How Interest Rates Affect the Market Value of a Multifamily Property

Multifamily properties are, for me, the best real estate investment one can do, when considered the risk and return factors. It provides steady income, it’s easier to manage than multiple single family homes, has better financing options, and allows the owner to have more control over the its market price. Nevertheless, there is a factor that is uncontrollable by the investor, which is the market interest rates. As the market value of a multifamily property is based on the present value of its perpetual cash flow, discounted by a rate of return, the higher the risk free benchmark is, the more the potential buyers will want to extract from their investments, and as the rate of return that the future cash flow will be discounted gets higher, the present value of the asset gets lower.

In this article, we’re going present:

• What’s a multifamily property
• Why Invest in multifamily properties
• How to determine a multifamily fair value
• What is the Fed Fund interest Rate
• How the Fed Fund Interest Rate affects the Multifamily market value

Multifamily Properties

Multifamily are real properties with two or more dwelling units under the same roof and over the same structure. It could be a duplex, with two units; a triplex, with three units; fourplex, with four units; or a multiplex, with 5 or more dwelling units.

The buildings composed by 2, 3 or 4 units are considered Residential Properties, whereas constructions with 5 or more dwelling individual housing units are called Commercial Properties. This will play a big factor on the definition of the market value simply because Residential properties are assessed differently from Comercial Properties. Where the first is evaluated based solely on the average value of similar properties, commonly called comparable properties, adjusted by property features, such as number of bedrooms, bathrooms, pool, elevator, etc, the commercial properties are priced considering the cash flow it generates and the rate of return used to discount it to present value.

On the multifamily properties, it is sill possible to categorize them according to their building structure.

Low-rise

Low-rise are buildings with 3 or fewer stories. It could be a small 3 story building, with several units, or a single-floor duplex, triplex, 4-plex or multiplex. This may include a complex with multiple buildings spread over a large area. This kind of multifamily is, usually, the entry door for small and individual investors that want to enter into this type of investment, but yet don’t have a large amount of money or credit to purchase bigger structures.

Mid-Rise

With 4-9 stories, the mid-rise multifamily properties are very common in urban areas with mid-density zoning. Different from the low-rise, the mid-rise usually have amenities to serve the tenants, such as pool, garage, gym, office spaces, and others. The more luxurious the project is, the more common areas it may provide to the tenants.

High-Rise

This type of multifamily is composed by 10 or more stories, usually located in busy metropolitan neighborhoods. They could be directed to serve blue or white collar communities, and can vary in several aspects to the luxury level, from a very modest to a super luxury infrastructure.

Why Invest in Multifamily Properties

Multifamily buildings are the only real estate asset group that can protect an investor in the long term, create value and wealth its holder and provide passive income. All the other ones will be short in one of those itens. Let’s see.

The office space was put in shock in the last pandemic. When Covid-19 hit the market, every employee in the world that was working from an office was sent… HOME. That’s right, soon enough the companies realized that people don’t need to dress up, commute, pass security checks, hang their coates in their chairs, go get a coffee, chat with their friends, and then, start to work. Not only they could perform 99.99% of their tasks wearing their bathrobes in their living room, at home they were more efficient.

In 2021, the freelance website Upwork estimates that 1 in 4 Americans will work from home. That’s 25% of the workforce in the biggest economy in the whole word.

Another study by Stanford with 16,000 workers over 9 months showed that their productivity increased 13%, when compared to their performance at an office. The result? Office real estate towers are starting to be transformed in hotels and apartment buildings.

The warehouse space will be dominated by one company: Amazon. How can an owner of a warehouse facility be protected against such a giant as Amazon? Virtually impossible. Amazon will dictated the rent, and the owner will have no control.

Hotels were also hit very harshly in the pandemic, with the worldwide hold on travels. The most benefited one was the residential properties.

Yes, in the United States there were “eviction moratoriums”, but they didn’t last forever. It had some negative impact on the payment of rents, however, the whole Covid situation showed how people care about their homes and how they are willing to pay more on their rents to have their needs covered.

We could argue that the Single Family Homes were also extremely benefited with the pandemic, and it was. Housing prices in America skyrocketed during the lockdown and the months after (they are still, at the time of the writing of this book - Jun/2021). However, as said before, every real estate asset group will fall short in one of the benefits of the multifamily buildings, and in the case of the Single Family Homes, one of them is the fact that one doesn’t control the value of the property: the market does.

Control the Value

The biggest difference between a residential property and a commercial property when it comes to determine the market value is that, on the case of the residential, a certified appraiser will run comparable agains other properties in the same neighborhood, or like-kind neighborhood to evaluate the fair market price of the property. Therefore, the price of property is as good as those of your neighbors. If you build the best house of the street, the average price of the other houses will bring yours down, and, because you have the best house, you will contribute to bring the other’s up.

