Interest Rate Risk and Real Estate
Interest rate policy has buoyed many types of assets over the recent past, including property. Prices of apartments, like all other property types, has been a beneficiary of low interest rates and given that we're near a long term floor in rates, it's sensible to be concerned that a reversal of that trend will drag prices back down. How far along is the party? Is the clock nearing 12 when we'll return to pumpkins and mice? Probably not.
Without question, rising rates by themselves, are not good for real estate. However, it should be understood that interest rates are not the only reason multifamily prices have risen. There are strong fundamental changes also at work. One of those is simply that there are a lot more people renting instead of owning; many by choice. Economic research at the federal reserve bank of St. Louis tells us that the rate of home ownership has fallen from a high of 69.2% in the 4th quarter of 2004 to 63.5% in the 3rd quarter of 2016. That level brings us all the way back to 1965. This equates to millions more renter households needing housing.
Owner/Renter Households
Despite this powerful, nationwide force, the eventual increase in rates will affect apartment investments and time spent thinking about how to be best positioned for this change is time well spent. The primary, negative way that higher rates will affect these investments is by pushing up "cap rates". A cap rate is essentially the return a buyer will demand and, as a seller, the higher the return you must give a buyer the lower the price you'll have to accept.
Apartment property investments are valued on their net operating income, or NOI. A cap rate fitting the class of a property is applied to its NOI to arrive at a value. Property classes are generally graded as A, B, C, or D. There are plenty of characteristics associated with each letter grade factoring into what class a property falls into, however, let's simply highlight age. Generally, the older the property the lower the class rating. What matters here is that cap rates get higher the lower the class of the building. A "C" class building should carry a higher cap rate than an "A" class building. The higher cap rate is meant to reflect the greater challenge that a lower class (older) building embodies. Lower class buildings typically require greater operating expertise than a new class "A" and therein lies the opportunity as well as potential for interest rate risk protection.
Let's say a class "A" building has a NOI of $1 million and the presently appropriate cap rate is 5%. It current value is, then, $20 million. Let further suppose that sometime in the future interest rates move up by 1% and that cap rates move in lock step so that now the market cap rate for this same class "A" property is also 1% higher at 6%. If that property had to be sold at the higher cap rate there would be a 16.7% decline in realized value. Now apply the same scenario to a "C" class property whose starting cap rate was 8% and became 9% as a result of that interest rate bump. The decline in value would have been 11.1%.
This lower sensitivity to interest rate risk in a lower class property is analogous to high yield bonds. Because high yield debt starts off with a higher rate, a given interest rate increase represents a smaller percentage change for it than a lower yielding, but higher grade bond. In that arena you are trading interest rate risk for credit risk. It could be said that you are doing the same with a lower class property, but not quite. With the property, the sponsor of the investment is able to exercise control over the operations directly affecting "credit risk", things like bad debt expense and tenant turnover.
Looking at the simple (NOI/Cap Rate) valuation fraction a different way shows that there is another, maybe more subtle lesson, what I'll call the "burden of growth"[1]. We can offset the negative effect of a higher cap rate if we can increase NOI by the same percentage change. In other words, if the cap rate has increased by 10%, there will be no decline in value if NOI also goes up by 10%. This quickly highlights the benefit of having a larger starting denominator. Going from a 5% to 6% cap rate, as in the Class "A" scenario represents a 20% increase, whereas going from 8% to 9% in the class "C" scenario is a 12.5% increase. Depending on the amount of time, a 12.5% growth in NOI is much more achievable than a herculean 20% growth.
I mentioned in the hypothetical cases above that cap rates moved point-for-point with an interest rate increase. That may not be the case. An important dynamic when considering cap rates is the spread between them and treasury rates (the most used treasury rate duration for multifamily real estate is the 10 year). Currently we have low cap rates relative to history, but we also have a spread to treasuries that is greater than historic average.
Cap Rate-Treasury Spread
It can be said that cap rates are again as low as they were in the overheated days of 2007, which alone would be cause for concern, however, the spread is much wider than it was then. As of first quarter 2016 the spread to treasuries stood at 375 bps compared to the average going back to 2001 of 320 bps and a thin 163 bps during the peak. This is important because that spread can act as an absorber of interest rate increases so that a 1% rate rise does not equal a 1% cap rate rise, allowing cap rates to rise more slowly.
To summarize, there is potential to minimize sensitivity to interest rate changes by focusing on lower letter grade properties. Market appreciation/depreciation should be less pronounced in this property category versus class "A"s. This would be a strategic positioning that makes sense when rates are expected to rise. The opposite would be true of course, when rates are expected to fall- holding higher class properties in an environment of falling rates would produce greater potential appreciation.
Interest rates are an important factor, but not the perched guillotine that some have feared. Other powerful forces have provided apartments with a tailwind and looking below the surface cap rates are not in the same precarious position they were in during the frothy 2005-2007 period. The real estate cycle will come and go. Maybe the most important factor, though, is how a property is bought and how it's operated. Something we try hard to do is bring our assumptions out into the light to be examined. Lots of smart people get into trouble when they don't do that.
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1. The burden of growth means the rate at which net operating income must grow every year to offset the valuation impact of a cap rate change. More formally:
((Sale Cap Rate)/(Purchase Cap Rate))^(1/(years until sale)) = Required annual growth rate of NOI
NOI can be grown rapidly during unusual periods such as after a re-position of a mismanaged property, but during normalized operations growth rates will mostly be constrained by the local market dynamics. This little equation serves as a reality check on assumptions. Bottom line, don't overpay up front and hope it works out.
