In a rising interest rate environment, investing in real estate can still be profitable.
It’s just all about managing risks and expectations and, of course, using the right experience and judgements for all real estate investments when interest rates do begin to rise.
Rising interest rates
On Wednesday, May 4th, 2022, as expected, the Federal Reserve raised the Federal Funds rate by 50 basis, the largest single interest rate hike since May 2000. This has been part of the Fed’s ongoing strategy since at least December 2015, using rising interest rates, in part, to combat inflation, and was the second of seven planned rate rises for the year.
However, the de-facto central bank ruled out a larger increase of 75 basis points in the future, but further one or two 50-basis-point increases might be announced in the Fed’s next meeting on June 14th-15th, 2022.
Indeed, the effective overnight lending rate is expected to increase to around 2%-3% before the beginning of 2023 if such a strategy of the Fed continues.
Investing in real estate as interest rates rise
For many real estate investors, investing in a healthy economy when interest rates begin to creep up can present several issues to be addressed.
On one hand, a strong economic outlook is likely to yield higher rents as demand increases for, say, multi-family homes, especially in and around some of the larger cities. On the other hand, it also raises concerns about rising interest rates and the subsequent higher cost of borrowing.
Bearing in mind that the Fed has been adopting an increase in interest rate strategy for quite some time and forewarning real estate market participants accordingly, astute investors only really need to slightly adjust or shift strategies to be able to maintain their profit margins.
Possible impacts on of rising interest rates on multi-family investing
A number of multi-family investors have some primary concerns about the impact of rising borrowing costs and possible changes in apartment cap rates, which have been trending down over the last twenty years or so.
Indeed, it is expected that cap rates are likely to face some upward pressure in markets with lower rent growth projections such as in the major city markets. Yet other markets may see cap rates react differently as levels of demand are not homogeneous across all markets.
There may also be some knock-on effects for developers due to the increasing costs of construction material suppliers, with such costs being passed on to those building new housing.
6 reasons risks can be mitigated and why to continue investing in a rising interest rate environment
Having said the above, investing in certain real estate sectors such as multi-family housing when interest rates are rising can still be considered attractive
So, let’s have a look at how the overall benefits of making multi-family real estate investments despite rising interest rates which, certainly by historic standards, remain low:
- Continued rental growth as interest rates rise
Even though the consumer price index rose 7.1% in the year to 2021 and 7.9% to February 2022, rents for professionally managed multi-family apartments rose by a higher 10.5% in the last year for new leases and 8.1% for renewals.
The ability of multi-family apartments to command higher rents in most major metropolitan areas allows investors to realise optimal cap rates on new deals or boost net operating income (“NOI”) on existing assets. This is partly as the short-term nature of such leases are uniquely positioned to simply re-price rents during inflationary periods. This will, in turn, help offset higher nominal interest rates.
What’s more, demand for multi-family housing continues to push rental prices upward, thereby negating the increased cost of funding due to rising interest rates.
Obviously, not all multi-family properties will see the same rental growth. For example, gateway markets which have faced slowing rent growth such as in San Francisco or New York might see cap rates increase or a slower downward trajectory.
However, certain other markets with strong projected growth will likely see cap rates compress even further, owing to unparalleled housing demand amidst changes in demographic trends.
- High occupancy on continued demand
The multi-family apartment market continues to benefit from historically high occupancy rates as well as rental growth as mentioned above—again making cap rates decrease further.
In Q4 2021 multi-family apartment cap rates reached a low of 4.7%, down 30 basis points from the prior year, with many investors being forced to accept a lower premium for holding such properties.
- Real rates of return
Even though the most recent rise in 10-year Treasury rates was in response to higher levels of inflation, in reality there hasn’t been a major change to the real, long-term rate of interest.
If higher rental growth rates can offset borrowing costs and NOI, cap rates remain unchanged, cap rates can be thought of more as a real rate of return only affected by changes to the longer-term real interest rates.
- Correlation between cap rates and nominal rates
For many years, falling long-term interest rates have enhanced the value of multi-family apartments, meaning that cap rates have decreased. Whilst interest rates naturally influence borrowing costs for investors, the correlation between long-term interest rates represented by yields on the 10-year Treasury bond and multi-family apartment cap rates is not particularly strong.
- Value-add strategies offset rising interest rates
Once interest rates start to rise, investors can pay even more attention to enhancing the NOI of a multi-family apartment block and trying to compress cap rates. Acquiring undervalued properties and subsequently renovating them and/or fine-tuning the operational management is always likely to deliver improved returns to multi-family investors over and above the effects of an increase in interest rates.
Operational enhancement may include reducing overhead costs and/or reducing vacancies plus gradually increasing rents. Capital improvements can also be counted upon to leverage the initial investment to add-value.
- Rising interest rates can be mitigated by tax benefits
Investors in real estate can use tax laws to their advantage by surrendering a portion of income and capital gains in order to obtain the benefit of tax deductions.
One such tool is depreciation on property, for example, which is one of the largest deductions for a real estate owner. Investors may, typically, amortise depreciation over 27.5 years on a residential property. Furthermore, any assets not attached to the property can be similarly depreciated, albeit via a shorter time span of 5-7 years.
This and other tax related benefits can help investors offset the effects of incrementally rising interest rates.
At CPI Capital we understand that, in a rising interest rate environment, investing in multi-family real estate can still be profitable and how to benefit from rising interest rates.
Of course, rising short-term rates will warrant adjustments to a portfolio, but don’t necessarily need to deter passive or active investors from pursuing their ultimate investment goals.
In any cost-benefit analysis, the advantages of REPE investing far outweigh the disadvantages, especially in view of the particular, well-documented, attractions of investing in the multi-family sector.
Coupled with the experience and strength of an experienced general partner, passive investors can continue to look forward to favourable returns no matter what the interest rate environment looks like!
CSO, COO, Co-Founder CPI Capital