The changing economic landscape, particularly the rising interest rates, has caused ripples in the real estate investment sector. While some investors might perceive this as a potential risk, others see it as an opportunity, particularly in the realm of value-add multifamily investments. This article takes a comprehensive look at the dynamics of value-add multifamily investments in a rising interest rates environment, post-COVID.
The Current Interest Rates Scenario
Since the end of 2021, the Federal Reserve has implemented numerous policy rate hikes, driving anticipations for a peak policy rate as high as 5.6% by the end of 2023. This uptick in interest rates, coupled with the highest inflation rates in decades, has complicated the investment market.
Despite the challenging environment, some real estate investment firms, such as Creative Realty Partners, have managed to maintain a robust strategy. A considerable proportion of their multi-family portfolio consists of fixed-rate loans, enabling them to generate added value for their investors in a rising rate environment. This kind of foresight and strategic management of debt plays a key role in their success in the investment landscape.
The Impact of Rising Interest Rates on Investment and Development
Higher capital costs, rising rents, and expensive cap rates are influencing multifamily investment and development in various ways. However, the rental housing fundamentals have stayed strong as housing demand continues to outstrip supply. This demand, driven partly by potential homebuyers being priced out of the market, is supporting rental demand and keeping investor appetite high.
Despite the rising costs and rates, certain real estate firms, like Creative Realty Partners, continue to pursue growth and invest in well-located, differentiated properties. By focusing on value-add multifamily investments with a clear business plan, they are able to navigate the uncertain waters of the real estate market.
Post-Covid Boom and Collapse
Due to the resistant nature of multifamily investments, the multifamily investment market went through a mini-boom post Covid due to a large influx of investors coming from other, less-resistant real estate markets (office, retail, hotels, etc.). Investors/investment firms with little to no experience in the multifamily sector flocked to multifamily after seeing the impact that Covid had on their native sector, and conversely, the resistant nature of the multifamily sector. These investors overpaid for multifamily properties while utilizing floating rate debt.
The outcome of this is now we are seeing those investors struggle due to a combination of their inexperience in operating multifamily property, the fact that they grossly overpaid, as well as the fact that their interest rates have increased dramatically from where they were at the time of purchase.
The result is an influx of value-add opportunities that more experienced multifamily investors are now capturing.
Opportunities Amid Uncertainty
Rising interest rates have exposed some vulnerabilities in investment strategies that thrived in the previous decade of cheap debt and economic stimulus. However, these changing dynamics are prompting investors to reassess risk and seek out opportunities with more attractive risk-adjusted returns.
The past decade saw an influx of investor capital into real estate, causing a drop in cap rates for multifamily properties to below 4 percent. But with rising interest rates and dwindling credit availability, investors are becoming more discerning and demanding when it comes to risk assessment and capital deployment.
Higher interest rates result in a decreased willingness to lock in long-term, high-rate debt which results in decreased competition from investors looking to hold long-term. This results in more opportunity for firms with a shorter-term value-add strategy, like Creative Realty Partners.
The Multifamily Market Landscape
Despite market-wide headwinds, the fundamentals of the multifamily market remain strong. Renter demand continues to be robust due to a fundamental supply/demand imbalance in many markets. This is leading to continual rent growth and high occupancy rates.
High-interest rates are influencing multifamily valuations. But they also boost demand by making homeownership more challenging, thereby increasing the pool of renters. This supply/demand dynamic continues to be favorable, particularly in the United States where there is a significant gap between household formation and housing units constructed.
Navigating the Rising Rate Environment with Value-Add Multifamily Investments
The rising interest rates environment presents several considerations for real estate investors. These include managing rental growth, occupancy rates, cap rates, and potential impacts on rehab and development costs. However, the value-add multifamily investment strategy can provide a robust approach to navigating these factors.
Value-add multifamily investments involve acquiring properties that have potential for improvement, either through physical upgrades or improved management practices. This strategy can deliver improved returns for investors, even in an environment of rising interest rates.
Here are six reasons why value-add multifamily investments can be an effective strategy in a rising interest rates environment:
Continued Rental Growth Amid Rising Interest Rates
Even with rising interest rates, multifamily properties can command higher rents in many metropolitan areas. This can help offset higher borrowing costs and maintain or enhance net operating income and cap rates. Demand for multifamily housing remains high, pushing rental prices upward and mitigating the impact of increased funding costs due to rising interest rates.
High Occupancy Rates
The multifamily apartment market continues to benefit from historically high occupancy rates. These high occupancy rates, coupled with rental growth, can lead to further compression of cap rates, enhancing the value of multifamily properties.
Real Rates of Return
While interest rates are rising in response to higher levels of inflation, there hasn’t been a major change in the real, long-term rate of interest. If higher rental growth rates can offset borrowing costs and enhance net operating income, cap rates can remain stable, providing a real rate of return for investors.
Correlation between Cap Rates and Nominal Rates
Although falling long-term interest rates have historically enhanced the value of multifamily apartments, the correlation between long-term interest rates and multifamily apartment cap rates is not particularly strong. This means that rising interest rates do not necessarily lead to significantly increased cap rates.
Value-Add Strategies to Offset Rising Interest Rates
Investors can focus on enhancing the net operating income of a multifamily property and compressing cap rates to offset the impact of rising interest rates. This can involve acquiring undervalued properties and renovating them, or improving management practices to boost returns.
Tax Benefits to Mitigate Rising Interest Rates
Investors can take advantage of tax laws to offset the effects of rising interest rates. One such tool is property depreciation, which can provide significant tax deductions for real estate owners.
The Bottom Line
Despite the rising interest rates environment, value-add multifamily investments can still offer attractive opportunities for investors. By focusing on rental growth, occupancy rates, cap rates, and value-add strategies, investors can navigate the current economic landscape and continue to generate robust returns on their investments.
In the post-COVID era, as the interest rates continue to rise, the importance of strategic, value-driven investing becomes even more apparent. Understanding market dynamics, undertaking comprehensive risk assessment, and focusing on value-add strategies can help investors not only survive but thrive in the fluctuating economic landscape.
As the saying goes, “In the midst of every crisis, lies great opportunity.” For shrewd real estate investors, the rising interest rates environment is not a crisis, but an opportunity to leverage value-add multifamily investments for sustained growth and profitability.