In the case of the commercial properties, their value is driven by how much money they make, what we call in the industry as NOI - Net Operating Income. With that, the more you can increase the revenue (rent, vending machines, laundry services, etc.), and reduce the costs, the more money will be made by a given property occasioning a higher market value.

Passive Income

The internet made the term “passive income” common to everyone. However, most people now think they will make money without doing anything, and that’s far from the truth of what “passive income” really means.

In my definition of passive income is that you, or someone, doesn’t have to do the work all over again to make money. In a job, for example, you need to work every day, week, month to get your pay check. When it comes? passive income, generally, you (or someone) only have to work once (or, at least, do the hard work once). If you receive an inheritance, even though you didn’t do any of the work, someone did it for you, so you can enjoy the benefits now. But if you are not that luck guy or gal, you need to create something to be your cash cow, and keep making money without you having to repeat the process all over again. Writing a book is a form of passive income: you work once, and as long as it keeps selling, you make money. The cast of Friends, the most successful sitcom in history, still make about $20 million per year each in royalties for the show. Now, THAT’S a passive income.

Back to real estate, the multifamily properties are a great way to have a passive income. You will have to work once (finding the deal, buying it, etc) and will collect rent forever. Of course that, for this to be completely hands-off, you will have to hire a manager, which is always recommended, and they will keep everything running well for you, as you enjoy the benefits of receiving money every week or month. That’s a trait of every rental-driven real estate property. However, the next item, no.

Lower Vacancy Risk

Another great reason to invest in multifamily properties is the lower vacancy risk. When you purchase a single family home, your vacancy risk is binary: either you have 100% of the revenue coming in, or you have 0% of it. Even if you buy several properties, you cannot analise it based on the portfolio, but only by a property-by-property basis, because the costs are also individualized. For each property, you will have one Property Tax, one maintenance, one water bill, one electricity bill, etc. Multifamily properties are different.

By having more than one door in your real estate asset, you multiply the number of income sources per address. If you have a duplex, 2 incomes; a triplex, 3 incomes; 20 doors, 20 income streams. Therefore, you reduce your vacancy risk proportionally to the amount of doors (tenants) you have. When you buy a duplex, you will have 2 tenants. If for any reason one of them leaves, you still have 50% of your occupancy paying you. If you have 10, if would left, your revenue still would be 80% (if they all pay the same rent). You’re still making money to pay for your expenses. You still have a positive cash flow property, and you will have time to replace your empty units without concerning with the bills to be paid.

Economy of Scale

In any investment, you want to try to reduce (proportionally) your costs as much as possible. We call that economy of scale. Basically, you want to do more with the same amount of effort/cost overall, which will lead to a lower effort/cost per unit produced, in this case, rentals.

When you have a single family home portfolio, it is harder to build an economy of scale, meaning, what you spend in one property, most of the times, you cannot explore in another address. For exemple, if you have two single family homes in different neighborhoods, both with pools, you will have to hire two different services for pool cleaning. If they are next to each other, MAYBE, the pool guy will give you [little] discount, however, you are still going to pay twice.

If you had a duplex (basically, a big house with two different entrances) and one pool in the back, the same cost would now be split by two tenants, and each one of them would pay just a fraction of the total.

The same applies to a management company. If you hire someone to take care of your single family home portfolio, unless they are all adjacent to each other in the same street, you will have a high fare for that. You could get a little break for the bulk purchase, nevertheless, if you have a single building with 20 doors, the management fee will be significantly cheaper than for 20 different houses.

Better Negotiation Power

If you have ONE client and you NEED to make a sale, you need to agree that the buyer has much more power to negotiate than the seller. That’s what’s happen in a single family home, or a condo unit, specially when it is time to renew the current tenant.

To not renew it can cause several problems: 1) elevate your vacancy, which is less money; 2) increase your cost by having to market your apartment for rent; 3) depending on the market, it could take months to rent it again; 4) spending money repairing the unit for the next tenant, etc. If you only have ONE property, and it is a soft market, or a renter’s market, they might have power to ask you to maintain the rent at the current level or, worse, reducing the rent amount. And because you have only one door, you don’t have economy of scale and a high vacancy risk, you might take the lower value.

Now, this customer were 1 out of 100, meaning, you have an apartment building with 100 units (if you think this is an exaggeration, make it 10, or 2, it will be the same effect), you would not be so compelling to reduce the rent, or keeping it at the same level, because, even though you would loose that revenue momentarily, other tenants would still be paying and covering the expenses for the one who left. By having a lower risk, you have a higher negotiation power with your individual tenants, therefore, you make better decisions for not having the pressure of being underwater.

