Interest Rates Just Don't Matter in Multi-Family

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Interest Rates Just Don't Matter in Multi-Family

Robert C.
Investor · San Francisco, CA · Member since 2016 · 338 posts · 444 votes

I thought I'd start a discussion about rising interest rates, because quite honestly I'm not hearing that much about it, and I'm wondering why. From what I'm observing, it's like the elephant that's NOT in the room, even though I'm POSITIVE every investor is privately obsessing over the rates as they put together their pro formas. 

I saw @Ben Leybovich put together a blog post back in February and the rates have only gone up since then, +1.25%-1.5% since last year. And I believe @Sam Grooms, made a mention in their trending success story (98-units Closed).

Here's the pickle... The MF interest rates have clearly gone up and are expected to continue that trajectory. However, at least in my neck of the woods, there's been no change in the cap rate expectations, and in some areas investors are paying even more. What gives?? What are you all seeing in multi-family? 

Here are some of the theories I'll throw out there to start the discussion:

1.) The market just hasn't caught up... I felt more strongly about this explanation earlier in the year, but it's been a while, and the Fed has clearly indicated where it's headed.

2.) People are getting stuck in 1031 land, and they have to compete for still limited supply.

3.) The short term trend in the achievable rates are slightly downward these past few weeks, and people are waiting to see what happens.

4.) Investors think we're headed for a crash, and the only lever the Fed has is to lower interest rates again. 

5.) Everything is going to keep going up - values and rents! (I don't really see how this is possible in the bay area for now, and the rents have already stalled).

Clearly, there is movement in the single family arena, which makes sense, so I'm talking explicitly about MF. I would love to hear some feedback. Are you seeing the same thing in your markets? What do you predict?

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Bill F.
Investor · Boston, MA · Member since 2015 · 1k+ posts · 3k+ votes
8y

@Robert C. will RE being very localized it is a tall order to come up with a story that fits all MF throughout the country and without being a macro-economist everything we say is just a guess. 

The simplest explanation is that the market still has lots of over exuberance and people simply don't care about rates. Why let a little thing like borrowing costs get in the way of a good time?

As a tool of monetary policy, are not meant to slam the breaks on an economy, but merely slow it down by making deals at the margin less attractive, mean that you shouldn't expect a systemic change quickly. Also, lending rates haven't been going up in a lock step 25 basis point per quarter. Look at the FF Rate and 10yr spread.

Finally, its important to remember that interest rates are driven by the market and not directly by the Fed Fund Rate. The US being pretty much the only economy that is safe and large enough to absorb massive amounts of capital, so foreign cash, from China, Russia, Brazil, South Africa... floods into the US and invests in both the bond, equities, and RE market; driving prices up and yield down. Again looking at the Fed Funds Rate, 10 yr  Treasury, and their spread helps illustrate this point. Another way to look at Cap Rate is as a signal of perceived market risk of the underlying asset. The US s less risky than other markets. Welcome to a global economy, your iPhones cost less, but yields/returns suffer.

Another idea is that since the fed is so transparent with their planned rate hikes, the market already takes them into account before they happen... 

 Or it could be something else entirely... who knows. I just add 75 basis points points per year to my refi projections when I model. I don't know what "new normal" rates look like, but they will most likely be higher than current ones. If the deal pencils at 9% it will work at 8%.

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    8y

    @Robert C. It's always interrelated.  If interest rates rise then rents have to rise to meet lender obligations or there will be a crash (or at least a fender bender)

    In order for rents to rise there must be an associated increase in wages to cover those rents (Rentors move locations not rents).

    In order for there to be wage increases there must be an increase in the money supply (either velocity or actual dollars).  each of these come from inflationary practices.  Unemployment ain't going to ever be better than it is today.  There's only one way to go.

    Inflationary practices lead to - higher interest rates on everything and higher cost of living which both negatively impact rentors ability to pay more rents.  

