Rising Interest Rates and Commercial Real Estate

Investors are keeping a sharp eye on interest rates as they are a major factor to leverage returns. Rates have rapidly climbed over the last few months, and it is expected this trend will continue through 2022 and well into 2023. At the start of the year, interest rates for investment properties were between 3.5% and 4%. In four short months, we are seeing rates inching closer to 8%.

What does this mean for real estate?

Increasing interest rates make borrowing more expensive, therefore impacting investors’ desired return. Investors are forced to offset the higher cost of financing with a lower purchase price on real estate. As rates climb, cap rates usually follow, which puts downward pressure on pricing. Unlike the 10-year treasury and interest rates, cap rates do not see daily volatility. There is usually a lag between the time it takes the market to see cap rates increase from interest rate hikes alone.

The aggressive interest-rate increases are a direct move to combat inflation, the highest we’ve seen in four decades. The general rule of thumb is that higher interest rates are usually a response to higher inflation, which could have a positive impact on real estate income growth. Even though rates are trending upwards, which impacts what investors can pay, they will be focused on pushing rents to keep valuations high.

Economists expect rates to continue rising over the next 1-2 years, potentially reaching the 6% – 8% range. This could have a drastic impact on cap rates. Luckily, with low vacancy and little new construction in commercial real estate, it doesn’t create the same problem we saw during the Great Recession with over-supply. Investors will be more focused on increasing rents than being cap rate driven for values, which caused cap rate compression over the last few years.

An increase in values over the past twelve months have forced lenders to tighten their underwriting — the loan-to-values (LTV — amount of a loan compared to appraised value) we have seen in the past no longer worked! Currently we are seeing 55% – 65% LTV rather than the 65% – 75% during the last few years. Lenders are being more cautious with rising rates, cap rate compression, increased values, and the changing environment we face with headwinds in the debt markets.

Increasing interest rates make borrowing more expensive, therefore impacting investors’ desired return.

Positive vs negative leverage

Sellers can anticipate investors showing more caution and patience if they need debt until 2022 unfolds and the impact on values is revealed. It becomes difficult to use debt today if it creates negative leverage, meaning debt is at a cost that eats into cash flow, reducing the cash-on-cash return compared to an all cash return. Typically, debt is used to maximize the return, which means investors need positive leverage. That doesn’t happen when you are buying at a 5% cap rate and borrowing at a 4.75% interest rate. To determine positive or negative leverage, you divide your annual loan payment by your loan amount to generate a loan constant. Based on the loan constant, you will know the minimum cap rate needed to generate positive leverage.

For example, if you bought a $5,000,000 property with 60% LTV, your loan would be $3,250,000. If you had a 30-year amortization with a 4% interest rate your annual debt service is $186,192 [$186,192 debt service/$3,250,000 loan amount = 5.73% loan constant]. This means you must buy a property at a higher cap rate than 5.73% to get positive leverage.

A 5.50% cap rate on $5,000,000 generates $275,000 of net income, less the $186,192 debt service, would leave you with $88,808 in cash flow. Take that $88,808 and divide it by your down payment of $1,750,000 and you have a 5.07% cash-on-cash return – which is less than the 5.50% cap rate, meaning that loan generated negative leverage.

On the other hand, a 6.00% cap rate on a $5,000,000 property would generate $300,000 of net income, less the $186,192 of debt service and you have $113,808 in cash flow. Divide that by the $1,750,000 down payment and you have a 6.50% cash-on-cash return – which is more than the 6.00% cap rate, meaning that loan generated positive leverage.

This concept is important to understand because it is what drives buyers to pay lower prices and have higher cap rates – making debt work to get positive leverage. Otherwise, bringing debt into a deal may not be advantageous to the borrower at current pricing and interest rates.

As we move forward in 2022, we may not see the movement in values right away, but sellers and buyers will soon enough find themselves at a crossroad of having to understand debt market pressure of increased interest rates and what buyers can (and will) actually pay. Sellers still find themselves in a great position to sell, as the amount of capital in the market is aggressively looking for real estate to hedge inflation. Today’s environment of changing rates and inflation causes uncertainty in stocks, cash, and other alternatives, whereas real estate is viewed as a much safer investment alternative.

Suburbs Apartment Rents Close to Their Pre-Pandemic Peak

Though the rental market in major cities has been hard hit by the Coronavirus pandemic—plagued with a mass migration by remote workers seeking larger homes, as well as relocations because of social distancing concerns—it appears that the suburbs have not just survived COVID-19’s wrath, they’re thriving in spite of it.

While rents have declined steadily in the larger, denser, principal cities at the core of each metropolitan region, rents in the outlying suburban areas have, on the whole, rebounded to pre-pandemic levels,” according to a new report from Apartment List.

