Main Takeaway: The market expects interest rates to fall as we enter a recession in 2023. That said, historically speaking interest rates will remain elevated and that impacts the multifamily market in a number of ways, including but not limited to: higher cap rates, lower sales volume, a decrease in prices, and a reduction in development.
Story: Interest rates are a funny thing. We saw record interest rate increases not seen since the 1980s, only to be moderated in the past few weeks. As of earlier this week, the average 30-year fixed mortgage rate sat at 5.05%, down from the June peak of 6.28%. Here is the latest chart showing the average 30-year interest rate.
Are interest rate cuts on the horizon?
According to Mark Zandi, chief economist at Moody’s Analytics, the bond market is already pricing in a high probability of an upcoming recession, which is not only sending lending rates lower but will likely prompt the central banks to reverse course and cut interest rates in 2023.
Assets with high debt ratios will be most at risk as interest rates will continue to rise in the near term as the Fed attempts to cool inflationary pressures. It is likely that the rapid rise in interest rates will shock inflation into moderating and reduce the need to further raise down the road. In this sense, we could be seeing peak interest rates sooner than many think.
Despite some potential reprieve, compared to the last decade we are witnessing a higher interest rate environment. This new reality will keep more homebuyers on the sidelines, turning them into or keeping them as renters for the time being. New supply is constrained as material prices rise with inflation and regulatory hurdles continue to delay development.
How interest rates affect multifamily owners and operators
Despite short-term decreases in interest rates, overall we are heading for a higher interest rate environment in the coming years. Here is what multifamily investors and owners should consider as debt becomes more expensive.
Sales Volume: Will decrease as investors as fewer deals pencil given higher borrowing costs. According to NMHC’s Sales Volume Index, we are witnessing a record low sentiment of 10 (out of 100), which outside of April 2020, is the lowest month recorded since 2008.
Prices and Cap Rates: Will rise as prices get adjusted downward. According to Wealth Management, “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 down 20 basis points from the year before. It’s the lowest average cap rate—and the highest prices relative to income from the properties—ever recorded for apartments. The record low largely represents sales of apartment properties that had been negotiated months before, long before interest rates began their recent rise.”
Tighter Lending: According to a new sentiment analysis from NMHC, financing sentiment among multifamily owners and investors is at record lows.
Source: NMHC – Note: An Equity Financing Index reading above 50 indicates that, on balance, equity finance is more available; a reading below 50 indicates that equity finance is less available. A Debt Financing Index reading above 50 indicates that, on balance, borrowing conditions are improving; below 50 indicates that borrowing conditions are worsening.
Sellers: Will continue to enjoy moderated price increases, but not at the same trajectory of the past few years. As noted above, investors wishing to liquidate assets in a rising interest rate environment will have a small pool of buyers which will moderate prices. That said, price growth in multifamily is still expected to grow, albeit at a slower pace than the previous 5 years.
Development: Will likely slow as projects with already thin margins due to a tight labor market and material price increases and shortages, will become less viable as construction debt becomes more costly. That said, the ROI metrics for multifamily development may improve as more would-be buyers are priced out of the single-family market and look for rental alternatives.
“[W]e also believe demand for multifamily rental housing will remain positive because elevated single-family housing prices along with higher interest rates are making homeownership far less affordable, perhaps convincing many renters-by-choice that staying in their units longer is the better option.” — Fannie Mae
“Higher borrowing costs have already hit the real estate landscape, and are having a noticeable impact on demand. Sales of new and existing homes have been declining during the first half of the year, and contract signings took a sharp downward turn at the start of summer. In turn, many home sellers are finding out that the sudden drop in buyer demand is causing their properties to sit longer on the market. For those motivated to sell, price reductions are becoming a go-to strategy. We can expect the rebalancing in housing markets to continue and to pick up speed, especially as we look toward the fall and winter seasons.” — George Ratiu, senior economist, Realtor.com