After two years in which the Federal Reserve has expanded the US money supply by a staggering 410 percent and kept interest rates near zero to prop up the economy, the Federal Reserve is scrambling to fight inflation, which has been a 40-year period -High has reached. This raises a crucial question: will these efforts to fight inflation help or hurt lending, investment and apartment building development?
In mid-June, the Fed rolled out its third rate hike of the year, a 75 basis point hike, the largest since 1994. This followed the start of the Fed’s plan on June 1 to reduce its expanded $9 trillion balance sheet from 4 $.2 trillion over the past two years.
The Fed’s cleanup failed to slow investment sales in the red-hot multifamily sector in the first quarter, as buyers poured $63 billion into homes, up 56 percent year-on-year and the strongest first quarter on record, according to CBRE. But since then, lenders have become more cautious. (Maybe move up?)
In anticipation of the Fed’s action, the benchmark 10-year Treasury yield rose from 1.6 percent in early 2022 to around 3.1 percent in less than three months. The sudden surge rocked the market, said Hessam Nadji, CEO of Marcus & Millichap.
“Going back to a 10-year Treasury yield of 3.5 percent or 4 percent shouldn’t be a problem for the economy or real estate,” he said. “But if you get to that level from near zero in two or three months, it’s going to create shock waves and a lot of uncertainty.
“Will it get worse before it gets better? Probably. But the point is we need to clean up what has been a most unusual response to a most unusual shock.”
volatility as the norm
In previous periods of rising interest rates, lenders typically kept the cost of capital relatively stable by narrowing the spread over the benchmark interest rate they were using, noted Eddy O’Brien, co-founder of Blaze Capital Partners in Charleston, SC Today. Lenders have either gone to the sidelines or are pricing more risk into deals.
“The scale of rate hikes, the threat of a potential stagflation scenario and general jitters in stock markets make for a slightly different reaction this time around,” said O’Brien, whose Southeast-focused company has a $400 million acquisition pipeline and development contracts. “There is a fair bit of volatility in the credit pricing environment right now.”
This volatility is also being felt in the collateralized loan obligation (CLO) market, from which many bridge lenders draw their capital, said Shlomi Ronen, founder of Dekel Capital, a Los Angeles-based real estate brokerage bank. The Secured Overnight Financing Rate (SOFR) rose from 0.05 percent to about 0.80 percent between mid-March and early May, and CLO spreads widened as buyers of the securities demanded higher yields.
“Combined with interest rate index hikes, the volatility of the CLO market has surprised some investors,” he added. “Everyone in the multifamily space has been running at full steam for the past 12 to 18 months and it appears that a healthy re-evaluation is taking place to determine whether assumptions are still relevant going forward or need to be adjusted.”
Hopes for rental growth
In the middle of the year, the capitalization rates still had to adjust significantly to the rise in interest rates, which is why buyers have become more cautious. Seller-friendly contract terms are disappearing as buyers reject demands for reduced due diligence periods and hard money on signing day, O’Brien said.
Still, according to observers, transactions are now occurring where a borrower’s mortgage rate is higher than the capitalization rate of the asset being purchased. The only way these negative leverage deals will work, they add, is if rental growth continues its upward trend.
U.S. apartment rental prices rose about 18 percent year over year, Nadji said. While this pace of growth is unsustainable, rental demand should remain strong given demographics and potential homebuyers facing higher mortgage rates and mid-range home prices, added Nadji, whose firm reports cooler but still steady rental growth from forecast 10 percent this year.
“I think there are reasons to be optimistic about apartment rent growth, especially when apartments are becoming less and less affordable,” he said. “Even if the Fed causes a recession, housing demand and rental growth should remain very strong.”
change of approach
In many cases, multifamily investors have changed their strategies to accommodate the hiccups in the capital markets. Prior to this year, DB Capital Management, which owns a $500 million portfolio of primarily value-added assets in infill markets in Texas and the West, was selling properties well before the end of their average holding period to take advantage of a rapid appreciation in value.
But to adjust to the market uncertainty, CEO and co-founder Brennen Degner now expects to hold the assets for a more typical three to five-year holding period. Additionally, instead of seeking bridging loans for 70 to 75 percent of the cost, the investor is aiming for around 60 percent leverage and using SOFR swaps to reduce interest rate risk. And because spreads on bridge loans offered by debt funds rose by at least 50 basis points to about 365 basis points earlier this year, he’s also resorting to bank financing.
“I’m still very optimistic about all of our markets — people will always need affordable housing,” Degner said. “But we wanted to change our debt strategies. For us it was a flight to quality in terms of debt structure.”
Property developers are also adapting to changes when looking for construction financing. The design-build company Ryan Cos. has seen funding rise from about 2.5 percent to 3.3 percent as SOFR has risen, reported Christa Chambers, the firm’s senior vice president of capital markets. The company typically adds interest rate reserves to its financing packages to counter further rate hikes, and it keeps track of older loans to see if the SOFR increase will result in a deficit.
Read the July 2022 issue of MHN.