The recent spike in interest rates has finally changed my perspective. Do you watch rates? Which ones do you watch?
The rate I watch most closely is the 10-year Treasury yield. This is the interest rate that the government pays the buyer until the treasury note matures in 10 years.
The reason I watch it is because the rate that Freddie Mac, Fannie Mae, and most commercial banks charge for loans on multifamily purchases are based on the 10 year treasuries. When the 10 year moves, Freddie Mac rates generally move in the same direction.
Today those 10 year Treasury rates are high and getting higher. We saw them bottom out in 2020, at about 0.3%, but they climbed steadily to 4.9% in October, 2023. Then they dropped to 3.9 a couple of months later, climbed to 4.6 in April of this year, dropped to 3.6 in September, and now stand at 4.5%.
What’s going on? What’s driving this?
That’s a topic for people way smarter than me, but I can see trends and I can read the analysis. What could be causing the increase has been attributed to inflation, which has dropped considerably over the last couple of years but has not hit the Federal Reserve’s target. When inflation is higher, investors require higher returns from Treasuries, so yields go up. Inflation might climb if tariffs are increased on imports, so investors today could be anticipating that by not buying treasuries unless the yields are higher.
Treasury yields are also driven by economic health. When the economy is getting better, investors are buying other assets, not treasuries, so treasury yields rise.
And they’re driven by the federal debt. The federal government borrows money by selling treasuries. When the debt is at $36 trillion, they have to buy a lot of debt. Investors only want so much of that, and if there’s too much being sold, the Fed has to take a discount to be able to sell it. Hence, an increase in interest rates.
But to jump to the bottom line, smart people will have different opinions about why it’s high now and where it’s going in the future. I’ve just decided that it’s not going down much any time soon, and the most likely future direction is up, not down.
How does that affect our real estate investing strategy?
First, buying today at a higher interest rate with a longer term, say 5-7 years may not be such a bad idea. Previously I believed that when – when – interest rates come down, I’ll be stuck with a high interest rate loan that the buyer will not want to assume, and I’ll be paying a prepay penalty to pay it off early. And if it is a Yield Maintenance prepay penalty, the more that rates drop from where my loan rate is, the bigger the prepay penalty.
But if rates are stable or higher, or don’t drop much, there’s not such a big penalty. I negotiate a good deal on the purchase price because rates are so high, and rates are higher down the line so a buyer gets a better deal by assuming my loan.
And maybe owners who have been hanging onto properties waiting for better rates will decide to sell when they finally see that this ain’t happening.
And distress. Unfortunately. Owners who can’t hang on, whose equity has vanished because they can’t refinance or sell. Properties returned to the lender. Some buyers may celebrate this but most of us can relate to the impact this has on investors who took reasonable risks on real estate, and a loss of equity could impact their family’s future.
These are the consequences of persistently higher and increasing interest rates. We need to be prepared for it.
Market update
Columbus, OH – We can credit Columbus with one of the highest population growth rates of any northern Midwest city, with a population of nearly 1 million just in the city, and over 2.5 million in the surrounding metros. Its population has grown steadily by 43% over the last 30 years, and in 2023 was the fastest growing city in the U.S according to the Bank of America Institute Ranking.
It is being driven by immigration but even more fundamental than that, there are several factors that continue to make Columbus an attractive home for so many. Cost of living is 8% lower than the U.S. average, it is headquarters for over 300 corporations, and 46% of the population of the U.S. is within a 10 hour drive. Although winters get cold, you’re not going to have hurricanes, tornadoes, or coastal flooding like so much of the U.S. experiences. Maybe a tornado or earthquake here or there but very infrequent.
The story of Columbus is the story of so many strong Midwest cities. They know that business drives comfort and security at all income levels, so they make it attractive for businesses and they take care of those who start and run businesses. Regarding landlord-tenant laws, they are generally favorable toward the landlord, allowing evictions to be processed quickly and notice requirements of nominal durations.
