One Last Fed Rate Increase
Is the Fed finally going to stop raising interest rates after the upcoming meetings in September and November? We hope so. While the meteoric rise in interest rates hasn’t caused widespread distress yet, it feels like more distress is on the horizon. At this point, I’m not a believer in long-term rates going back to 2%. I think we all need to get comfortable with the 10-year US Treasury in the 3.5-4.5% range even if the short rates fall back to the low 3%s. That would give us interest rates on apartment properties in the 5.0-6.5% range, and cap rates will need to adjust (i.e., increase) accordingly. While cap rates have risen, they still aren’t high enough to provide positive or even neutral leverage.
More than anything, we need some level of certainty in the market. A constantly changing interest rate environment does not allow buyers and sellers to come to terms. Currently, potential sellers, if they can hold on, are waiting for interest rates to drop so that they can either refinance their property or sell into an appreciating market. On the other hand, buyers don’t really want to lock in debt at today’s rates because they fear rates may be lower in the next 24 months (and don’t want to pay a large prepayment penalty) and are also not willing to use floating rate debt because of the cost and potential risk. There’s a stalemate in the market which has reduced apartment transaction volume by 74% over Q1 last year and on par with that of the Great Financial Crisis (GFC).
In non-inflationary times, rising interest rates were a function of growth in the economy. If the economy was doing well, increases in interest rates wouldn’t stop the party, but it would make sure the punch bowl wasn’t spiked either. Rents and net operating income could still increase, and both would offset the gradually rising cost of debt and potentially higher capitalization rates all leading to modest valuation increases. Today, we’re in an environment where interest rates are increasing but growth is slowing. The changes in property valuations have been dramatic as apartment values have dropped 20-25% in most markets. This is a difficult market in which to absorb significant increases in interest rates.
We also believe some perspective is needed. As of writing this, the 10-year US Treasury yield is 4.15%. That’s not historically high, and neither are all-in interest rates in the 6% range for apartments. They’re both considerably higher than 12-18 months ago, but they’re not market killing numbers. The issue is with the speed of the rate increases as well as the short memories of many apartment investors and high-paying short-term treasuries as an alternative to real estate. This has created issues with valuations and refinancing risks.
As rates rise, valuations go down. Investors want a higher initial yield on their capital and alternatives like money market funds paying 4.5% are an attractive alternative. At the same time, even properties with conservative leverage and a maturing loan may be in a situation where cash flow is hampered by a significantly higher refinance rate. Additionally, an apartment owner may not be able to pull out as much equity to either improve the property or purchase a new one, limiting one’s business plan. Highly leveraged borrowers with pending debt maturities will be in the unenviable position of needing to raise additional capital for a cash in refinance or, more likely, sell the property instead.
We can’t prognosticate where interest rates are headed or if the Fed is pushing the economy into a recession. We do know that growth is slowing and that there remains a large bid-ask spread between sellers and buyers in the apartment market. Stability of interest rates, even at this elevated level, plus a more normal upward sloping yield curve (i.e., short-term rates lower than long-term rates) would provide significantly more clarity in which to operate. If this were to happen, we believe buyers and sellers would find more middle ground and price discovery would be much easier and more transparent. We’re hoping for a pause and a return to normalcy, though we’re not necessarily holding our breath for significantly lower rates.
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