As you know, the Federal Reserve increased interest rates today by another 25 basis points. This decision is expected to reflect the Federal Reserve’s efforts to find a balance between curbing inflation and addressing a range of imminent risks such as potential bank collapses and the likelihood of a U.S. debt default as early as next month.
What this means for Viking Capital and our investors:
- Higher interest rates could price would-be homebuyers out of the single-family housing market, thereby increasing the number of renters.
- Multifamily property owners and investors with strong balance sheets can benefit from the current economic environment. It offers them an opportunity for portfolio growth by acquiring properties at a lower cost.
- We at Viking Capital think the interest rate hike will likely be the last of the year, and if so will help increase the transactional volume for Q1 2024. The decision to raise interest rates in the midst of the First Republic Bank collapse indicates that the Feds still believe the economy is resilient.
- For those who are investors in our Crossings at McDonough, or are still trying to get into this investment, you will take advantage of the fixed lower interest rate of 3.5% compared to the current market rate of 5.75%-6.25%.
While some renters are forced to delay buying until there are more favorable conditions, many renters now expect there’s a good chance they will never own a home in their lifetime. Though the “American Dream” remains unaffordable, apartment rentals provide a powerful alternative to have lifestyle amenities and convenience, as well as affordable places to live.
How Interest Rate Hikes Can Impact Multifamily:
The purpose behind these rate hikes and directives is to control the historically elevated inflation rate. Although they are advantageous for long-term economic well-being, the near-term outlook is not as definite, particularly in the context of multifamily investing.
- Expensive Debt: It’s evident that expensive debt can lead to a decrease in investor returns, demand lower prices to maintain returns, or investors opting to use less debt. This change in market dynamics could result in a fall in transaction volume or investors holding properties for an extended period, waiting for a better seller’s market.
- Variable-Rate Debt: Investors with variable-rate debt may face problems at their next reset as properties that previously produced positive cash flow may not work under higher interest rates. This could lead to negative cash flow, and investors could face loan covenant breaches or exhaustion of operational reserves. Consequently, loan defaults and foreclosures may increase for those caught on the wrong side of these rate hikes.
- Job Losses: Rising interest rates often result in layoffs, and industry executives have confirmed the possibility of reducing headcount or implementing hiring freezes. Investors and property managers in the multifamily market may respond to operational challenges by cutting staff, leading to rising late payments, collection costs, and impacting property profitability.
How Inflation Works:
Fundamentally, inflation occurs when there is an excess of money in circulation, leading to a scarcity of goods and services, which in turn causes a surge in prices. Typically, the Fed aims to maintain inflation at a target of 2% to 3% annually, but recent figures indicate it has reached 8.5%.
Raising interest rates is a strategy to reduce demand by making borrowing more expensive. With lower demand, there is less upward pressure on prices, leading to reduced inflation. For instance, in the residential mortgage market, at the beginning of the Fed’s rate hike program in early 2022, the rate for a 30-year fixed-rate mortgage was approximately 3.8%. However, after multiple rate increases, mortgage rates have now climbed to roughly 5.8%.
As a result, the demand for mortgages has declined to its lowest point in 22 years, and there has been a considerable drop in the volume of new home sales. This decline in home sales can have a ripple effect on various sectors related to the housing market, including banking, construction, furniture, and building materials.
To prepare for the anticipated period of economic uncertainty, multifamily investors can take these steps:
- Raise Cash: Investors should raise cash to build operational reserves to protect against an increase in vacancy and collection costs.
- Move into Fixed-Rate Debt: Investors holding variable-rate debt should evaluate medium to long-term fixed-rate refinance options to avoid the uncertainty of interest rate increases.
- Tighten Underwriting Criteria: Investors looking to purchase properties should make assumptions based on historical data and stress test them to see where they break down.
- Review Leasing Strategy: Property owners should ensure their properties remain full with tenants who pay rent on time by revisiting leasing criteria such as credit score or debt-to-income ratios.
- Be Creative: Property owners should look for opportunities to increase income and decrease expenses by offering rentable storage units or waiving upfront security deposits in return for monthly fees added to the rent.