Will Rising Interest Rates Freeze The Multifamily Sector?

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Financing

Investment Allocation

Profitability

Multifamily is the stable cornerstone of the commercial real estate sector.  Since everybody needs a place to live, multifamily assets are more resilient to macroeconomic changes than business cycle sensitive assets like retail and office. Nevertheless, macroeconomic conditions do play a role in shaping the relative performance and desirability of the various CRE asset classes. During this time of economic uncertainty, it is useful to reexamine the assumptions underlying the multifamily market and assess whether multifamily has become a more or less desirable asset.

Financing

Because of low risk, multifamily assets are priced with low cap rates, particularly for bluechip large unit buildings. These large buildings provide a steady and reliable source of income, and small cap rates reflect this. However, most deal flow in the multifamily sector flows via debt. As interest rates increase, the cushion between newly financed property revenue and debt service becomes thinner. If a property owner wants to maintain a consistent profit margin in this scenario, the only way is to raise rents as operating expenses are usually an ongoing cost. This is not always possible, however, as many properties have their rent increase capacity constrained by government rent control regulations or by multi year leases with rents set at a static price. Under these conditions, it is likely that the continued appeal of multifamily properties will be contingent upon the financing terms offered and the demand of the rent base.

Investment Allocation

Another important factor affecting the health of the multifamily real estate market is investor demand. The current market changed investors’ appetites for risk as conditions have changed from risk-tolerant to conservative. This change can be a positive or a negative depending on the type of investor. Some conservative investors may only be exposed to real estate via investments in the multifamily sector — multifamily assets may comprise the risk in an otherwise staid portfolio of low risk bonds and similar assets. These investors may reassess the appeal of multifamily real estate assets as bond returns rise closer to multifamily asset, but offer none of the risk. On the other hand, many commercial real estate focused investors may hold multifamily properties as the safe cornerstone of a diversified CRE portfolio including riskier assets like office and retail. As the threat of recession looms, CRE investors may make the decision to only execute new deals in the safer multifamily asset class, keeping multifamily demand healthy.

Another factor that may reshape investment allocation is liquidity. In the current market, increases in liquid assets may happen by choice or via compulsion. Savvy investors may foresee an opportunity in a market downturn and look to conserve cash to be ready to pounce on a bargain rate deal. Conversely, overstretched investors may find creditors demanding increased available capital. No matter the reason, a desire for increased liquidity can dampen demand for multifamily real estate assets.

Profitability

The profitability of a multifamily asset is a simple formula of rent minus operating expenses. However, the last few years have been some of the most turbulent for rents in many markets as the unprecedented COVID pandemic temporarily reshaped the multifamily rental market. COVID’s impact was felt differently across different locations — city centers, particularly those in expensive markets like New York City and San Francisco, saw a temporary exodus and a major drop in effective rent. Markets like Miami absorbed some of these COVID runaways with increasing rents throughout the pandemic. In 2022, it is clear that for all its transformative effects, the pandemic did not signal the end of people’s desire to live in places like New York City. Rents have exploded and the median rent for a new lease in Manhattan recently crossed $4000 for the first time.

Multifamily rent rolls reflect all of these trends at once. New leases are signed at record high prices. Older leases signed in 2020 or early 2021 by contrast are dramatically below the current market rate. As 2022 progresses, and buildings turn over units and ink new leases, landlords are able to realize dramatic gains in effective rent. Even though rent control laws limit the allowable nominal increase in rent to a few percentage points, most buildings utilized clever concession structures that enabled them to set the stage for a massive post-COVID rebound in rent prices. During the peak of the pandemic, landlords have been offering extraordinary free months concessions to occupy vacant units at attractive prices for tenants. However, once the lease term is over, this mechanism allows landlords to raise rents at pre-pandemic prices and in some cases, like New York City, even higher than ever given current demand. 

When evaluating a property for purchase, prospective buyers need to take a deep dive into the rent rolls. A building stocked with a lot of peak COVID leases that are set to expire in the coming months can expect to see a massive jump in rents. On the other side, a property mostly holding recent leases from 2022 and late 2021 has less locked potential and can be expected to have rent grow at a more market standard rate. Thus, it’s important to evaluate a property’s cap rate changes over time by looking at lease expiration dates, net effective rents, and unit count and comparing them against current market demands. These trends are further complicated by the distinct local effects of rent control laws, remaining COVID-era eviction protections, and local market dynamics. 

Pricing multifamily assets today is not simply a matter of calculating cap rates and looking at historical rent averages. Multifamily properties are being pulled in different directions by the effects of a rapidly changing investment, financing, and rental climate. Nuanced, detailed, reliable multifamily data is a must to confidently close deals. Learn more about our recent multifamily data integration with RealPage and join CompStak are keep the pulse on current CRE trends.