Protection over Recession

In the stock market, investors are always looking for two macro kinds of assets: the ones that will grow with the economy and the ones that will grow, or, at least, not go down, with the economy in case of a recession. We call the second type as “defensive stocks”. Those are stocks that will perform, more or less, the same in any scenario, as the demand for their product or service fluctuates very little, as well as the costs of the companies. Examples of those kind of stocks usually are found at the utilities segments, such as cable tv, telephone companies, etc.

In real estate, rents play the same role. It is a fact that everyone needs a place to sleep, a roof to be under, and they can do it in two ways: buying or renting. Some buy, some rent, however, during a recession, more people are inclined to do the second rather than the first. Even people that are “owners" (actually, they have a mortgage), in a moment of recession, they might sell their house, payoff their loan, cash out some money (if they have it), and start paying rent until the situation normalizes. People that are currently paying rent, they might downgrade, they might move in with someone, they might sell their cars to have more money to pay rent, but they will always put their lodging situation at a top priority.

Because of this behavior, in moments of recession the rents usually increase their prices, of course, there is a higher demand and the [almost] the same supply. Between 1982 and 2020, the US economy had 5 periods of recessions: July 1981-November 1982; August 1990-February 1991, March 2001-November 2001; December 2007-May 2009; and more recently, February 2020-April 2020. In none of those periods the rent levels decreased, according to the Consumer Price Index for All Urban Consumers: Rent of Primary Residence in U.S. City Average, from the U.S. Bureau of Labor Statistics.

Easier to Leverage

In finances, leverage is the usage of third party funds to buy an asset. That means that the buyer will have to deploy less of his/her own capital to acquire an investment, may it be stocks from a company or a real property. You can use banks, private lenders, seller’s finance, investors. Those are all source of founds called “OTHER PEOPLE’S MONEY”, or simply, OPM. In essence, is the use of a liability to acquire an asset. And that’s good. Usage of debt to purchase something that will produce you income is not a problem. Debts that don’t generate you value, are.

When you are buying a residential property, you have several lines of credit to do so. The ones that are guaranteed by the Government, such as FHA or VA loans, are great sources of leverage at low rates. If you are a first time home buyer, for example, you can finance (leverage) up to 97% of the property appraised value; if you are a veteran, you can go up to 100%. If you don’t fall in any of those categories, you need to go Conventional, which would require 5-25% of downpayment.

The problem of purchasing a single family home, or a condo unit, is that the bank will analyze your free income (your gross income, less other debt payments you may have, less property taxes and insurance) to calculate how much could be your monthly payment and your maximum loan amount. Usually, the monthly payment, cannot exceed 50-55% of your free income, or 70% of your gross income.

Since those kind of properties don’t generate revenue, you are only getting debt to pay bills. However, if you buy residential multifamily properties (2-plex, 3-plex, 4-plex), you can use the same lines of credit and some banks incorporate the revenue you are making with the property to your income to give you a higher loan amount.

If you buy commercial multifamily properties (5-plex or more), than the most important analysis for the bank is of the property. Most of the lenders will lend you the money based on the fact that the property can pay for itself. Yes, they will still check your credit and income, however, because the properties [often times] have lower risk of default, that will play a major role and you might qualify for loan amounts that you would never if you were buying a residential property.

A great exemple of this was my first multifamily real estate deal. Coming from Brazil to America, I had no credit, no history in this country and I still could get a $1.5 million dollar loan to acquire a $3 million dollar 20 unit property. Even though the loan-to-value (LTV) was low (50%), I was amazed that a bank would lent me that amount of money.

Tax Benefits

Your house is a liability. People want to tell you that it’s your asset, but it is not. You make no money on it, actually, it brings you costs every single day, you cannot deduct all of your expenses on the house from you personal taxes, and it is cash flow negative.

When you have investment properties, structuring them under a company, you can deduct all of your expenses to run that company, which would include maintenance of the property, pool cleaning, gardener, electricity, water, insurance, improvements, etc. All costs are deductible, which is not true for your own property.?

Depreciation

Another advantage is the use of depreciation to reduce your gains. Depreciation is an accounting mechanism to represent, on paper, the loss you have on the property with its wear and tear. Real estate assets can have their structure (buildings, not land) over 27.5 years in a straight line, example:

If you have a property that you paid $1,000,000,00 for, usually 70-80% is the structure. Let’s take, for this example, 70%: $700,000.00 can be depreciated over 27.5 years, meaning that you can deduct from your taxable income $25,454.55 per year ($700,000.00/27.5 years). In some cases, you can apply a “accelerated depreciation”, which allows you to depreciate 100% of your depreciation in 5-15 years, thus granting you more tax benefits.

