In March, the US Federal Reserve approved its first interest rate hike in more than three years, “a gradual salvo to tackle spiraling inflation without torpedoing economic growth”, reported CNBC.
The quarter-point increase (or 25 basis points) brought the rate back to a range of 0.25% to 0.5%.
Along with the rate hikes, the committee also scheduled increases at each of the remaining six meetings this year, indicating a consensus funding rate of 1.9% by the end of the year. This is one percentage point higher than that reported in December. The committee predicts three more increases in 2023, and none the following year. At the end of March, market analysts suggested that the next rate hikes would be 50 basis points. It should be noted that yields on 10-year Treasury bonds as of March 28 had doubled since August, also contributing to higher mortgage rates.
Recent Fed action in this rising interest rate environment may have a modest effect on apartment investment and performance. Going forward, the industry will focus more on rising inflation, the cost of capital, asset prices and cap rates, rental growth and investment sentiment.
Given the health of the apartment industry, AppFolio spoke with leading economists and apartment executives about what could happen and the potential ramifications.
Underlying flat fundamentals are ‘best ever’
Greg Willett, senior vice president, research services, Institutional Property Advisors, said the forces pushing the Fed to put upward pressure on interest rates are tied to strong economic growth.
“High inflation is a byproduct of outsized economic growth during a time of commodity and commodity shortages,” Willett said. “Underlying apartment fundamentals are the best ever, and apartments are uniquely positioned to outperform during a period of high inflation as strong demand drivers support absorption.”
Willett said labor and material shortages, as well as rising construction costs, could reduce new supply risk this year.
“As interest rates rise, this puts pressure on the underwriting of multi-family investments. Apartment cap rates have tightened significantly over the past year. With interest rates putting upward pressure on the cost of capital, yield spreads have narrowed. This has the potential to restrict investment activity in apartments.
He said investor sentiment remains elevated by historical standards, suggesting deal activity is likely to be substantial, at least through the first half of 2022.
“But investors signaled heightened interest rate sensitivity,” Willett said. “If the 10-year Treasury is in the mid-3% range, many investors have suggested that they may reduce their acquisition activity. Thus, the prospect of higher interest rates could support the short-term investment activity.
Asset prices will soon stabilize
Neil Schimmel, CEO of Investors Management Group, said rising interest rates point to a mixed outlook for apartment investors.
“For starters, asset prices should stabilize in the near term, as capitalization rates have historically moved with interest rates. Debt servicing will clearly become more expensive and eat into cash flow.
“But we have to appreciate the recent burst in rental growth. The picture has been particularly rosy in the Sun Belt states, with tenants moving to more affordable markets. Vacancies have reached historically low levels in our portfolio. Nationally, demand has pushed rent growth to double digit rates – and the cost of housing is the most important factor in measuring CPI inflation.
“Apartment owners who have benefited from inflated incomes since the start of 2021 now face the realities of Fed policy aimed at calming inflation.”
Real estate investment as a “safe haven”
Jay Maddox, Director, Capital Markets, Avison Young, said the recent spike in interest rates has not stifled overwhelming demand from investors and lenders for multifamily properties, particularly in markets where growth in rents continue to accelerate.
“As long as investors continue to factor projected rapid rental growth into their projections, we don’t expect to see much upward pressure on cap rates. If the inflationary environment persists, we can expect some stabilization in valuations.
“However, a slowdown in the multi-family sector seems highly unlikely given strong overall investor demand, the need for housing and the perception that real estate investment is a safe haven from capital market volatility.”
A healthy lag before rates factored in
Eli Randel, chief strategy officer, CREXi, said the Fed’s interest rate hikes that aim to fight inflation and cool a booming economy could cause rental rate growth to slow. (and operating expenses), but there is likely to be a healthy lag before the hikes achieve the desired effect on inflation.
Randel said that more likely, “NOIs will continue to grow in the near term, especially given relative supply constraints ahead of any potential reductions. However, rising interest rates will lead to higher costs of capital and expanded capitalization rates, which will eventually soften the value of assets around the edges. That said, we believe that the growth of the NOI, pent-up pools of capital competing for investment, and the allure of commercial real estate on a flight to quality and safety will keep values high and be leveraged reactive.
Technology can help counter margin squeeze
Leveraging technology that optimizes a property’s income statement can be a powerful way to increase NOI. For example, technology that speeds unit turnaround translates to less time units aren’t producing, or technology that tracks metrics and rental information can help weed out underperforming marketing channels.
In today’s work environment, where staffing and retaining property management talent is a priority challenge, tools that help existing property management teams be more productive can help counter the compression of cap rates. According to Tommy Lawing Jr., President, TR Lawing Realty:
“I don’t need the rookie anymore. I don’t need someone to fold the letters and stick them in the envelope. I can focus on higher quality staff because they hire, process applications, do what makes us money instead of just answering phone calls and hanging out with a hundred prospects which can lead to two applications.
You can view TR Law Realty’s customer testimonial hereand for more information that can help you turn staffing challenges into opportunities, be sure to save your space for AppFolio Wave Summit 2022. It’s 100% free and 100% virtual, so you can bring your whole team. We hope to see you there!