Updated: Dec 6, 2022
The Federal Reserve just announced another 75 basis point interest rates. What will the impact be on multifamily investing?
That's a great question. The impact depends on whether you’ve already bought an asset or whether you're looking to buy now.
If you bought an asset three or four years ago, you probably couldn't have predicted that rates would rise so quickly in such a short period of time, and there are a couple of scenarios to consider.
For anyone who's already bought an asset; if they bought at a fixed rate there won’t be an immediate, direct impact. Indirectly, however, it means that cost of services are going to increase, payroll is going to increase and other operating costs are going up because interest rates are going to go up along with inflation for now. Because of that, operating the assets might be more expensive than originally underwritten.
If you bought an asset and the interest rate hasn't been fixed and it's fluctuating, then it will impact your cash flow because, obviously, the higher the interest rate the higher the debt service.
Normally when you buy an asset, you'd also buy a cap. It's basically an insurance you pay for the possibility of rates going up. You basically say, “Right now I'm buying at a three cap. If interest rates are going to go up, I'm going to pay a higher rate, but up to a four cap or four and a half.” Whatever you choose. Obviously the lower the interest rates, the higher the cap payments but once you hit that cap, it cannot go above that.
That's the impact on assets you’ve already purchased. For any assets you're buying right now, it depends how you behave as an owner, as a sponsor.
At Blue Lake Capital, right now we like to buy assets on a fixed rate, usually agency debt, because we don't want increasing rates to impact the cash flow of the assets that we're buying.
Because lending has changed, we have too. Rates are higher, but the type of assets we target are sometimes 20 and 30 million less than what they would've been just a few months ago, and we've adjusted. We stick to conservative underwriting, low LTV’s and fixed rates. And right now, when buyers might be a little bit shy, we feel that there’s great opportunity because we don't have as much competition and we are normally not the highest bidder.
After the past several years, it feels different to underwrite to those numbers, but another reaction we’re seeing to rising rates is that property prices have started to come down. That allows us to ensure the properties are cash flowing and we'll hit or exceed our projections.
And so, because lending has changed, we have too. Rates are higher, but the type of assets we target are sometimes 20 and 30 million less than what they would've been just a few months ago, and we've adjusted. We stick to conservative underwriting, low LTV’s and fixed rates. And right now, when buyers might be a little bit shy, we feel that there’s great opportunity because we don't have as much competition and we are normally not the highest bidder.
Based on all of that, if the deal still works, then we know it's a good, conservative deal. At Blue Lake, we navigate these times to make sure the deals still work. You can always make a good deal and a bad deal in any part of the cycle.
Another way to do it would be to buy a cap and underwrite to the cap. This assumes that, from day one, you're already hitting the cap. If there's enough cash flow, then you know you're already underwriting to the worst case scenario.
Looking at a worst-case scenario, let’s say interest rates go to 9%. Now, I certainly hope it's not going to get there and don’t think it will. But if we do get there, and you locked in a rate at 6%, it doesn't matter what happens since your payments are going to stay fixed. And that's one great way of making sure that you're not going be impacted by rising interest rates.
Now, mind you, this is the direct impact. As I've mentioned before, there's an indirect impact to the operating of the expenses of the assets. Exactly like your existing properties, Increasing interest rates mean, it's going to cost a little bit more to operate those assets. So, whenever you're looking at a new acquisition, make sure that your model accounts for an increase in expenses.
Finally, higher rates are causing pressure on rents. As you probably know, rents have increased dramatically across the board the past couple of years. In our portfolio specifically, we’ve seen increases between 30 and 60%, but now we’re starting to see some softening.
Source: Yardi Matrix
To account for this, we’re look for good properties where rents are below area comps and have room for growth, but we're not underwriting big growth. We're underwriting very small, single digit growth numbers to be conservative.
We're also underwriting some concessions. If we need to give a month or two months for free to make sure the tenants come to our properties, that’s a part of our underwriting now to make sure we are the right investments and have upside in the business model.
Ultimately, I do believe that interest rates will go down at some point. Otherwise, we're going have a much bigger problem than just real estate. Looking ahead to 2023, I believe that rates are doing to go down a bit and cap rates are going to either stabilize or compress a bit towards Q3 and Q4. I don't expect interest rates to go back to what they were before, but I do see things slow down and calm down a bit.
· Interest rates have risen very quickly, and we expect to see more rate hikes over the next couple of months until the Fed sees material changes in the market.
· For existing properties, if you have a fixed rate or cap on a floating rate, you shouldn’t see any changes in your debt service, but you’ll want to account for the impacts higher rates and continued, even if it’s decreasing, inflation will have on your operations.
· For new properties, we’ve been focusing on financing with fixed debt right now. It allows us to use very conservative underwriting and gives us confidence that we’re getting the right deals.
· Rents are softening, so you’ll want to find good properties with some room to grow, but your underwriting needs to account for smaller rent increases and possibly some concessions.
· As an investor, make sure that that your sponsor is taking all of these things into account when they were underwriting a deal.
The next year will still be challenging when it comes to interest rates and extended cap rates, especially in Q1 and Q2. If you have conservative underwriting and a strong operational plan, you can still find great deals, continue to scale your business and provide strong returns for your investors.
Be well, be strong, and keep pushing forward!
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About Ellie Perlman
Ellie is the founder of Blue Lake Capital, a commercial real estate investment firm specializing in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology.
Ellie is the host of REady2Scale, a podcast that highlights the assets, processes, and strategies for the multiple approaches to successful real estate investing.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.
You can read more about Blue Lake Capital and Ellie Perlman at www.bluelake-capital.com.