Archer’s Automated Underwriting explores multifamily value adjustments over time as rates have increased.
Inflation and the resulting rise in interest rates have dominated headlines throughout 2022. Borrowers enjoyed record-setting lows across 2020 and 2021, making the cost of borrowing as inexpensive as any time in history.
But the days of cheap money have come to an end in 2022 as the Federal Reserve increased rates four times. Because of the rise in interest rates for 10-year treasury bills and secured overnight financing rates (SOFR), debt payments have increased 19% and 25% respectively. For example, the annual payments on a $100 million loan would increase more than $800,000 due to this increase in rates.
The policy behind the increases makes perfect sense. Rates hikes are an effective tool for fighting inflation. But, that said, the higher cost of borrowing makes a real-world impact on everything from first-time buyers looking for homes to real estate investment firms trading multifamily properties.
Commercial real estate teams may find themselves affected on both sides of a transaction — buying and selling. At Archer, we recently analyzed how higher rates are influencing transactions. Here’s a look at what we discovered, plus more information on what to expect and how to respond as interest rates remain elevated.
The Consequences of a Growing Bid-Ask Spread
The velocity of commercial real estate transactions has slowed down as interest rates have climbed. This is mostly due to a mismatch in expectations between sellers and prospective buyers.
Sellers are looking at recent trades and demanding record-setting prices. Unfortunately, as the market slows, comps quickly become dated and less relevant, which means that the record-setting prices of six to 12 months ago may no longer be informative for transactions today.
On the buyer side, underwriters are accounting for fast-rising interest rates and concluding that they need reduced prices to achieve competitive returns. Owner expectations have not fallen in line with these new market realities, which is leading to a larger bid-ask spread and fewer completed transactions. Many sellers have decided to wait until prices stabilize — no matter how long that takes.
And the dynamic of mismatched expectations between buyers and sellers has a compounding effect on the slowdown. With less supply on the market, some owners are reluctant to sell for fear they won’t be able to find another attractive investment to put their money into.
While this sounds like bad news for buyers and sellers, there is a silver lining in the commercial real estate industry — specifically in the multifamily sector. Because of high interest rates, demand remains strong among renters, which helps keep occupancy levels high.
The average rental rate for a 2-bedroom apartment is currently $2,048, according to Rent.com. At the same time, Fred Economic Data indicates that the median home price increased 36% between Q2 2020 and Q2 2022, while mortgage rates have increased 17% in the past six months.
Homebuyers need to come up with more money for down payments, and they also need to make higher mortgage payments each month. That expensive combination has led many would-be buyers to remain in the rental market as it’s become less expensive to lease than to fulfill ongoing mortgage obligations. The increase in renter demand has helped buoy multifamily prices while the increase in interest rates applies downward pressure.
Interest Rate Analysis: Multiple Properties Re-Valued Across 4 Time Periods
To put the current environment into perspective, the Archer team pulled a mix of 13 core, core plus and value add deals from various markets and ran them over four different time periods. The results demonstrate the impact of rising interest rates on returns and ultimately on pricing.
We initially looked at the deal in the context of four different scenarios (while keeping return targets and leverage the same across each strategy):
- Steady going-in cap rates
- Steady spreads between going-in and exit cap rates
- Steady spreads between exit cap rates and interest rates
- Steady spreads between going in cap rates and interest rates
No. 1 above seems unlikely. In this scenario, buyers would be reluctant to sign up for that level of risk during a hold period while assuming so much of the return on residual.
No. 4 above also seems unlikely. In this scenario, sellers would likely prefer to hold and cash flow rather than sell at what feels like a discount.
Given that No. 1 and No. 4 seem unlikely, we ran our analysis of the 14 properties using both scenario No. 2 and No. 3.
The time periods were October 2021, February 2022, April 2022 and July 2022. The 10-year treasury rate rose on average for those months from 1.58% to 2.94%. This represents an 83% increase in the 10-year treasury during this window, which makes these dates particularly relevant and interesting for analysis. See the chart below for an aggregate look at how rising interest rates affected property values, and continue reading for a closer analysis of each deal type and scenario.
How Rising Rates Influenced Core Values
Our analysis of Core acquisition interest rates in October was 2.98%. Using the same logic of treasury rates and spreads we analyzed Core deals using a 4.59% interest rate as of July, 2022. This resulted in an average 10% decrease in value under scenario No. 2 and a 20% decrease under scenario No. 3.
How Rising Rates Influenced Core Plus Values
Our analysis of Core Plus acquisition interest rates in October was 3.17%. Using the same logic of treasury rates and spreads we analyzed Core Plus deals using a 4.75% interest rate as of July, 2022. This lift in rates has led to a 12% decrease in value under scenario No. 2 and an 18% decrease under scenario No. 3.
How Rising Rates Influenced Value Add Values
Our analysis of Value Add acquisition interest rates in October was 3.36%. Using the same logic of treasury rates and spreads we analyzed Value Add deals using a 4.92% interest rate as of July, 2022. Our analysis indicates that property values have fallen 12% under scenario No. 2 and 17% under scenario No. 3.
What Can Investors Do?
The analysis above may make you worry about the performance of your properties and/or portfolios. After all, when values are falling for reasons beyond your control, it’s only natural to brainstorm ideas that can boost property performance.
Curbing expense spending is the most common approach for multifamily owners looking to maximize net operating income. Start by reviewing financials in search of opportunities for revenue improvements and expense minimization.
At Archer, we’re working with clients to analyze how their current properties and potential acquisition targets perform in the market. This helps us support clients as they update their business plans so that they can benefit from rising rents while also planning for the rising costs that result from inflation.
You can also use a benchmarking tool like Archer’s Automated Underwriting. Our tool allows you to compare your operating costs to similar properties and identify areas for improvement. For example, reducing maintenance and administrative costs helps on the expense side, while increasing rent or improving occupancy helps on the revenue side.
Start Benchmarking Now
Rising interest rates are an unavoidable reality in commercial real estate right now. But, rather than worrying about property performance, take action that can turn higher rates into an opportunity for your firm.
Get in touch with us to discover how you can use our Automated Underwriting platform as a benchmarking tool that helps optimize operating costs.