The Federal Reserve this week increased interest rates for the tenth consecutive time in 14 months, bringing the cost of borrowing in the United States to the highest it has been in 16 years. US base interest rates are now 5.25%, up from 0% just over a year ago in March of 2022. In the US the sharp rise in interest rates has caused a slowdown in most investment activity from tech companies, to manufacturing, to distribution, to the housing sector, and construction. After holding a national popularity contest among cities Amazon is pausing the development of its highly touted second headquarters, HQ2, in Arlington, Virginia. Higher interest rates make it more expensive for borrowers to pay back loans. This is true for developing countries who are exposed to foreign exchange risk and now have to pay back loans denominated in more expensive US dollars relative to their local currency. It is also true that paying back loans is now more expensive for real estate investors who took out floating interest rate loans. There have been news stories of over-leveraged firms losing large portfolios of apartments to foreclosure. Higher rates have led to the failures of three US banks. First Republic bank was taken over by the authorities this past weekend and sold to JP Morgan Chase to provide stability to First Republic customers and the banking sector at large.
With all of this as background over the past few months many people have been reaching out to me asking whether multifamily investing is still sound today. This is a smart question.
The short answer is—it depends. You have to dig into the details and understand what you are investing in. As I continue to have these conversations I developed a framework which I thought I would share below. Being clear about these four points should keep real estate investors out of trouble:
1. Understand the Business Thesis: Most real estate business models fall into either develop/build new property or buy existing assets. We don’t build new as it is not our forte and there tend to be a lot more variables to manage than buying existing property. On the buy existing multifamily investment side business plans fall somewhere on the continuum between a). “buy-and-hold, change fairly little” and b). “buy-and-renovate, change a lot”. Both work. The former is typically characterized by slightly lower returns and lower risk. The trouble is that it is very difficult to find deals in today’s market that fall into this category. The latter inherently has more risk due to more change and more moving parts. It usually does have a higher return or reward for taking on the risk. In both scenarios it is important to understand the price per unit at purchase as you don’t want to overpay, relative to what it costs to build new in that market. In the case where there are a lot of renovations the final cost per unit is a mix of the cost to purchase the unit plus the cost of renovations completed per unit. If that total cost (cost to buy + cost to renovate) is significantly lower than what a similar renovated unit goes for in that market then it is still a good deal. There is execution risk to navigate. How quickly can the renovation work be completed? How quickly can the renovated units be marketed and filled at the new and increased market rental rate? Will the work be completed on budget? Working with a team that has executed similar work previously, on time and on budget, in the same market, mitigates this execution risk greatly. Of course, there are all the variations in between these two extremes on the continuum. Analyze to your heart’s content.
2. Local Market Dynamics: What is happening locally where you are deploying your dollars? Not what is happening in that state! Most states in the US are relatively large and are bigger than many countries. When investing anywhere you want to get down to that county level and the metropolitan statistical area (MSA) or city/town. Is the local economy diversified? Is the town small but a bedroom community for an employment center near by? Which way are rent growth, job growth, income growth, population growth trending. What is happening with the supply of apartments? Las Vegas, Phoenix, Austin and New Orleans had seen massive multifamily investment interest in the past few years. Builders followed and over-delivered inventory. All of these cities are now reporting negative rent growth as operators have to discount inventory and offer huge incentives to get residents to live in their properties. By contrast most of the Midwest and still some parts of the Southeast have been slow and steady and continue to see moderate rent growth.
3. Fixed or Floating (Variable) Interest Rates: The cost of capital, that is the cost to borrow money, is much higher today than it was just a year ago. The business plans of today have to reflect this fact and have to adjust to the new reality. There needs to be a clear understanding by the investor of the risk of borrowing and how much cash flow or excess cash reserves may be required to weather potential storms. While the Fed signaled a pause to future rate hikes yesterday, taking on new floating interest rate debt in this environment is risky. The stories you see in the Wall Street Journal about thousands of apartment units being foreclosed upon usually are a result of having floating interest rate loans and no interest rate caps to protect investors from the downside. In that scenario as interest rates adjust higher so do the monthly interest rate payments to the bank. If the pace of rent increases cannot keep up with the higher mortgage payment then the operator is in a race against time until they run out of cash.
Historically at Cape Sierra Capital we have had a very strong preference for fixed interest rate loans. All but two of our current loans are at fixed interest rates, and many of them are at sub 4% interest! The two assets with floating rate loans in our portfolio have an interest rate cap and ample cash reserves to give us time to accomplish our business plan.
4. Trust the Operator: This is perhaps one of the most important factors. It is impossible to know everything at the beginning of a project and it is impossible to foresee all risks, economic conditions in the future, catastrophic weather events, etc. A trustworthy, honest and smart operator goes a long way to mitigate the unknowns. If the operator you are working with is someone that you trust to handle events to the best of their ability, has their interests aligned with yours, and they communicate well, then you have a winner.
If you feel confident about a number of the factors above then yes, today is indeed a good time to invest in multifamily real assets. Other investment options have not fared well and often have more risk. As of this writing stocks are in negative territory for 2023 to date. Crypto has shown itself to be in its infancy and very volatile. Unless you have the time to actively run a business there is a shortage of good, tax-advantaged, passive income options. The covid-19 pandemic put the spotlight on the fact that the multifamily sector is one of the most resilient and recession proof in real estate. People work from home more, people may travel less sometimes, we all physically shop less as online shopping now delivers same day in more places, but everyone still needs a place to live. As labor shortages continue, costs to build increase, there is upward pressure on the cost of a single-family residence. All of these factors come together to create strong demand for apartment living. This is not going away in the coming decades as our population continues to grow. You just have to make wise decisions about which projects, in what locations and with which operators suit your appetite for risk and returns.
At Cape Sierra Capital we focus on providing investors with passive cash flow by investing in multifamily real estate. To learn more about how cash flow works and how you can gain back control of your time download a free copy of The Personal Cash Flow Formula. To hear about our upcoming investment opportunities join our Exclusive Investor Network.