    And the circle goes on and on and on.

    Why two of the most important 1031 strategies are...

    1. the ability to change sectors in anticipation of a correction or lack of inventory in the sector you are currently investing ( e.g. MF to SF)

    2. The ability to separate cash and debt so the smart investor over time eliminates debt risk from an increasing % of their portfolio but maximizes leverage to gain best market returns on the rest while not putting their cash owned asset portfolio at risk.

    It's kind of a paradox but while leverage is the most powerful tool of the 1031 investor, smart 1031 investors are never held hostage by leverage.

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  • Sam Grooms
    Investor · Phoenix, AZ · Member since 2017 · 583 posts · 919 votes
    8y

    @Robert C., I'm very curious to hear people's thoughts on this. 

    Another theory I've had for Phoenix (it sounds like this wouldn't hold for the Bay Area), is that the fundamentals have only gotten stronger over the last year. Phoenix rent growth is projected to be higher this year than the last two years. We're seeing some of the strongest population and job growth in the country. New construction hasn't caught up, and occupancy is still at all time highs. 

    As for the country as a whole, I'm not sure why cap rates haven't started to move. It could be that there's still so much cash out there, people are willing to accept lower and lower returns, so that it doesn't get eaten up by looming inflation. 

    1Reply
  • Dennis M.
    Rental Property Investor · Erie, PA · Member since 2018 · 6k+ posts · 9k+ votes
    8y
    You can thank the people mortgaging 300k to get a100$ profit a door . It’s supply and demand .in a hot market investors pay big bucks for little reward hoping and praying it’ll stay the same or go up
    1Reply
  • Robert C.
    OP
    Investor · San Francisco, CA · Member since 2016 · 338 posts · 444 votes
    8y
    @Dave Foster, so it seems you and @Dennis M. are saying crash and right now the market is just dangling on borrowed time. The interrelated-ness makes total sense but I guess I’m wondering why it hasn’t kicked in at all yet. Also, Dave, wise words about not being a slave to leverage. @Sam Grooms, I can understand much better if your market is expecting further rent increases. At least there’s a rational for buying at a lower cap because you have the wind at your back. In the Bay Area, you can’t expect the rents to go up anymore. My most recent MF play is a reposition strategy to hit a higher paying renter. It feels riskier than previous though because rents are generally flat and I do feel the squeeze from rates while in the remodeling phase!
    0Reply
  • Bill F.
    Investor · Boston, MA · Member since 2015 · 1k+ posts · 3k+ votes
    8y

    @Robert C. will RE being very localized it is a tall order to come up with a story that fits all MF throughout the country and without being a macro-economist everything we say is just a guess. 

    The simplest explanation is that the market still has lots of over exuberance and people simply don't care about rates. Why let a little thing like borrowing costs get in the way of a good time?

    As a tool of monetary policy, are not meant to slam the breaks on an economy, but merely slow it down by making deals at the margin less attractive, mean that you shouldn't expect a systemic change quickly. Also, lending rates haven't been going up in a lock step 25 basis point per quarter. Look at the FF Rate and 10yr spread.

    Finally, its important to remember that interest rates are driven by the market and not directly by the Fed Fund Rate. The US being pretty much the only economy that is safe and large enough to absorb massive amounts of capital, so foreign cash, from China, Russia, Brazil, South Africa... floods into the US and invests in both the bond, equities, and RE market; driving prices up and yield down. Again looking at the Fed Funds Rate, 10 yr  Treasury, and their spread helps illustrate this point. Another way to look at Cap Rate is as a signal of perceived market risk of the underlying asset. The US s less risky than other markets. Welcome to a global economy, your iPhones cost less, but yields/returns suffer.

    Another idea is that since the fed is so transparent with their planned rate hikes, the market already takes them into account before they happen... 

     Or it could be something else entirely... who knows. I just add 75 basis points points per year to my refi projections when I model. I don't know what "new normal" rates look like, but they will most likely be higher than current ones. If the deal pencils at 9% it will work at 8%.

