The obvious and immediate impact of rising interest rates are:
- Increase borrowing cost for investors. Post-election the 10 year treasury increased 60bps from 1.75%-2.35%, which increased borrowing costs from 4.40% to 5.00% on a typical 10 year loan.
- Decreased leverage as loan proceeds are typically maxed out at 1.25x debt service coverage. Most Fannie Mae loans do not lock an interest rate until a week before closing. Due to higher debt service, loans originally sized at 80% LTV were cut back to 75% LTV.
Both of these changes drive investor returns lower as 75-80% of their capital stack (debt) is more expensive, and a larger percentage of their capital stack is coming from equity.
If these were the only factors of multifamily valuations, then higher interest rates would lead to lower multifamily values in 2017. However, we have to understand the underlying causes of the interest rate increases to better gauge how valuations will be impacted.
Why did interest rates move upwards in Q4 2016?
President elect Trump has promised tax cuts and higher infrastructure spending. Both of these items are going to increase inflation so bond investors demanded a higher yield on the 10 year treasury, which drove the yield up 60 bps.
Let’s look at how the underlying causes of the interest rate increases might raise the value of multifamily properties:
1) Infrastructure spending leads to more jobs, which leads to higher demand for housing and thus higher rent and occupancy.
2) Tax cuts leads to more investment dollars available, which leads to higher demand for multifamily properties and thus Lower cap rates.
As you can see the immediate impact of rising interest rates negatively impacts values through higher borrowing costs and decreased leverage, but the underlying causes of these interest rate increases might benefit multifamily valuations in the long term through more jobs and more investment dollars available for multifamily properties.
It is hard to say whether multifamily values will continue to rise in 2017, but one thing is clear that as multifamily investments continue to generate cash on cash annual returns of 8-10% the demand for these investments will continue to be strong due to their 2x-3x return relative to other asset types.