Interest Rates are Temporary, but Basis is…

Thank you for joining us for this issue of The Multifamily Memo.?

There is an old saying in the real estate investing world:? “Interest rates are temporary, but basis is permanent.”

At no time in the past decade has this saying rang truer than today.? For most, only in hindsight do we see the telltale signs that a market has peaked.? This is particularly true when everyone seems to be making money by investing in a specific asset class.? In this instance? – the large-scale multifamily sector.? We, like everyone else, enjoyed the ride fueled by a decade of ultra-low interest rates.?

Fortunately for us, we had the wisdom gained from our four decades of experience in the industry to recognize the characteristics of a market top. ?Note:? I would gladly trade some of this wisdom in return for a couple of decades of my youth!

The first sign was when cash flow from operations (distributions), which historically make up 67% of the return in real estate investing, shifted to a 20% component in the five years leading up to 2022.? This signaled to us that multifamily had moved from an “investable” class to a “speculative” class, dependent on the assumption that the asset would continue to experience strong appreciation driven by an unsustainable rate environment.

The second trend we noted was that a majority of value-add investors were not adding any value.? They would turn a couple of units for “proof of concept” and then flip the asset in a 12–30-month period, which really juiced investment returns.? This led to a massive proliferation of new investors armed with investment guru training seeking easy profits.?

This led to the third telling characteristic when a fundamental mistake emerged – buyers started to pre-pay sellers for value-add potential.? Simply stated, there is no value-add if you already paid for it.? This is why most of the emerging distress is centered in the value-added category.

As the market begins to sober up, it is important to differentiate between value-added and development projects.? Historically, value-add projects have generated enough cash flow to support themselves but offer opportunities for operational or physical improvements.? In essence, the value-add should enhance the investment’s performance rather than being integral to its success like a new development deal.

A case in point is Blackstone’s initial foray into real estate investing at the end of the 1989-1992 downturn.?? During this period, they bought high-quality properties that were on average only 80% leased, projecting a 23% IRR on existing operations even though they believed the market had bottomed and occupancy would substantially improve.?? It did, and Blackstone was rewarded with a 45% IRR for getting the “market-timing” value-add right, but they did not pay for their belief upfront.

Fortunately for the acquisitions prior to 2020, steadily declining interest rates and the continued proliferation of hungry new investors bailed out all but the most overzealous buyers. ?In a rising tide that lifts all boats, it is easy for investors without any particular strategy or process to make money “accidentally.”

Multifamily investing is first and foremost a numbers game that is based on risk-adjusted assumptions. This is why we have covered the fundamentals of cap rate spreads and band-of-investment analysis as components of your investment analysis.

Acquisition and sale cap rate assumptions are perhaps the most important determinants of investment success – especially in a market where valuations are in the process of resetting.? Get these wrong and it is nearly impossible to recover.? Remember our example from a previous issue, where we illustrated that even if you were able to increase the NOI by 30%, if future pricing is indicating cap rate expansion from 4% to 6%, your investment will still lose 20% of its value.

To conclude this section of the Memo, let us circle back to the old adage we opened with “Interest rates are temporary, but basis is permanent.” to make a fundamental point – do not overpay for a property.? Especially in a market like today’s, make sure you are fundamentally grounded in historical valuation indicators and tools.

Expert Insights:?Know Your Numbers – Understanding the Impact of Interest Rates on Value

If you are not aligned with an experienced operating partner that has been through similar market cycles, today’s market is unforgiving.? There is fine line between seizing opportunity and catching a falling knife.? For those new investors or sponsors that have never experienced a full market downturn, survival and prosperity in a resetting market dictates a firm understanding of how the various economic numbers work in establishing value.

Let us start off with how interest rates have affected valuations over the last three years by examining a typical deal structure.? In this example, an investor wants to acquire a property with an equity contribution of 30% and a loan of 70% - historically, a well-balanced capital stack for investors seeking the advantages of leverage while guarding against the downsides of macro-economic swings.

As can be seen in the following image, all things being equal the change in interest rates from 2021 to today results in valuation adjustment of – 29% on a stabilized property.

Note that the interest rate adjustments on the floating rate debt issued at higher LTV ratios (the majority of acquisitions between 2020 – 2022) have had even more of a negative impact on values. Many of these transactions will ultimately result in a total loss of equity and a partial lender loss as the market capitulates after the burn off of loan extensions and regulatory pressure.

In our last issue we opined that we thought we would never see another pricing reset of this magnitude during our lifetimes due to the belief lenders would pull back once they saw significant pricing deviation from historical norms.? We were wrong in our overall belief but correct when it came to the stalwards of industry lending, the agencies (FNMA & Freddie Mac).?

One common complaint we heard at industry conferences over the past few years is that the agencies would not lend enough on a LTV basis.? At best, borrowers were targeting 55% - 60% LTV ratios as rates began to normalize.? This was Fannie and Freddie telling the market that valuations had significantly outrun historical norms.? As can be seen from the calculation below a return to the well-balanced capital stake of 30% equity with 70% loan requires a 6.6% cap rate in today’s market.? This is a far cry from the 3.5% caps we saw during market peak.

That is a wrap for this issue. ?We hope you have found it enlightening and invite you to contact us with any questions or thoughts.? We are always happy to help.

Finally, if you have not already, be sure to Subscribe for more insights gleaned from over four (4) decades of navigating market cycles.?

We look forward to bringing you more of the information you need for successful multifamily investing.