Monday, September 25, 2023

How rising interest rates affect cap rates and rental returns

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With interest rates soaring in 2022 and showing no signs of stopping, what should real estate investors expect among property prices, rents and cap rates?

History offers plenty of clues. Still, macroeconomic trends don’t always play out in real life the same way they do on paper. 

Keep the following in mind as you chart the troubled waters of skyrocketing interest rates, cooling home markets and potential recession storm clouds on the horizon.

High-flying interest rates

With inflation passing 9 percent in 2022, the Federal Reserve has raised the federal funds rate — the rate at which banks lend money to each other — from the 0-0.25 percent range at the start of the year to the 3.75-4 percent range by November. 

That’s a sharp hike by any standard. In fact, the Federal Reserve has hiked interest rates by 75 basis points several times in 2022 which it hadn’t done in decades

The Fed funds rate indirectly drives the 10 Year Treasury rate and mortgage interest rates. In fact, 30-year mortgage rates started the year around 3 percent and passed 7 percent in November

All of that in turn makes buying properties far more expensive. 

Cooling property prices

With home values having skyrocketed since 2020, the median home price has surpassed $450,000. 

A 3 percent mortgage for 30 years at that loan amount would cost you $1,897 per month. At 7 percent interest that monthly payment jumps to $2,994. 

You can see why rising interest rates put a damper on home prices. Buyers simply can’t afford to pay the same amount for homes when interest rates leap. 

We’re already seeing this play out as home prices start dropping in more markets. Homebuyer sentiment has fallen and pricier new home sales fall.

As the Fed keeps driving up interest rates to tame inflation and the risk of a recession looms, most analysts see a buyers’ market in 2023.

What about rents?

The market forces affecting rents don’t perfectly parallel those impacting home prices. 

When renters consider whether or not to buy homes, they compare affordability based on the monthly cost. High-interest rates make homes more expensive compared to continuing to pay rent, leading many tenants to stick with renting for the moment. 

That drives up demand for rental housing, which, in turn, keeps rent high, even as home prices dip. 

Something similar happens during recessions. When unemployment spikes, some homeowners default on their mortgages and lose their homes. These homes hit the market at a discount, driving down property prices. 

Meanwhile, those ex-homeowners become renters, pushing up demand for rental housing which is precisely why rents don’t historically fall during recessions, even as home prices do. 

Even so, vacancy rates do typically climb during recessions as do rent defaults and evictions. That impacts investors’ net operating income (NOI), which can in turn impact cap rates. 

The impact on cap rates

Falling property prices and steady rents are a winning combination for investors looking for high yields on REITs, rentals and real estate syndications. If you can spend less money on an investment but earn the same income from it, you come out ahead and achieve higher capitalization rates or cap rates.

That’s how it works on paper, anyway. But the effect is tempered by higher vacancy rates that reduce the NOI even if rents stay steady. Higher borrowing costs also throw a wet blanket on investors, just like homebuyers. 

The latter doesn’t apply to cash buyers, however. During periods of high-interest rates and falling property prices, cash investors can make out like bandits. 

While there are plenty of investors who can pay cash for a $100,000 single-family rental, the same can’t be said for commercial real estate. Few buyers have $20 million sitting around collecting dust, after all. 

So higher interest rates can put a dent in commercial property prices too. The mechanics look a little different: When the risk-free 10 Year Treasury yield goes up, investors expect to earn higher returns on their other, riskier investments. They don’t accept the same low returns — low cap rates — on commercial properties that they did previously. 

In other words, they pay a lower multiplier for the same income yield. Read: Lower commercial property prices. 

We’re already starting to see it, if slowly. Lawrence Yun, chief economist at the National Association of Realtors, forecasts lower commercial property prices and higher cap rates in 2023. 

What it all means for investors

First, if you can buy in all cash, you’re well positioned to score bargains in the year to come. It holds true for both residential and commercial real estate. 

Second, real estate investors should expect higher cap rates in 2023. That means they should underwrite new acquisitions more critically, with no assumption that they’ll be able to sell the property at the same low cap rates we’ve seen over the last few years. 

In other words, be more discerning in your deals and more conservative in your underwriting. That goes for residential investment properties, larger real estate syndications and other commercial investments. 

Finally, watch out for higher vacancy rates and evictions over the next year or two. Screen your tenants well, enforce lease agreements aggressively and offer competitive rents for renewing tenants. 

Real estate markets and the economy at large are cyclical. The current wave is likely crashing, which in turn sets up the next wave to crest. I continue to invest in multifamily real estate syndications and keep an eye out for other recession-resistant types of properties, such as self-storage facilities and mobile home parks. 

G. Brian Davis is a real estate geek and co-founder of SparkRental.

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