Over the course of 2022 the Fed has raised interest rates at a historically aggressive pace. The change in rates combined with the uncertainty on what decisions the Fed will make next has created a disconnect between buyers and sellers with buyers expecting a discount on current transactions and sellers striving for only slightly reduced prices compared to Q1 of this year. With so much chaos in the market many investors have asked if now is a good time to invest or instead sit out on the sidelines? Our argument in today's article is yes if one sticks to the fundamentals of investing and accounts for the current debt market in their underwriting.
Why have rates gone up this year?
While it's impossible to capture every aspect of this complex economic environment in a short paragraph, it's important to understand a few key events. During COVID, the supply of many goods (including even housing) diminished greatly while the demand for these goods increased. This economic imbalance combined with historic amounts of money being injected into the economy has resulted in the highest inflation that we have seen in forty years. Unfortunately, the only way to curb inflation that is out of control is to slow down the economy artificially which is what they Fed is doing by raising rates. As the Fed raises rates, it becomes increasingly expensive to do business and eventually forces companies to reduce their work force and cut expenses. This of course reduces the demand on consumer goods which will allow pricing to stabilize. While there are many negatives to forcing the economy into a recession and increasing unemployment, the net result of stabilized prices is deemed to be more desirable by the Fed due to the burden that a rapid increase in cost puts on Americans.
How do rising rates effect real estate?
In the world of residential real estate, rising rates results in an increase in cost when acquiring a mortgage for a home. This upward cost in debt service puts pressure on rising home prices which is of course coupled with normal market supply and demand. With rates being the level we are currently seeing, house prices may drop noticeably in softer markets while house prices in hotter markets (such as many in Texas) will likely see only a slight reduction or simply a much lower rate of increase.
In the world of multifamily the overall economics of higher debt service creating pressure on pricing remains the same, but the underlying goal is a little different. Instead of a desire to buy a house that is affordable, investors are looking for a price where combined with current debt terms the returns on investment are still attractive. While one would think this means that we would be seeing pricing that supports similar cash on cash returns we are simply not. Instead, we have seen cash on cash returns shrink noticeably. This is because the majority of investors still believe that the overall returns of real estate investing are promising based on the fundamentals of sound investing, the fact that properties are now available at a relative discount and the belief that rates will eventually return to a lower amount where properties can be refinanced.
How should we respond to this as investors?
Since the early 2010's, there have always been a group of investors claiming we are at a peak in the real estate cycle and that they would prefer to wait to invest when there is a price reduction. However, many of these investors are now too skittish to invest. We are now seeing pricing somewhat reduced (on the order of 15%) in Texas making the actual purchase price of properties more desirable than we have seen in recent years. This fact combined with the ability to refinance in the future has motivated most sophisticated investors to stay active and competitive in pursuing new acquisitions. While cash on cash returns could be lower, we at Apogee at bullish on the fundamentals on multifamily investing and the markets in which we search. This has lead us to remain active in this market with goals of finding deals at a fair discount which could provide outstanding opportunity to us and our investors. One question that we are often asked is when will we arrive at the "bottom of the market?" The short answer is that neither we nor anyone knows for sure. That said, when the Fed decides to quit pushing rates upward pricing will likely stabilize at a new normal and then shortly thereafter begin to trend upward again based on historical data. The Fed has stated that they will continue to raise rates until they are confident that inflation is coming down and with inflation numbers finally starting to trend in a downward direction we can speculate that perhaps only a couple more rate hikes are in store. That being said, as with any investment you cannot perfectly time a market nor can you always find a deal when you believe the market is at the bottom. Rather, when the opportunity to buy at a discount presents itself, you take a long term investing perspective and take advantage of the opportunity while you can. This is our strategy at Apogee and we encourage you to reach out to us directly if we can clarify anything.
Next week we will dive deeper into how higher interest rates effect our underwriting and what we can do in response.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please check out our free ebook "Achieving Financial Freedom Through Multifamily Investing."