    2Reply
  • Samuel Glantz
    Peoria, AZ · Member since 2018 · 55 posts · 24 votes
    8y

    If I may enter a little guy perspective. Interest rates on a sub $150k loan don't matter that much monthly payment wise. Until it hits 6%, I am not too concerned with the rate. To me its still a great time to get into the market. Yes 3.5% would be better but there is still a lot of profit potential at 5% and 6% for smaller loans at least. I can not comment about larger ones. 

    0Reply
  • Russell BrazilBusiness Member
    Moderator
    Real Estate Agent · Washington, D.C. · Member since 2012 · 17k+ posts · 30k+ votes
    8y

    Interest rates are still at the historically low end of the range.

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  • Robert C.
    OP
    Investor · San Francisco, CA · Member since 2016 · 338 posts · 444 votes
    8y
    @Bill F., 8%-9% would be a dream in SF Bay! But that underlines your point about not having uniformity nation wide. With caps that high you definitely have wiggle room. I’m certainly not looking for a cohesive response, but I am curious how things look across the country to see if there might be any warning signs. And of course I’m always interested in other perspectives. I would have expected locations like mine to react first given the maturity of the market and having had a couple years sooner recovery compared to most places. I mean, we’re talking 3.5%-4.5% caps on average, maxed out rents, and plus higher interest rates. There shouldn’t be wiggle room, but folks are still in the game.
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  • Bill F.
    Investor · Boston, MA · Member since 2015 · 1k+ posts · 3k+ votes
    8y
    Originally posted by @Robert C.:
    @Bill F., 8%-9% would be a dream in SF Bay! But that underlines your point about not having uniformity nation wide. With caps that high you definitely have wiggle room. I’m certainly not looking for a cohesive response, but I am curious how things look across the country to see if there might be any warning signs. And of course I’m always interested in other perspectives.

    I would have expected locations like mine to react first given the maturity of the market and having had a couple years sooner recovery compared to most places. I mean, we’re talking 3.5%-4.5% caps on average, maxed out rents, and plus higher interest rates. There shouldn’t be wiggle room, but folks are still in the game.

    Sorry for not being clear, I meant 8-9% interest rates. My bad.

     I also sort of disagree that 8-9% would be a dream. 

    First off, that probably means some drastic shock has happened in the markets. What that could be? We can only speculate, but its likely not good. 

    Second, Cap rates get a lot of attention on here BP with the common refrain being something like "OMG look at cap rate compression! We are in for 2008 all over again!!" but when you dig a little deeper that person is still full invested in the market and actively looking for deals. So what they really are saying is something to the effect of "I'm upset that I can't get deals like were available in 2009-2012"

    This train of thought misses the point that the purchase Cap Rate can only tell so much of the story and depends on a host a factors that aren't obvious at first glance.  Sure, buying core MF asset or a mall in Iowa at a 3 Cap is expensive because the upside is limited. But if you are a Argentinian energy mogul who is worried about the government defaulting on its debt again you really only care that you beat inflation and your money if safe. Different stroke for different folks and goals matter. 

    On the other hand, buying a value add B class 100 unit mixed use building in a closed city at 5 cap sounds crazy to a lot of folks on BP, but if you can come in and, using your established systems and process, clean up some units, narrow the loss to lease, cut energy use through software updates, pretty soon you the same property now yields a 8 Cap. Still a crazy buy? 

    Point being, unless you see the underwriting and the plan, it can be hard to figure out exactly what the play is on some if these deals. Not trying to say that people aren't over paying, but maybe not to the extent that we would all like to think.

