What high interest rates mean for US multifamily

Private real estate is facing an inflationary environment that is much less transient than it first appeared. The annual growth rate in the Consumer Price Index, which has risen steadily since August last year, reached a new 40-year high of 9.1 percent for June. Also in June, the Federal Reserve surprised the markets with a 75-basis-point increase to the Federal Funds rate, the biggest since 1994. It has suggested another hike of the same magnitude could come next month, with further raises slated for later in the year.

The rising rate environment has had a dual effect on the US multifamily market. On the one hand, it has continued to keep multifamily rental demand robust. Mortgage rates have jumped from around 2 percent to over 6 percent in some instances, doubling many buyers’ monthly payments since the Federal Reserve announced its surprise rate hike.

“We think that will continue to really tamp down the ability of first-time homebuyers,” said Richard Litton, president of Harbor Group International, one of the largest multifamily owners in the US. “[That] will continue to create strong rental demand.”

Median rents nationally crossed the $2,000 threshold for the first time ever, according to a report in May by Redfin, a Seattle-based real estate brokerage firm. Median rents in Manhattan, a borough in one of the US’s most notoriously expensive cities, surpassed $4,000. Annual rent growth on new leases signed has reached over 50 percent in some US cities and is over 30 percent in many more. Another Redfin report from June found asking rents had continued to rise, although in a sign of rents beginning to soften, that increase had dropped to 14 percent from the year prior, the smallest annual increase since October 2021.

Because of the increase in rents, renewals are also increasing. Typically, renewal rent increases are lower than those for new lease rents so tenants are staying put rather than testing the market. For example, national renewal rents in May 2022 saw growth of 10.9 percent versus 19.3 percent for new leases, according to data from RealPage and MSCI Real Assets. RealPage also found that 57 percent of renters stayed put in April, relative to an average of 51.5 percent between 2010 and 2019.

Higher rates will also further exacerbate supply shortages that have already been driving up apartment rents, said Nadeem Meghji, head of real estate in the Americas for Blackstone. The US has a shortage of housing in excess of 5 million homes, though an exact number varies depending on source and methodology.

The supply shortage is unlikely to be solved soon. All the market participants PERE spoke to said that financing difficulties due to the increased rates, along with higher construction costs and supply chain issues, make bringing new supply to market more difficult.

The supply and demand imbalance has raised concerns about a bubble forming in the multifamily sector. “The situation that we’re in is nothing like 2008. But in some ways, the housing bubble may be even more severe than it was then,” Nate Kline, founder and chief investment officer at One Wall Communities, an owner of over 5,500 units nationwide. “Not because of the same types of things that led to it but because of how fast and how significantly prices have risen.”

Feeling the impact

At the same time, the sector is starting to feel the negative impacts from a high inflationary environment, continued rate hikes and worries over a potential recession.

“Prices for multifamily are coming down. They got extremely overheated the last few months,” Kline said. “About [two months ago], the brakes started squeaking.”

Indeed, investors have been pumping the brakes in transactions. Despite apartment sales volume hitting a record $21.5 billion in May, according to MSCI Real Assets, transactions have since become increasingly difficult to underwrite, with many deals repricing on a weekly, if not daily basis, many of the market participants said. Rising interest rates have led to a rise in borrowing costs that has reduced loan proceeds and had a negative impact on pricing, according to Brian McAuliffe, president of multifamily capital markets for CBRE. Cap rates for multifamily assets have increased up to 50 basis points, depending upon quality of assets and specific markets.

Patrick Carroll, chief executive officer of CARROLL, a multifamily manager with $8 billion in assets under management, said his firm closed on a deal in early June but has been sitting it out since then because of the real-time changes happening. Since that deal closed, he is seeing more and more lenders dropping deals and not quoting on properties, particularly if they were built in the 1990s or earlier.

The sudden rise in rates has resulted in significantly smaller entry cap rates for many assets, making it difficult to justify buying.

“It has literally frozen up the market,” Carroll said. “You’re seeing a 10 percent to 15 percent reduction in pricing. That is just to make up for the interest costs.”

This sentiment is shared by Litton. He said it is possible there will be further price resets in the market before transaction activity picks up. The bid-ask gap needs to narrow significantly, because it is keeping a lot of levered buyers on the sidelines, he said.

“It’s a whole different world than it was in 2019 in terms of the cost of debt,” Litton said. “That’s influencing cap rates.”

The dreaded ‘R’ word

The multifamily sector currently is bolstered by strong employment numbers. The US unemployment rate remained at 3.6 percent, or around 5.9 million people, for the fourth month in a row in June, according to the US Bureau of Labor Statistics. The number of job openings at the end of May was 11.3 million, meaning the unemployment rate could get even lower.

“Multifamily is well positioned today relative to other pre-recessionary periods given the strength of the employment market across the country,” said Nicholas Stein, managing director of Sentinel Real Estate, a New York-based multifamily specialist.

Consumption also remains strong, said Brad Case, chief economist and director of research for Middleburg Communities, a Virginia-based specialist manager. However, a recession would become likely should either the consumption or job numbers falter in the coming months.

A decline in consumption or employment is expected to have a direct effect on both new lease rent growth and lease renewal rates as vacancies would likely rise as renters get squeezed by rising costs across the board. Managers will need to pay closer attention to new resident qualifications going forward, said Joe Lubeck, chief executive officer of American Landmark, a Sunbelt-focused multifamily manager.

If that were to happen, dominoes might start falling. For current owners with floating rate debt, the cost of debt service on those loans will climb, Litton said, impacting the bottom-line cashflow for properties. Even a modest increase in vacancies could put some of those loans in trouble, creating opportunities for buyers with capital and essentially easing the slowing transaction market.

“We’re hopeful that there will be some good opportunistic situations where someone really needs to sell,” Litton said. “To the extent they’re acknowledging the reset in the market that’s unfolding on pricing, we do want to be opportunistic and buy.”