Numerous large employers take advantage of this qualified labor force. Nationwide Insurance has over 16,000 employees, JPMorgan Chase over 17,000, and Amazon is investing $10B in a data center in Columbus.
One of the driving strengths of any large metro area is a large university, and Columbus has one of the largest. Ohio State University has a student population of 67,000, which grew 2.3% last year from the year before. They also play football there. Okay they play championship football, and as of this writing, prior to the Rose Bowl on January 1, they are still in the playoffs.
A statistic to be aware of, though, is jobs growth. It has been anemic and even negative over the last couple of years. Bureau of Labor Statistics shows jobs growth dropping from over 3% in 2022 to 1.6% in 2023 and 0.3% in 2024. It is very difficult to sustain jobs growth but with an economy as diverse as Columbus’s, it may indicate systemic issues which are often long-term.
Rent growth, however, is a different story. Rents have grown 5% over the last year, according to Zillow. Zumper ranked it #5 in the U.S. for rent growth as of March, 2024, and Costar ranked it #8 in the U.S. for rents through July, 2024. Those are great numbers, but they are historical and are notoriously bad at predicting future rent growth.
It’s likely Columbus will return to its earlier strength as these Midwest markets are so consistently resilient but choose your submarket wisely and be a patient real estate investor.
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Finer Points of Multifamily Properties
The Myth of Negative Leverage
We’ve been watching this interest rate and cap rate trend for awhile, waiting for the interest rates we pay for loans to get down below the cap rates we’re seeing for multifamily properties. Waiting and waiting. But these things change slowly.
First, a little bit of educational background. Cap, or capitalization, rate is a percentage, Net Operating Income divided by Purchase Price. It’s the rate of return you would get if you paid all cash, but it’s much more than that. It’s a reflection of what the market thinks about real estate. Newer and nicer properties have lower cap rates, older properties and properties in bad areas have higher cap rates. Cap rates might typically be in a range of 4-8%, but there are many reasons why they could be lower and even much higher.
When interest rates on loans rise, all else being equal, the cash flow a buyer receives on a property is lower because debt service payments are higher. That makes the buyer want to pay less so they can continue to make the returns they expect. But the seller doesn’t want to take less, so the deal doesn’t get done.
That is, unless the buyer is anxious and badly wants to do a deal. Then they pay what the seller is asking and they accept lower returns, hoping they can magically operate this asset into better than expected returns.
Here is what we hear from experienced investors. When the interest rate is high but the cap rate has not seen a corresponding increase, in other words, sellers’ prices have not come down, it’s a bad deal. And when the interest rate is higher than the cap rate, it’s negative leverage. You’re borrowing money at a higher rate than you can make on an unleveraged investment, so of course you’re going to lose money.
Don’t listen to that advice.
It is far too simplistic and ignores the real reason most of us invest in real estate. Adding value through improvements to the property.
A property whose owner has not upgraded the property to keep it modern and attractive, and who has kept rents low so occupancy is strong, but whose property sits in a good part of town in a growing market knows they have a desirable property. Their income is low but a buyer will bring in fresh capital, invest in renovations and get the income up.
The purchase price will reflect the lower income but also the upside opportunity. Gone are the days when the price you have to offer is based only on the NOI. Other investors will see this upside too, and will pay more for this opportunity.
If you’re looking at the cap rate on the deal, the cap rate is based on today’s actual income, what the current owner has received over the last year. This may not be much. In fact, the cap rate may approach 0%.
That should not tell you to not buy the deal. Maybe it is a bad deal but you should discover that through your underwriting.
Your pricing needs to reflect the investment required to add the value you need, the rent you believe you can get when you finish your renovations, the cap rate you believe that specific submarket can get for a property like this one which is fully renovated, and other factors. But not the cap rate based on the seller’s actual income.
Negative leverage? Maybe. But keep going. Do your homework. Let the underwriting tell you if it’s a good deal or not.
“The purpose of computing is insight, not numbers.“
– Richard Hamming