As you can see, there are many benefits for investing in multifamily properties, and here we listed just the most obvious ones. Now, let’s understand the classes and kinds of assets you can invest on.

How to Determine the Fair Value of A Multifamily Property

The fair value of a multifamily can be stablished in two ways: using comparable properties and by discounting their future cash flow to a present value by an interest rate.

The use of comparable properties is more commonly used on residential multifamily, where an appraiser will compare the subject property to the most recently sold properties in the same neighborhood, or a similar one in the case of lack of sales in the subject property area, adjusting it to particular features, such as the number of units, bathrooms, bedrooms, pool, elevator and other amenities.

Commercial Properties, in the other hand, take into consideration the present value of its cash flow, discounted by an interest rate, as per the formula below:

where:

CFt = Cash Flow from a given period;

i = discount rate

t = period

Since the operation of a multifamily is infinity when it comes to the timeframe, we simplify that equation with the calculation of the Perpetuity, which is the sum of all cash flows, into perpetuity, of a given asset, defined as:

?The tricky thing is to define the discount rate. In a day to day operation, each investor will discount it by the rate they find it suitable. Often referred as Capitalization Rate, or simply Cap Rate, investors use the number they fell comfortable, based on the property conditions, tenants, return of risk-free assets, etc.

In a more sophisticated fashion, the discount rate should be able to compensate the investor for the risk, comparing it to the expected return of the overall market and the risk-free benchmark, which often is the Fed Funds Rates.

What is the Fed Fund Interest Rate

The FED, or the Federal Reserve is the guardian of the US dollar value. It is its job to control the purchase power of the money. The loss of this purchase power it’s called inflation, which is the reduction of the power to purchase a compound of goods and services in a given economy in a given period. Summarizing, one of the main jobs of the FED is to control the inflation.

Inflation occurs by the excess of money available in the market. By having too much money, individuals and company tend to spend more. Since the speed they want to spend their money is faster than the capacity of companies to provide goods and services to everyone, the prices goes up. When there is lack of money, the opposite occurs.

The FED, then, acts in both cases. When there is money in excess, they take it out of the market, reducing the capacity of individuals and companies to spend money, driving prices down; or putting more money in the market, increasing the interactions between buyers and seller, driving prices up.

One of the ways the FED does that is by incentivizing people to not use the money they have, giving they a premium for that.

On a daily basis, individuals and companies make decisions on what to do with their money: spend/invest or save. If the premium for saving is too low, they will prefere to spend/invest a greater part of it. If the benefit of saving is high, they will reduce their expenses and leave money parked in risk-free investments.

Basically, when the inflation is high, the FED increases the premium for individuals and companies to not use their money and, instead, save it by buying Fed Bonds or investing in Mutual Funds that buy fed bonds, in exchange of a return.

In the last 20 years, the premium for not spending money was low. The FED kept their interest close to zero, but recently, as the inflation got higher, the FED started to increase that premium, bringing the Fed Rates to 0.5% per year. Though it seems still low now, before covid the FED did the same movement, spiking the interest rates up to 2.5%.

And how does this affects the multifamily properties value?

How the FED Funds Rates Affects the Value of Multifamily Properties?

As discussed before, the market value of a commercial multifamily property is affected by its periodical (monthly or annual) cash flow and the discount rate. The discount rate will be affected if the investors have a risk-free option with a good return. Basically, the more money the investors can make with low (or zero) risk, the more return they will seek in opportunities where they incur risks. The discount rate is defined by:

where,

Krf = risk-free return (fed funds)

Km = expected market return

B = subject asset risk

Given that all variables stay the same, and the only change is on the risk-free return, the higher this one is, the higher the CAP RATE wanted by the investor will be. Exemplifying in numbers, we could have the hypothetical situation of:

KRF = 0.25%?

Km = 6%

B = 0.54

The cap rate would be

Therefore, if you’d have a multifamily that generates $300,000.00 net per year, it’s market value would be:

If the interest rates would rise up to 2.5% again, the market value of this asset, assuming all other variables were to stay the same, the new CAP RATE and market price would be:

SUMMARIZING

Multifamily properties can be classified in Residential and Commercial. While Residential properties are valued based on the sales of comparable properties, the commercial properties take into consideration the perpetuity of its cash flow discounted by an interest rate. This rate is affected directly by the risk-free option the investor might have, commonly referred to the Fed Funds Targeted Rates. As the risk-free option returns a better rate for the investor, he seeks more return for riskier opportunities, increasing the discount rate. As the discount rate reduces the present value of the asset, the increase of Fed Funds tend to adjust the prices of multifamily properties down.