Rising Interest Rates and Multifamily Real Estate:
What to Know (Part 2 of 2)
by Max Sharkansky
Managing Partner at Trion Properties
Cap rate dynamics and historical total returns
For individuals investing in multifamily real estate, rising rates are top of mind. Conventional wisdom might tell us that interest rates are positively correlated to real estate cap rates: When Treasury yields rise, so do cap rates, causing property values to decline and dampening total returns for real estate investors. But in reality, rising rates have a complex impact on the performance of multifamily real estate investments. Here we take a closer look at cap rate dynamics and historical total returns.
(Read part one for a discussion about the key role of earnings growth and the challenge of managing borrowing costs.)
Cap rates and Treasury rates: Not tied at the hip
In March, Fed began its long-awaited liftoff, raising the benchmark federal funds rate by 0.25% to a range between 0.25% and 0.5%. Against a backdrop of intense inflation and war in Ukraine, the central bank is embarking on a significant effort to tighten monetary policy without hurting growth—and investors are quickly moving to adjust their expectations. As recently as December, investors expected the benchmark rate to increase by just 0.75% in 2022. By April 15, the CME FedWatch Tool showed the futures market pricing at a rate that tops out at 2.75% to 3% by year-end.
The federal funds and Treasury rates are clearly rising—but this doesn’t necessarily mean multifamily cap rates will also increase. Treasury rates are just one of many factors that impact cap rates. In other words, multifamily cap rates can’t be reliably predicted by moves in Treasury rates; they don’t move in lockstep. Freddie Mac illustrates this less-than-perfect historical relationship over the last 10+ years.
Research from CBRE further illustrates the concept: Over the five quarters ending Q3 2021, long-term interest rates more than doubled, rising by more than 70 basis points (bps) while cap rates for the multifamily segment compressed by roughly 75 bps over the same period. Other examples of a prolonged upward rise in interest rates include 2003-2006, 2012-2013 and 2016-2018, where 10-year Treasury yields rose by more than 100 bps each time, and cap rates remained flat or even compressed.
How does this happen? Cap rates—and real estate valuations in general—can be impacted by investor appetite, among other things. When investor interest is high and the climate is competitive, it can lead to more aggressive valuations. Increases in interest rates can be offset, at least partially, by spread compression and strong capital inflows.
Generally positive performance during past periods of rising rates
When we examine total returns in the multifamily segment during historical periods of rising rates, we see moderate to relatively strong performance, except for 2008-2010, the period which encompassed the heart of the global financial crisis and early recovery. The range of positive outcomes speaks to the multitude of factors that influence returns.
Trion Properties’ approach to success in a rising rate environment
As we discussed previously, the multifamily sector appears well positioned to successfully navigate the current macroeconomic environment characterized by rising inflation and climbing interest rates. That said, not all multifamily properties, strategies, or funds will fare equally well.
At Trion Properties, our proven value-add strategy is designed to optimize NOI and add economic value to each investment through extensive renovations and hands-on management. Because we invest in assets with substantial earnings potential and take a proactive approach to improve NOI, we believe our multifamily portfolio has considerable ability to withstand interest rate increases.
Furthermore, we target markets where we can successfully operate throughout the real estate cycle—not just when times are good. Our prudent investment approach enables us to ride out difficult environments, then exit once conditions have improved. For assets with compounding annual NOI growth, time can heal most wounds caused by rising cap rates.
Lastly, as it pertains to managing the cost of financing, we are fixing rates when possible and using derivatives to hedge risk on floating-rate debt. We have also purchased multiple assets in the last year with assumable long-term fixed-rate debt.