In an effort to taper inflation, the Federal Reserve has set in motion what could be a series of interest rate hikes this year. The central bank raised its federal funds rate by 0.25% to a target range between 0.25% and 0.50% on March 16.
The Fed’s action ends a period without rate increases that started in 2018. With that long streak now over, how will rising interest rates affect the real estate market? While higher interest rates may have meaningful impacts on borrowing, several factors could blunt the effects.
In this article, we will examine the potential effects on the multifamily real estate market — including the burgeoning single-family rental (SFR) and build-to-rent (BTR) asset class — and touch on the possible effects on the real estate industry as a whole.
Loan Sizes May Shrink
Rising interest rates could affect loan sizes for commercial properties as it would result in higher debt service payments and could lower property cash flow. Fortunately, strong rent growth in many markets could help offset the impact to borrowers of rate hikes on debt service payments in multifamily real estate. For 2022, Freddie Mac envisions further multifamily rent growth will outpace inflation in most metro markets.
Additionally, higher interest rates could discourage some potential homebuyers from taking out mortgages, meaning these would-be homeowners may keep renting or could become renters.
Spencer Levy, senior economic adviser at commercial real estate brokerage CBRE, notes that over the long term, rising interest rates can be good for commercial real estate rents and values. The market, he says, can absorb three to five increases in interest rates.
The numbers back up Levy’s assertion. According to the National Association of Real Estate Investment Trusts, public REITs have historically performed well amid rising rates. In fact, REITs have had positive returns during 84% of the periods when interest rates have climbed between 1993 and 2021.
Cap Rates Can Expand as Capital Flow May Be Restricted
The increase in interest rates has the potential to expand capitalization rates (also referred to as “cap rates”) for multifamily and other property types, as the increased cost of capital would require a lower going in price to generate similar returns that could be achieved prior to rate increases.
Additionally, rising interest rates could reduce the amount of capital flowing into the real estate space if investors focus more attention on fixed-income investments like bonds. These securities could be seen as more attractive investments, prompting institutions to consider allocating more of their portfolios to high-yield, fixed-income products.
However, short-term to medium-term economic growth should support cap rates, according to real estate brokerage JLL, and high demand for rental assets and continued flow of institutional capital into the space could limit the reallocation of capital into the bond markets compared with the past.
The amount of capital chasing assets could act as a counterbalance to rising interest rates’ effect on cap rates. For instance, John Burns Real Estate Consulting reported in early 2022 that more than $50 billion had been invested in the SFR space since March 2020, translating into approximately 125,000 homes at the current median resale value of a house. That $50 billion was just one slice of the estimated $20.7 trillion commercial real estate sector in the United States. Sales of U.S. commercial property was a record $809 billion last year, and demand remains very strong.
Overall, CBRE forecasts the volume of U.S. commercial real estate investment this year to increase 10% compared with 2021. In part, that’s because investors’ appetite for commercial real estate has grown as the United States forges ahead with pandemic recovery. With so much capital clamoring to access multifamily real estate, especially the SFR and BTR asset class, investors may be willing to accept lower yields on their investments.
Moreover, the Mortgage Bankers Association (MBA) expects the volume for multifamily lending in 2022 to reach $493 billion, which would be a 5% increase over last year. Multi-Housing News explains that generally speaking, mortgage bankers and economists believe “increases in the cost of capital will be modest and will not dampen the availability of financing or the surge of investment.”
In tandem with the CBRE prediction, the MBA forecasts commercial and multifamily mortgage lending activity will surpass $1 trillion this year for the first time. That would represent a 13% spike compared with the estimated volume of $900 billion in 2021.
Although the Fed’s anticipated string of interest rate hikes could cause some turbulence in commercial real estate, the strong fundamentals in the multifamily space, especially within the SFR and BTR asset class, should ease the impact of the rate hikes. In short, investment activity in these segments and other strong performers within the broader commercial real estate market should register significant growth this year.