Insight: Swimming With The Sharks
Anyone with a heartbeat probably knows by now that multi-family assets across the country have been on a sustained upswing lately, fueled by changing demographics, low interest rates, a tougher lending environment, and a large cohort of people who are still too broke, too shell shocked, or just too disillusioned to be home owners. By any benchmark, the ride since 2012 - around the time the housing market bottomed - has been spectacular - with strong rent and occupancy growth sending valuations higher. And, according to most experts, the good times should continue until homeownership starts ticking up again, which of course, is anyone’s guess when.
But, while the overall macro-economic prospects for the multifamily industry look quite compelling, the recent interest rate 25 bps hike by the Federal Reserve in December 2015 - after having kept rates almost zero for 7 years - marks an important inflection point, especially for small, private, mom-and-pop investors such as ourselves. The modern multifamily industry today is made up of a large cross section of players - from mom and pop, small, private investors; to global sovereign funds; to large multibillion dollar pension funds, and multinational insurance companies; to both public and private REITS.
In this diverse market, different investors face different prospects as interest rates change. Large REITS can often tap equity capital to meet their financing needs, especially if interest rates rise. And, while equity capital usually demands a higher rate of return, it generally comes without strings attached (aka interest payments and refinancing), especially useful when real estate markets stagnate or dip or when credit markets get jittery.
Large pension and sovereign funds as well as, insurance companies, usually allocate a small percentage of their total asset base to real estate as an asset class and thus, any cap-rate expansion driven by interest rate hikes is unlikely to affect these large multibillion dollar colossals significantly. Also, most of these investors use pension contributions, sovereign wealth, or insurance premiums to fund their real estate investments and hence do not rely too heavily on debt markets - making them less susceptible to interest rate fluctuations as well as refinancing risk or negative carry. Of course, none of these investors would appreciate any potential dips in the values of their real estate holdings but given their large, balance sheets and often, long-term outlooks, these fluctuations in their real estate portfolio values would not cause sleepless nights to most well diversified investors in this group.
This brings us to small, mom and pop, private investors. What these investors lack in financial muscle, they make up for by their passion, local knowledge, and diligence. However, time and again, despite their superior local knowledge, these investors too can get blindsided by the good times and fail to remember that real estate is a cyclical industry where good times often lead to over-confidence and excessive supply causing a market mismatch and subsequent negative price correction and bad times to over caution, inadequate supply and price appreciation. The pendulum often swings too far in either direction.
In a dynamic multifamily real estate market like today’s with valuations, rents, occupancies all setting record highs, it is very easy (and convenient) to ignore the elephant in the room - namely, interest rates. No other group is as negatively exposed to interest rate hikes as small investors given their heavy reliance on debt markets to finance investments and the relative lack of market power to negotiate favorable terms (longer-term fixed-rate debt, low/no prepayment penalties, etc.). Also, these investors are very likely to have high LTV ratios (70% to 75% LTVs are not uncommon) as high leverage enables super-sized returns, which can be very addictive, especially when it seems that nothing could go wrong.
The above calculation shows that for a multifamily asset valued/bought at $1 million at the prevailing 6.5% cap-rate and offering a 200 bps spread over financing costs of 4.5% would depreciate by 15.5% if financing costs increased by a 100 bps in order to maintain the same spread (200 bps). The only way to compensate for that loss would be to raise rents and increase occupancy - but with both running at record highs there is only so much room left. And if there is room to raise either, a savvy multifamily investor would do so irrespective of what interest rate changes occur. An improving economy (an interest rate hike would be preceded by an improving economy) may enable some improvement but can also spur homeownership and what course of action unfolds remains to be seen. Another possibility is that once interest rates rise, markets reduce the risk premium (spread) demanded from multifamily assets and hence, the market value would stay the same. However, the possibility of something like that happening is slim, at best, and none, realistically. On the contrary, given the strong price appreciation in multifamily assets and the extent to which occupancy and rent growth have already been milked to improve operating performance, the markets may very well demand a higher risk premium - especially if liquidity is negatively impacted by rising rates.
Small investors in their passion and strong emotional ties to their investment areas, can often overlook this potential for loss from interest rate hikes while bidding for assets and competing with larger players who may not have the same exposure to the rate curve. Also, once interest rates rise, these small investors would have to refinance their debt at the higher interest rates - risking negative carry if the asset was bought at a price that made sense at lower financing costs and with very favorable rent growth and occupancy assumptions - always a possibility in a multifamily market like today’s. Or , if unable to secure adequate financing at reasonable rates, these investors may have to sell their assets at lower valuations and hence book their capital losses.
In these times, smaller, private investors would be better served by using their local expertise to acquire distressed assets in good/turning neighborhoods at reasonable discounts through cash or high equity - keeping leverage ratios low. Leveraging their local contacts to reposition the property through creativity, sweat equity, and patience may be a better bet than leveraging their balance sheets. This would give investors more leeway if multifamily valuations fluctuate with interest rates and investors could carry their assets for a longer-term rather than book potential losses if they can’t refinance at an appropriate rate. Another advantage of targeting distressed assets that need rehab work is that most investors would be less likely to overpay for these assets - when you have substantial skin in the game, it is interesting how conservative and prudent investors become. While this strategy would not mimic the super-sized returns from high LTV properties, when the music slows (or stops), this strategy could mean the difference between surviving to fight another day and financial doom.
History, especially real-estate history, is replete with private investors trying to out compete institutional money and getting burned in the process. Loses that would be footnotes for institutional investors, could wipe out years of handwork for smaller investors. Small investors, instead, should compete on their terms, exploit their strengths, and engage in asymmetrical warfare. Competing with institutional/equity money with high debt is just too high a risk proposition in a maturing multifamily market with potential interest rate increases. Keeping leverage low would allow small investors to keep their powder dry to capitalize on opportunities that may open up once the multifamily market inevitably softens and there is greater certainty regarding interest rate movements.
