In mid-June, the Fed instituted its third rate hike of the year, a 75-basis point increase that was the biggest since 1994. That followed the June 1 start of the Fed’s plan to reduce its $9 trillion balance sheet, which had grown of $4.2 trillion over the past two years.
The Fed’s cleanup failed to slow investment sales in the multifamily sector during the first quarter, when buyers sank $63 billion in apartments, a 56 percent year-over-year increase, and the first quarter was the strongest on record, according to CBRE. But since then, lenders have become more cautious. (Maybe move this up closer to the top?)
In anticipation of the Fed’s actions, the benchmark 10-year Treasury yield has risen from 1.6 percent at the start of 2022 to about 3.1 percent in less than three months. Hisam Nadji, CEO of Marcus & Millicap, said the sudden rise has shaken the market.
“A return to a 10-year Treasury yield of 3.5 percent or 4 percent should not be a problem in the economy or the real estate business,” he said. “But when you go from close to those levels in two or three months, it will create shock waves and a lot of uncertainty.
“Will things get worse before they get better? Probably. But the point is that we have to clean up what was a very unusual response to a very unusual shock.”
Volatility is the norm
Eddie O’Brien, co-founder of Blaze Capital Partners in Charleston, SC Today, notes that in prior periods of high interest rates, lenders typically kept their cost of capital relatively stable by narrowing the spread above whatever benchmark rate is used. Lenders have either moved to margin or are pricing more risk in the trades.
said O’Brien, whose Southeast-focused company has a $400 million acquisition pipeline and development deals. “There is a great deal of volatility in the loan pricing environment at the moment.”
This volatility was also felt in the CLO market, from which many agile lenders draw their capital, said Shlomi Ronen, founder of Dekel Capital, a Los Angeles-based commercial real estate bank. The guaranteed overnight funding rate (SOFR) swelled from 0.05 percent to about 0.80 percent between mid-March and early May, and CLO margins widened as securities buyers demand higher returns.
He added, “In conjunction with the rise in the price index, the volatility in the CLO market surprised some investors.” “Everyone in the multi-family space has been operating on what appears to be a complete tilt over the last 12 to 18 months, and there appears to be a healthy reassessment taking place to determine whether the assumptions going forward are still relevant or need to be modified.”
Rental growth hopes
In the middle of the year, cap rates have not yet adjusted to higher interest rates, and as a result, buyers are becoming more cautious. O’Brien said seller-friendly contract terms are disappearing as buyers reject requests for truncated due diligence periods and hard money on the day the contract is signed.
However, transactions in which the borrower’s mortgage interest rate is higher than the capitalization rate of the asset being purchased are now occurring, observers say. They add that the only way negative leverage deals will work is if rent growth continues on an upward trajectory.
Njie said multifamily rental rates in the United States grew at an annual rate of about 18 percent. While this pace of growth is unsustainable, demand for rental housing should remain strong given demographic trends and the fact that potential home buyers are facing higher mortgage rates and median home prices, added Nji, whose company expects cooler but still strong rental growth in 10 percent this year.
“I think there are reasons to be optimistic about apartment rent growth, particularly as home prices become less expensive,” he said. “Even if the Fed causes a recession, apartment demand and rental growth should still be very strong.”
change of approach
In many cases, investors from multiple families have changed their strategies to account for hiccups in the capital markets. Prior to this year, DB Capital Management, which has a $500 million portfolio of value-added assets in the Infill markets of Texas and the West, was selling properties before the end of the mid-decade period to benefit from a rapid rise in values.
But in coping with market uncertainty, CEO and co-founder Brennen Degner now expects to hold the assets for a more typical period of three to five years. Additionally, instead of seeking staging loans at 70% to 75% of the cost, the investor looks for leverage of around 60% and uses SOFR swaps to reduce interest rate risk. And because the bridge loan spreads offered by debt funds increased at least 50 basis points to about 365 basis points early this year, he’s tapping into bank funding.
“I remain very optimistic in all of our markets — people will always need an affordable place to live,” Degner said. But we wanted to change our debt strategies. For us, it was an escape to quality in terms of debt structure.”
Developers looking for construction financing are also adapting to the changes. Design and build firm Ryan Cos saw funding increase from about 2.5 percent to 3.3 percent as SOFR rose, said Christa Chambers, the company’s senior vice president of capital markets. The company typically adds interest reserves to its financing packages to meet additional rate increases, and it monitors older loans to see if an increase in the tax base interest rate will cause a deficit.