ offers remains very wide. According to MSCI, the sales volume of apartment transactions totaled $55.6 billion during the first half of 2023. That volume is on pace to be the lowest annual total in over 10 years. The RCA Commercial Property Price Index for apartment prices fell 11.7 percent as further proof that economic conditions and higher rates are severely affecting the multifamily sector.
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After many months of stable cap rates, we are finally seeing an increase in cap rates (and therefore a drop in valuations) reflecting an investment climate that is starting to adjust to the realities of the market. During the first half of 2023, we have seen prices drop about 5 percent from 2022 full year levels, according to Marcus & Millichap. As a result, we have seen cap rates increase to 5.4 percent overall nationally, the highest level since before the pandemic. With current mortgage rates in the high 6 percent and low 7 percent range, there is still a wide gap between cap rates and interest rates. The cap rate differential will need to change significantly before sales volume returns to industry norms.
Apartment vacancy rates are also on the increase across the country. In mid-2023, the national vacancy rate stood at 5.3 percent and is expected to climb another 40 basis points to 5.7 percent by the end of the year. A rate of 5.7 percent exceeds the historic average of 5.5 percent. This is a very different number from the rate during the pandemic when apartment vacancies were at an all-time low. Higher vacancy rates are causing a drastic reduction in the rent growth rate. During 2021 and 2022, we saw a surge of nearly 25 percent in rent growth (fueling higher sales prices). We are now expecting rent growth at a very modest rate of 3.1 percent this year, below the long-term average of 3.8 percent.
Operating Expenses on the Rise
In addition to all this bad news for the sector, we are also seeing a disturbing rise in operational expenses, which are not being covered by the modest increase in rent growth. Besides ballooning debt service costs (because of higher interest rates), we are seeing drastic increases in insurance and utility costs in many parts of the country. Markets that are subject to natural disasters are seeing drastically higher insurance costs. Florida, Texas, and the Gulf Coast have been particularly affected by escalating insurance costs that have exceeded 100 percent in many cases. Other areas affected by tornadoes, earthquakes, mudslides, and wildfires have seen drastic increases in their insurance costs as well. In fact, insurance costs have climbed by at least 10 percent in 2023 in all but five of the major markets in the US.
In 2022 we saw the average rental growth exceed the increase in expenses by a 2:1 margin. Those trends have reversed in 2023 as operational costs grew 8.6 percent over 2022 levels, more than twice the rate of rental growth during that period.
We anticipate that higher vacancy rates, lower rental growth, and drastic increases in operating expenses will cause cap rates to climb and pricing to decline. Until seller expectations and buyer offers are more closely aligned, we do not see sales volume increasing from current levels.
Stephen A. Sobin is president and founder of Select Commercial Funding LLC, a nationwide commercial mortgage brokerage company. He is a proud member of the Inter-Capital.com, a nationwide alliance of commercial mortgage professionals.
