The wild economic ride continues as the FED announces another significant interest rate hike on top of increases already made. In the announcement on 06/15/22, the FED stated that the purpose of taking more aggressive action is to curb the soaring inflationary environment we are in. The FED hopes to accomplish this without sending the economy into a deep recession.
From the news release dated 06/15/2022:
"The Fed's policy rate is now set in a range between 1.50 to 1.75, and policymakers suggested more rate increases to come. The Fed, in a fresh set of economic projections, penciled in interest rates hitting 3.4 percent by the end of 2022. That would be the highest level since 2008, and officials saw their policy rate peaking at 3.8 percent at the end of 2023. Those figures are significantly higher than previous estimates, which showed rates topping out at 2.8 percent next year"
- Jeanna Smialek, New York Times
Source: (6) Fed Takes Aggressive Action on Inflation: Live Updates - The New York Times (nytimes.com)
What does this mean for the multifamily industry?
A more conservative approach to underwriting is needed using less debt, which means that more equity will be needed to close a financially sustainable deal. It means locking in fixed interest rates with long-term financing and mitigating risk by establishing reserves as a safety net. It means making offers at lower prices because as interest rates rise, so do cap rates.
For those who do not know what a cap rate is, a cap rate is,
"a snapshot in time of a commercial real estate asset's return. The cap rate is determined by taking the property's net operating income (the gross income less expenses) and dividing it by the value of the asset."
The relationship between cap rates and property prices is as follows:
As cap rates increase, property prices decrease.
As cap rates decrease, property prices increase.
Until this year, cap rates have been low in the mid 3% to the mid 4% as overzealous buyers compete with each other and buy on proforma instead of actual income and expenses to win deals. This created an overheated market. Consequently, many buyers who bought properties using low-interest rate bridge loans in a low cap rate environment two years ago will find themselves in hot water this year as interest rates soar and their bridge loans come due.
Here's why:
When we buy properties, ideally, we want the cap rate to be higher than the interest rate because it results in positive leverage, which happens when the property's cap rate is higher than the cost of debt. It represents the strength of the property to service the debt. If the cap rate is lower than the interest rate, this creates an unfavorable situation called "negative leverage," which means the loan is stronger than the property's ability to service the cost of debt. When this happens, "the cash-on-cash return or return on the investor's equity is less than the cap rate, and this is a big 'No-No' in CRE"
For this reason, we are reviewing opportunities paying close attention to the terms of the proposed mortgage. For more information or questions, please schedule a time to talk. We are happy to discuss more and answer questions.
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