Real Estate investing & volatile interest rates

How to Invest Successfully in Real Estate as Rates Soar

Although counterintuitive, in a rising interest rate environment, investing in real estate can still turn a profit.

It is a matter of managing risks, expectations, experience, and judgement when investing in such a market.

Interest rates are climbing

Recently the Federal Reserve raised the overnight lending rate between banks by 75 basis points. This is basically the only tool available to the Fed to combat inflation. This is the second of seven planned rate increases for the year.

Rates are expected to increase by over 3% before the beginning of 2023, if the Fed continues its stated strategy.

Real estate investing as interest rates rise

Most investors are comfortable in a non-inflationary environment, but investing when interest rates are on the rise can be unnerving, and there are issues that need attention.

Points to consider:

• A robust economic environment is likely to mean higher rents, as increased demand for multi-family homes in and near large metropolitan areas grows.

• Heightened concerns with rising interest rates and the resulting higher cost of borrowing.

The Fed has been moving toward interest rate increases for some time and has forewarned real estate market participants of their intentions. Savvy investors need only to shift strategies slightly to maintain profits.

Possible impacts of rising rates on multi-family real estate investing

Changes in apartment cap rates, which have declined over the last two decades, and the rising rate environment have many multi-family investors concerned.  

However, many also believe that cap rates will face upward pressures in those markets with lower rent growth projections, while other markets may see cap rates react differently because demand levels are not homogeneous.

Developers are also wary of the increasing costs of construction materials, as these costs are passed on to those building new housing.

Six ways to cut risks as rates rise

Certain real estate investments remain profitable in rising rate environments, historically multi-family real estate has done particularly well - see below for for a further explanation for the top strategies used or leveraged:

1)     Continued rental growth as interest rates rise

Even though the consumer price index rose 7.1% in 2021 and 7.9% by February 2022, multi-family apartment rents have risen by 10.5% for new leases and 8.1% for renewals, outpacing inflation.

Multi-family apartments command higher rents in most major metropolitan areas, allowing investors to achieve optimal cap rates on new deals and boost net operating income (NOI) on existing assets. Because of the short-term nature of such leases, they are positioned to re-price rents during inflationary periods. This helps offset higher nominal interest rates.

Increasing demand for multi-family housing pushes rental prices higher, which mitigates the increased cost of funding caused by rising interest rates.

Of course, not all multi-family properties will experience rental growth. For example, gateway markets facing slowing rent growth, such as New York City or San Francisco, may see cap rates increase, or experience a slower downward track.

Other markets, with robust growth projections, are likely to see cap rates compress further, owing to unprecedented housing demand and changes in demographic trends.

2)     High occupancy rates

The multi-family apartment market is enjoying historically high occupancy rates and rental growth as mentioned above—making cap rates drop.

In Q4 2021, multi-family apartment cap rates reached a low of 4.7 percent, a percentage change of 6 percent from the prior year, forcing many investors to accept a lower premium for holding such properties.

3)     Real rates of return

Even though the rise in 10-year Treasury rates was triggered by higher levels of inflation, there hasn’t been a major change to real, long-term rates.

Higher rental income can offset borrowing costs and NOI if cap rates remain unchanged. Think of cap rates as a real rate of return that is only affected by changes in long-term interest rates.

4)     Correlation between cap rates and nominal rates

For years, we have seen falling long-term interest rates enhance the value of multi-family apartments, which means that cap rates have declined. While it is true that interest rates impact investor borrowing costs, the correlation between long-term interest rates and yields on the 10-year Treasury bond is not particularly strong.

5)     Value-add strategies offset rising interest rates

When interest rates rise, investors should pay attention to enhancing the NOI of a multi-family apartment block and trying to compress cap rates. By buying undervalued properties, rehabbing them, and/or fine-tuning operations management is likely to deliver investor returns that exceed the effects of increased interest rates.

Reducing overhead costs, and/or reducing vacancies, plus gradually increasing rents are proven operational enhancements. Capital improvements will also leverage the initial investment and add-value.

6)     Tax benefits can counter rising rates

Real estate investors can use tax laws to their advantage by surrendering a portion of their income and capital gains to secure tax deductions.

One of these tools is  depreciation—one of the largest deductions for a real estate owner. Investors can amortize depreciation over 27.5 years on a residential property. Assets not attached to the property can be similarly depreciated via a shorter time span of 5 to 7 years.

These and other tax benefits can help investors mitigate the impact of rising interest rates.

Closing thoughts

Don’t be intimidated by rising interest rates. Investing profitably in multi-family real estate is possible.

While rising rates will mean adjustments to a portfolio, do not allow yourself to be deterred from your investment goals.

By any measure, the advantages of Real Estate Private Equity (REPE) investing will exceed the disadvantages, particularly in the multi-family sector.

A highly experienced and strong general partner will allow passive investors to look forward to favorable returns in any interest rate environment!