Multifamily Market Shift? Navigating When Interest Rates Rise Above Cap Rates

In today’s dynamic real estate market, multifamily investments offer the potential for strong returns, but navigating this asset class requires a keen understanding of key financial metrics. Two such metrics, cap rates and interest rates, play a crucial role in determining the profitability of a multifamily property. This article delves into what happens when interest rates climb above cap rates, explores alternative factors to consider beyond cash flow, and offers insights into navigating this scenario for a potentially successful multifamily investment.

When interest rates for multifamily loans rise above capitalization rates (Cap Rate), it’s generally understood that you’re not making money directly from the rental income (operating income). No cash flow!

Cap Rate:

This represents the expected annual return on your investment property, calculated as Net Operating Income (NOI) divided by the property value. For example, if a property generates $10,000 in NOI per year and has a value of $100,000, the cap rate would be 10% ($10,000/$100,000).

Lending Interest Rate: This is the rate you pay on the money you borrow to purchase the property. Higher interest rates mean higher borrowing costs.

The Issue:

When the cap rate is lower than the interest rate, it means the rental income isn’t sufficient to cover both the loan payments and your desired return. In other words, you’re essentially paying more in interest than you’re earning in rent.

How important is cash flow? I would argue that its important but just because a deal does not cash flow does not necessarily make it a “bad deal”. I have personally completed many highly lucrative multifamily investments that never cash flowed but still produced great returns.

When looking at a property that needs heavy renovations, it is not uncommon for the property to not cash flow as the renovations are being completed and during the stabilization period in which the newly renovated units are brought “online”. While creating cash flow is ultimately important it is not the only factor that should be considered when analyzing a multifamily investment opportunity. Here are a few other things to consider.

• Total Return:?While negative cash flow from rent isn’t ideal,?investors often factor in?potential property appreciation?when calculating their total return.?If the property value increases significantly over time,?it can still be a profitable investment.
• Tax Benefits: Tax advantages are another saving grace when interest rates surpass cap rates. Depreciation allows you to deduct a portion of the property’s value from your taxable income each year, essentially reducing your tax burden. Additionally, deductions for repairs, maintenance, and mortgage interest can further offset negative cash flow. Remember, consult a tax advisor to fully understand the tax implications specific to your situation, but these benefits can significantly improve the overall return on your investment.?
• Leverage:?If you have a large down payment and use less borrowed money,?the impact of the interest rate can be lessened.
• Specific Property:?Some properties,?like luxury apartments in high-demand areas,?might have lower cap rates but attract higher rents,?potentially making them viable investments even with high interest rates.

Data and Historical Examples:

While writing this article I set out to find the average cap rate for multifamily over the last 30-50 years. Apparently, there is no actual record of this data. There are too many variables (market, condition, age, etc.) to be able to decisively say what the cap rates were over that period.

I have been in the multifamily business as an owner operator for 20 years and I can personally tell you that from my experience the cap rates over that period have been on average between 5-8% for most multifamily properties with occasional exception.

Here is a breakdown from the information I have found on historical multifamily capitalization rates in the U.S market over the last 40 years. Remember, this is a very general estimate and may not reflect specific markets or property types.

• Early 1980s:Following high-interest rates and a recession, cap rates could have been in the 8-10%
• Late 1980s and 1990s:As the economy improved and interest rates dropped, cap rates likely compressed to the 6-8%
• Early 2000s:Another recession might have pushed cap rates back up to the 7-9%
• Mid 2000s to Late 2010s:A strong economy and low-interest rates led to a period of “cap rate compression,” with averages potentially reaching 5-7%. I personally remember these caps.
• Early 2020s (present):Rising interest rates are likely causing cap rates to creep back up, possibly towards the 6-8%?range again after dipping into the 3-4%?range in 2022.

According to a report?by www.cbre.com, the average cap rate for multifamily properties in Q4 2023 (U.S. market) was 5.06% and considerably lower than that in Q1 2022 and Q2 of 2023.

Source: CBRE Research, Q4 2023.

Meanwhile, interest rates have fluctuated throughout history. For example, during the early 1980s, interest rates reached highs of over 15% (source: Federal Reserve) leading to a significant decline in real estate values.

This isn’t to say every interest rate hike above the cap rate will trigger a crash. However, it highlights the potential impact on pricing. ?In the late 1980s and early 1990s, the S&L crisis led to stricter lending standards, further limiting access to capital for real estate investors. This, coupled with a moderate rise in interest rates, resulted in a period of stagnant or declining property values.

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- Bill Ham