The changing dynamics of multifamily real estate investing

For the past 2 years, apartment complexes and other multifamily properties were among the most attractive investments in commercial real estate. But higher interest rates have curtailed demand for multifamily properties. 

Multifamily real estate is any residential building with 5 or more units covered by a single deed. In the past few years, the demand for multifamily properties rose as work-from-home policies drove demand. In addition, supply chain disruptions limited construction materials, reducing the number of new units coming on the market and driving up rental revenue.

Despite the challenging environment, many sellers are still expecting a premium similar to what they could have received a year or 2 ago. That’s led to a disconnect between the prices sellers will accept for their properties and what buyers are willing to pay. 

Interest rates touched historic lows during the COVID-19 pandemic, then began rising in 2022 as the Federal Reserve increased the benchmark interest rate to combat inflation. Interest on the 10-year Treasury bond rose to 4.2% in October, and by late spring 2023 it had fallen back to about 3.5% before rising to 4% in mid-July. Multifamily lending rates, which typically move in tandem with Treasuries, have remained in the 5.5% to 6% range for a 10-year product, said Kristen Croxton, senior vice president for loan originations at Capital One Agency Finance.

“It’s been very challenging to predict where rates are going to at any given time,” Croxton said during a Commercial Real Estate Women’s Network webinar in April. “As recently as last year, people were expecting to buy at rates of 3% or 3.5% and now they’re at 5.5% or 6%, and that has a big impact on the ability to buy.”   

Higher rates affect the loan amounts that buyers can support, and as a result, their deals may require that they provide more equity. At the same time, many sellers have not adjusted their asking prices. 

“There’s a breakdown between buyers and sellers as to what is real value,” Croxton said.

By the start of this year, higher interest rates were taking a significant toll. First quarter sales fell 74 percent compared with the year prior. 

The higher rates have also affected interest rate caps, which buyers use to hedge against rising rates. Caps are based on the Secured Overnight Financing Rate (SOFR), a broad measure of short-term borrowing costs. SOFR is used to set a strike price for caps over a period of years. For example, a 2-year cap with a 3% strike will pay if SOFR exceeds 3% over the next 2 years.

Eighteen months ago, borrowers could buy a 2-year cap with 3% strike on a $20 million deal for 9 basis points. By July 2023, the price had risen to 376.8 basis points. As a result, buyers who purchased caps 2 years ago are finding them much more expensive to renew. 

“If you’re assuming a $20 million deal, that [two-year cap 18 months ago] was about $18,000,” Croxton said. “Today, your $18,000 cost went up to $754,000.” 

While the caps can provide some protection for buyers in the short term, lenders typically assess escrow requirements semi-annually or annually. As escrow demands increase, buyers face a double hit. 

“Interest-rate caps are putting a ton of pressure on cash flow. Escrow requirements are increasing, and so are mortgage payments because of floating rates,” Croxton said.       

The result can hurt cash flow from the property. Fortunately for buyers, rents in most markets remain strong. But expenses such as insurance can be more challenging in some markets, she said.

All these factors may force some institutional investors to sell properties as the uncertain economic outlook is driving an increase in requests from fund investors to withdraw cash. 

Because interest rates were low for so long—and interest rate caps were stable—sellers don’t yet have a clear picture of what’s happening in the market. As more data comes out, sellers may adjust their prices, which could lead to more deals, Croxton said. “Sellers will start to understand where the current value of their asset sits,” she said. “And they may bring it to market and have buyers that can buy the asset at that level.” 

While lower interest rates would help restore some of the lost luster to the multifamily market, the Fed raised benchmark rates another 25 basis points in July 2023—to their highest in 22 years. 

Despite the uncertain economic outlook, delinquencies on multifamily loans remain little changed, Croxton said. As of March 2023, delinquencies tracked by Fannie Mae were 0.13%, while those for Freddie Mac were at 0.35%. 

Buyers seeking financing for multifamily investments still have options. Fannie Mae and Freddie Mac have been able to offer competitive loans despite rising interest rates, in some cases through favorable loan terms. Early rate lock programs can reduce interest-rate volatility by mitigating the risk that rates will increase during the underwriting process.

The two agencies also have programs that offer more favorable terms for properties that install green-energy installations or  support affordable housing.

While the uncertainty of interest rates continues to impact the multifamily market, buyers that know where to look can find the right loan programs for their needs and continue to reap the benefits of multifamily real estate investments.