From June through September, rents dropped in cities but “quickly rebounded” in the suburbs from losses that were seen from March to June across all of the property type’s markets, the report stated. In October, rents were 0.5% higher than they were at the start of the year, and came in just under their pre-pandemic peak in March.

Suburbs are outpacing cities across the country. In 27 of 30 large metropolitan areas tracked by Apartment List, “principal cities are experiencing faster rent drops or slower rent growth than their surrounding suburbs. And in 11, including major economic centers like Atlanta, Dallas, and Philadelphia, apartments in the principal city are getting cheaper while at the same time apartments in the suburbs are getting more expensive.”

The data jibes with other recent research concerning the impact of move-outs from cities, and the resulting strength of the suburbs. A recent report from Redfin showed that in the third quarter 29.2% of Redfin.com users looked to move to another metro area—the highest share since Redfin started tracking migration at the beginning of 2017. The uptick is partly due to the pandemic, Redfin stated, as well as the now pervasive work-from-home culture.

Short-term suburban rentals—which it defines as one-to-two-year lease terms—could be demand drivers for residents seeking work-from-home space and outdoor access. Suburban renters typically seek larger units, such as two-to-three bedroom apartments.

If this work-from-home trend is going to be a little bit longer term, people will feel more comfortable with moving out into the suburbs.

Efforts to socially distance also are fueling shifts away from major cities to the suburbs people just don’t want to be in enclosed, dense areas.

Six Trends to Watch for in Multifamily Property Management in 2021

Pandemic creates opportunities to rethink how best to serve residents.

2020 has presented the multifamily industry with unparalleled challenges due to the pandemic with the secondary and tertiary effects forcing the industry to quickly pivot to meet resident and prospect needs. However, the pandemic has also created opportunities for multifamily owners to creatively rethink resident retention strategies and communication and how to demonstrate value. While some external factors will remain uncertain as we transition into 2021, here are six trends we expect for the future of the multifamily industry:

1. Service Will Be a Secret Weapon

Next year, enhanced customer service will become the most critical component for demonstrating value and increasing resident satisfaction across multifamily communities. While efficiency and timely communication remain two essential strategies for solid customer service, expectations are on the rise as more residents work from home. Although some prospects and residents may continue to request face-to-face (albeit socially distanced) interaction, we foresee most leaning into digital communication via smartphone apps, emails, or text alerts for updates and ongoing communication with on-site teams. For multifamily operators, that means expanding your digital resources and increasing the frequency of communication in 2021.

This also means accelerating response times and prioritizing maintenance requests since many residents are still working from home and spending ample time in their living space. It’s important for on-site teams to prioritize quickly and efficiently, especially as the volume of requests increases and residents expect almost real time responses. What was once a minor maintenance issue can now quickly escalate into an unsatisfied and angry customer as residents are experiencing the maintenance issue for more hours of the day. As we continue into 2021, on-site teams will have to provide an enhanced experience by quickly managing requests, clearly communicating all updates, and going the extra mile to offer the best possible management experience.

2. Prioritize the Retention of Top Qualified Talent

Employing a highly skilled property management and maintenance staff is paramount to resident satisfaction and successful day-to-day operations. However, finding and retaining top talent will remain a challenge in 2021 for several reasons. Multifamily is a highly competitive and growing industry with a surplus of opportunity. We’re now seeing an excessive demand for experienced, trained personnel, but a labor shortage of qualified candidates entering the market. 2021 will continue to expose the need for more highly skilled and passionate staff members. The companies that succeed in attracting top talent do so by offering competitive salary packages; providing training, education, and support; and continually looking for creative ways to “surprise and delight” employees. Example perks could always include an appreciation day for the teams, flexible work hours, or an unexpected day off. Onboarding a professional, qualified, and capable team translates to resident satisfaction and long-term resident retention.

3. Looming Economic Uncertainty Clouds the Industry

Although this year brought economic uncertainty with changes in income and employment status, rent delinquency for multifamily hasn’t been as significant as anticipated. Research conducted by the National Multifamily Housing Council reflects a 1.1% increase in overall delinquency in September 2020 versus the prior year, with a 4.8% decrease in on-time payments. We’ve had a similar experience at Fogelman. Rent collections have outperformed expectations during the early part of the pandemic; however, we recognize that many are still struggling financially, which might impact future collections.

It’s difficult to predict what delinquency will look like in 2021 since it’s dependent on employment recovery and what stimulus is available to help struggling renters pay their rent. Along with the rest of the industry, we’ll be monitoring economic conditions as we head into the new year.

4. Getting Creative with Resident Connection

Striking the balance between resident interaction and safety precautions will continue to be a challenge for multifamily teams in 2021. Residents may want to resume “normal” social connection and activities with the coming winter months, but the ongoing pandemic will challenge property management teams to rethink social events and connectivity. Though we’ve seen a lot of virtual happy hours, drive-by celebrations, and Zoom classes, it’s the teams that leverage creative programming to bring people together online that will have the most success in 2021. For safe, socially distanced resident activities next year, we expect to see more virtual scavenger hunts and trivia, virtual cooking and mixology classes, and community visits from local favorite food trucks.

