How Multifamily Borrowers Adapt to Rising Interest Rates

With the Federal Reserve’s recent rate hikes, the cost of borrowing for multi-family investments is also rising. This disrupts sales volumes as higher interest rates cause some potential home buyers to factor higher borrowing costs into previous assumptions they made when they first planned to buy a home. Potential buyers will likely want to cut the amount they’re willing to pay relative to the income from the property — but it’s too early to say how much and if sellers plan to renegotiate.

“We’re hearing from our brokers that some amount is being used to trade back,” says Dave Borsos, vice president of capital markets at the Washington DC-based National Multifamily Housing Council

Condo buyers are demanding higher returns on their investments, according to dealmakers and economists. They push prices down as interest rates on acquisition loans rise.

It is too early to see this change in the latest national data. In May 2022, investors accepted an average cap rate of 4.8 percent for apartment properties, according to MSCI, based in New York City. That is 20 basis points less than in the previous year. It’s the lowest average cap rate –– and the highest price-to-real estate revenue — ever recorded for homes. The record low largely represents home sales that had been negotiated months earlier, well before interest rates began their recent rise.

Anecdotally, investors are asking for higher cap rates, but not nearly as much as the more than 200 basis point rise in long-term interest rates. The net result could be a narrowing of the risk premium – the spread between cap rates and yields on 10-year Treasuries.

“The average interest rate has not increased as dramatically as lending rates,” says Borsos. “There are compensating market forces keeping cap rates lower.”

Interest rates rose sharply

Investors in apartment buildings have to pay higher interest rates when they take out fixed-rate, perpetual loans.

“The total cost of debt is up more than 150 basis points from six months ago; an initial rate of over 4.5 percent for both fixed and variable bonds due to a dramatic rise in underlying indices,” said Kelli Carhart, head of multifamily bond production at CBRE.

Interest rates on most fixed-rate, permanent home loans are based on US Treasury yields. Ten-year government bonds yielded 2.99 percent on July 11, 2022. That’s more than two full percentage points from less than 1 percent for most of the first year of the coronavirus pandemic. Yields stayed close to 1.5 percent for most of 2021. Benchmark yields soared in 2022 as Federal Reserve officials signaled they would raise federal funds rates to fight inflation and cool the overheated US economy.

Fed officials have already hiked rates, and Treasury yields show that bond investors are expecting more rate hikes in the future.

“Everyone expects the Federal Reserve to hike rates another 75 basis points because inflation was 9.1 percent (in June),” Borsos says.

In order to keep interest rates relatively low, lenders have sometimes reduced the amount they add to interest rates in the past. That has not yet happened in 2022. But even lenders haven’t greatly increased the amount they charge in response to volatile capital markets.

“Spreads have been relatively flat over the last 30 to 45 days in the residential mortgage lending space,” said Jonah Aelyon, director for JLL Capital Markets, Americas, who works in the firm’s San Francisco office.

However, lenders also make smaller loans. “The drop in leverage is significant from 75 percent to under 65 percent and often much smaller,” says CBRE’s Carhart.

Most permanent loans are now limited to the amount of debt service the property can pay from rental income. As interest rates rise and the cost of debt service payments increases, the amount of loan that the property can support becomes smaller.

Home buyers also need to worry that price inflation will affect the labor and utility costs of the properties they buy – and this will also hurt the return on their investments. “People take this inflation into account and run their numbers again,” says Borsos.

Nevertheless, borrowers have many options when looking for financing. That’s partly because demand for apartments remains strong and apartment rents continued to rise in 2022 – even after a very strong 2021.

“Liquidity in the debt space is not an issue today, rather prices and interest rates have changed,” says Aelyon of JLL.

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