Changing Interest Rates and the Importance of Underwriting
Preservation of capital is the cornerstone of multifamily real estate investing. Paying close attention to interest rates and their impact on cash flow and value is part of protecting owned real estate assets. As underwriters, we quantify risk, therefore, it is necessary to understand how interest rates affect the value of multifamily assets.
It is important to remember there is a very direct line between interest rates and value in multifamily. As a savvy investor, this is no new news. We ask you here to highlight the premise and in so doing exclude the possibility of a knee-jerk reaction to the news cycle about changes in interest rates. Every long-term investor understands the interest rates cycle in both directions. Recognition that pending changes to interest rate policy (guidance by the Federal Reserve) moves money into and out of institutional real estate further prepares the real estate analyst and investor to position their dollars and decision-making accordingly.
Cap Rate Expansion
Cap rate expansion is nothing more than a fancy way of saying asset values are falling, or decreasing. It is an established fact that as interest rates increase real property valuations fall. Said another way; as the cost of capital increases, people are less willing to pay a higher price for a real estate asset because the cost of acquisition is higher when interest rates increase.
While it’s not a one-to-one ratio, you can measure the change in projected “value” against changes in interest rates.
Example: An asset offered for sale at $20M, with existing debt of $13M (20-year amortization at 5.5%) experiences a one-half percentage upward change in interest rate increases the cost of debt by $44,528 annually. This added cost has a material effect on value.
Interest Rate Sensitivity
As much as people can have a “feeling” about the direction of interest rates, only one person who knows their direction going forward; the Chairman of the Federal Reserve. Everyone else is guessing. This “feeling” is called investor sentiment.
Sentiment: a view of or attitude toward a situation or event; an opinion
Excluding times of hyper-inflation (seldom experienced in the U.S.), we are provided with notice of changes to the cost of money. Interest rates “trend” up and down. Watch the Fed Funds Rate and LIBOR (London Interbank Offer Rate). LIBOR is with us until at least 2021, then being replaced by Secured Overnight Financing Rate (SOFR). Keep an eye on the 5-year Treasury. Simple advice, yes, but consider this as an integral part of protecting the value of a multifamily portfolio.
Rent Growth Projections
Rents rise when job growth is accelerating, right? Yes, until an area becomes overbuilt from too many developers attempting to capture the wave. Rent growth projections must consider absorption.
Absorption rate is the rate at which available housing is sold in a specific real estate market during a given period.
Absorption, the pace of occupancy of new construction, directly impacts rent growth. Recognize that supply and demand are seldom in balances. Underwriting requires a close look at current and future construction starts (real construction starts- not just permits planned or pulled) to accurately factor in future supply.
Predicting interest rates is as old as money itself. The cost of capital intimately folds into the keep, buy, or sell decision of commercial assets. Underwriting that ignores interest rate risk is inviting an unwarranted blindside risk that forward thinkers make valiant attempts to compartmentalize.