5. Adapting to the Evolving Needs of Residents

We understand residents are using their living spaces differently in the wake of increased remote working. Apartment units have become a place of work and leisure, and there are no signs of that changing anytime soon. Some major companies, such as Google, Target, Salesforce, and Facebook, are delaying the return to a traditional office environment until summer 2021, and a handful of companies, like Microsoft and Twitter, are transitioning to a permanent remote status.

In 2021, management companies will need to continue adjusting their offerings to meet resident needs in the short and long term. Whether that’s providing better high-speed internet packages, creating socially distant co-working spaces, offering reservation-based conference rooms, or establishing wellness-focused areas like outdoor green spaces and trails. Those that adapt the fastest and implement feedback from their residents will be most successful in strengthening resident retention and satisfaction.

6. Go Digital, Stay Connected

Because of the pandemic, we’ll continue to see less physical interaction with residents, causing a greater demand for information and the frequency at which it’s delivered across online platforms. As mentioned earlier, digital communication tools like apps, emails, and texts are the industry standard and mainstay for properties in 2021. Another must-have for convenience is a web portal that allows residents to make payments, submit maintenance requests, and view discussion boards or upcoming events. For prospects, offering self-guided and virtual property tours will be an important, safer option. Overall success in 2021 requires that digital tools provide both convenience and ease of fast, frequent communication to help us meet our residents and potential residents right where they are—online.

Rents are soaring — and so are evictions nationwide

In cities across the United States, millions of people will be kicked out of their homes this year.

Some can’t afford their soaring rent, others are getting evicted over minor violations by landlords eager to get higher paying tenants in place.

Rents have risen 7% in the past year, while incomes have inched just 1.8% higher — making it that much harder for people to afford their housing payments. In fact, the average renter now spends 30% of their income on rent, up from a longtime average of about 25%, according to Zillow.

One big emergency or unexpected expense and it can mean a missed payment — and an eviction notice.

The Neighborhood Law Clinic at the University of Wisconsin Law School estimates that several million families a year face evictions nationwide. In Milwaukee County alone, eviction notices were up by about 10% in 2013. Statewide, they’ve risen 10 years straight to about 28,000 a year.

In Georgia, there was one eviction notice filed for every five rental households, more than 200,000 total filings last year. Many cases involved renters who were unable to keep up with rent increases.

Most evictions from Baltimore’s public housing are for just causes like failing to pay rent, hoarding and noise complaints, said Shawn Boehringer, chief counsel at Maryland Legal Aid. But other evictions are occurring as some subsidized, low-income buildings are being converted into middle-income or luxury housing.

For the displaced, it can be a long road back. Once renters are out, most landlords don’t want them. They often wind up in substandard housing with leaky roofs, broken windows, rodent infestations and no heat, said Boehringer. “It’s a tremendous hardship for them.”

Even for the solidly middle class, evictions can force families out of familiar neighborhoods and make it harder to rent new homes.

In San Francisco, an influx of thousands of highly-paid tech workers has sent rents soaring and longstanding tenants are being pushed out as landlords seek to make a small fortune by selling their buildings or converting the units into condos.

The city’s Rent Board reported 2,064 wrongful eviction appeals during the 12 months ended last June, up 45% since 2011. The total number of evictions have surpassed 5,000.

Tom Gullicksen, the director of the San Francisco Tenants Union, said the same thing happened during the dot-com boom. As a result, the city lost a large number of middle and working class residents.

“But this time is the worst,” he said. “It has made the city less diverse, less artistic and, definitely, less cool.”

Affordable apartments have been converted into million-dollar condos. Mom-and-pop stores have become expensive boutiques. Teachers, policemen and nurses have moved to places like Oakland and distant suburbs like Concord and Hayward, which are also getting very expensive but are still more affordable than the city.

Many of the eviction cases have been for minor violations, often for behavior that was formerly tolerated, like keeping a canary when there is a “no pet” policy or storing a bicycle in the hall, said Deepa Varma, a litigator with the Eviction Defense Collaborative (EDC).

Making matters worse in San Francisco is the Ellis Act, state legislation that allows landlords to escape strict rent control and tenant rights laws by taking rentals off the market for a minimum of five years.

Some owners have invoked the act to clear their buildings out and then sell the vacant apartments as condos.

Since February 2013, Evan Wolkenstein, a 40-year old teacher, and four of his neighbors have been fighting Ellis Act evictions on their apartments in the Mission District, where he has lived for almost 10 years.

“Rents have skyrocketed to the point that an Ellis Act eviction is tantamount to an eviction from the city,” said Wolkenstein. “People who are not wealthy cannot afford to stay. This effects, naturally, the most economically vulnerable people more profoundly.”