As interest rates rise, many are concerned about the potential negative impact on multifamily real estate values. Although there is a correlation between cap rates and interest rates, a closer examination of the overall market fundamentals reveals that multifamily values may not be as negatively affected as some fear. In fact, they may remain stable or even increase in certain markets.
Four key factors in the multifamily space could offset the potential drawbacks of rising interest rates: 1) the supply/demand imbalance, 2) inflation, 3) high construction costs, and 4) the trend of would-be homebuyers continuing to rent.
Supply/Demand Imbalance
The multifamily asset class currently faces a significant supply/demand imbalance in the United States. A study commissioned by the National Apartment Association (NAA) and the National Multifamily Housing Council (NMHC) indicates that the U.S. needs to construct 4.3 million new apartments by 2035. This figure includes a deficit of 600,000 apartment homes due to underbuilding during the 2008 financial crisis. Greater demand than supply puts upward pressure on rents, which can lead to higher cash flows and potentially higher property values. Indianapolis, IN, is an example of a market with such an imbalance.
Hedge Against Inflation
Multifamily assets have long been considered a strong hedge against inflation. Apartment owners and operators can adjust rental rates as frequently as every 12 months, in contrast to other real estate asset classes with longer-term leases. This flexibility allows them to respond quickly to rising operational costs. Historically, apartment rents have outpaced inflation rates, unlike some other asset classes.
High Construction Costs
A variety of factors, including labor shortages, supply chain disruptions, and inflation, have driven construction costs up dramatically over the past year. CBRE’s Construction Cost Index forecasted a 14.1% year-over-year increase in construction costs by the end of 2022. When combined with rising interest rates, these factors make it difficult and often cost-prohibitive for developers to build, which in turn reduces supply and strengthens the supply/demand imbalance. This situation is favorable for cash flows and real estate values.
Would-Be Homebuyers Continue to Rent
While rising interest rates are generally unwelcome, they do have a positive impact on apartment fundamentals. According to the Mortgage Bankers Association, mortgage applications to purchase a home have decreased by approximately 40% compared to the previous year. As the Federal Reserve continues its campaign to curb inflation by raising interest rates, mortgage rates have more than doubled. Consequently, more people are unable to afford home purchases and continue to rent, boosting the demand side of the equation. With supply remaining relatively flat, increased demand puts upward pressure on rental rates, potentially leading to higher cash flows and property values. Des Moines, IA, serves as an example of a market with strong fundamentals that has attracted institutional capital.
When building a diverse portfolio of institutional-quality apartment communities, it’s crucial to conduct thorough fundamental analysis at both macro and micro levels to make informed decisions. Understanding the specifics of each asset and the overarching trends in the broader and local economy can instill confidence in projecting future cash flows and stabilized yield on cost. This approach helps protect investor capital and generate substantial returns.
While it’s too early to say definitively whether multifamily fundamentals will outweigh the effects of rising interest rates on cap rate expansion, one thing is clear: opportunities for investment will not be scarce during these times of economic uncertainty.