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  • Michael Gansberg
    Investor · New York City, NY · Member since 2015 · 388 posts · 563 votes
    8y

    Hi @Robert C. - I'm seeing pretty vigorous buying activity where I operate(primarily the Capital District in NY.) One way some investors might look at it is this:

    1. Interest rates are rising, making loans more expensive.

    2. But they're rising in an attempt to stifle inflation. So investors, expecting inflation, are willing to pay more for an asset because they(like the Federal Reserve) believe the rents supporting the asset will rise, which has largely borne out in my market over the last few years. 

    Think of it this way- the investor can get a fixed-rate loan. Inflationary pressures incentivize just that- while the investor's loan costs are(or can be) fixed, rising rents can really goose returns and protect the investor against inflation.

    This path that we're taking was easy to see coming- we've had accommodative monetary policy for about a decade, and just when the economy hits full employment, we get accommodative fiscal policy as well, which  in tandem with easy monetary policy and full employment should generally cause inflation, or rising interest rates, or both. The people running things right now are not the sharpest tools in the shed. 

    0Reply
  • Robert C.
    OP
    Investor · San Francisco, CA · Member since 2016 · 338 posts · 444 votes
    8y

    @Bill F., I always hesitate using the phrase "cap rate" on this forum because I know it triggers heated discussion. I do think that most people who own a couple multi-families have an intuitive understanding of what a cap rate does and doesn't say, even if they can't explain it very well in writing. In this case, I'm just referring to it as a measure of the initial return from which you can infer whether someone is starting out in a greatly positive or negative leverage situation.

    Anyway, you have good points that I agree with, but I have to admit it's not very satisfying to just go with the "every deal is different" explanation. Just speaking from personal perspective, if you're someone like me who buys local and knows the players, you pretty much know what can and can't be done with the properties. You also know who's buying them, which is really what makes me scratch my head and say "really, you paid how much for that?..."

    I'm trying to think of a way to reframe my question, since there is clearly great variance across the country. Even so, I do like asking this kind of stuff on Bigger Pockets, because I realize that the Bay Area is a special sort of place that can warp my perspective on things. 

    @Michael Gansberg, Thanks for the interesting feedback. Certainly inflation is another factor to consider. In my area, I wonder if it's still doing anything more to the rents, and can rents go any higher without more significant wage growth? And what kind of gamble are we investors making, when most MF loans are only locked in for 5-7 years?

    0Reply
  • Michael Gansberg
    Investor · New York City, NY · Member since 2015 · 388 posts · 563 votes
    8y

    @Robert C. - I think national inflation generally plays second fiddle to trends in local real estate markets. It's likely more than background noise, but less than a primary driver(this is personal intuition speaking, not something garnered from hard data.)

    But inflation is one of those situations where perception becomes reality. If you think assets will inflate in value, what do you do? Convert as much cash as possible into assets that benefit from inflation. In other words, gobble up real estate like Godzilla. Now we're seeing inflation in the numbers- 2.9% year over year, handily outpacing wage growth of 2.7%(feel conned yet, certain voters from 2016? Maybe you should.) And what's the main goal of the Federal Reserve? Take away the punchbowl just as the party is getting started. I think the Fed chairman left the punchbowl out a little longer than past Fed chairpersons would have.

    I guess the short of it is this- if inflation continues at the current pace, owners of real estate should generally be beneficiaries of that inflation, and renters will generally suffer. But to your question above, Robert- growth in wages can certainly keep upward pressure on rents.

    Where does it all end? The divide between rich and poor will widen in the above scenario. The rich may feel good about it now, but when it continues for too long, it tends to rend the societal fabric upon which we depend- and it isn't too long before the "have-nots" show up at the door with pitchforks. I think November 8th, 2016, was an early display of pitchforks, though the wielders likely anticipated a populism which has not been forthcoming.

    1Reply
  • Mike Dymski
    Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
    8y

    Rising interest rates have been discussed ad nauseam on the BP forums and in every real estate periodical; so, it's front and center.

    Rates were at stupidly low levels that there was gap before an increase even mattered.  It certainly will matter going forward as the artificial stimulus goes away.

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