At What Interest Rate Would Multifamily Die?

Due Diligence Tour, Atlanta, Georgia

Happy Wednesday!  I trust your week is going well so far.  I’m writing this while catching a flight back from Atlanta to Sarasota after a couple productive days on the road.  Monday was the 6th annual IMN middle-market multifamily forum and Tuesday was our due diligence walk for the new Atlanta deal.  IMN offered a good opportunity to connect with fellow operators and catch up with several friends on the lending side of the business – and we were able to time our due diligence walks in tandem with the event for a win-win trip to Atlanta. 

WHAT HAPPENS IF RATES GO SKY HIGH? 

I had a great question come up at the IMN Middle Market conference. Someone asked at what interest rate level would it make sense to exit the multifamily market. It’s a great question and in some ways very practical. As interest rates go up, the cost of debt goes up, and, so it would seem, profits go down. At some point if interest rates go up too much, it must be completely unprofitable to own multifamily.  

HISTORY OF INTEREST RATES 

The first point of reference in my mind is past history – say, the 80s when rates were north of 10%. People were still buying (and making money) in the real estate business. And I’m sure we could point to some recent deals where people lost money when rates were south of 5%. So what’s the catch – where’s the nuance here? 

MARGIN

The key to our business doesn’t revolve around interest rates. Like most businesses, our business is built on a margin – more specifically the spread between our cost of capital (usually a majority debt) and our return on capital (the cap rate). This spread is the risk premium that we get as investors (both debt and equity) for putting our money on the line. We want a risk premium for our investment. If there is too much capital and not enough available investments, investors may be more willing to accept a lower return just to get their dollars invested. Vice versa, if the economy collapses and we as investors view the investment as riskier, that spread will likely increase because we will want a higher return for our risk-taking activity as the available capital decreases. 

Here’s the bottom line – just because interest rates go up doesn’t mean we’re out of business. Just because rates go down doesn’t mean we’re home free. It always comes back to our experience. 

• Do we have the ability to pivot as the market changes?  
• Do we have the operational experience to maneuver a challenging market environment and still be successful?  
• Do we have the capital reserves to capitalize on potential opportunities during a challenging market?

I like to think we’ve got all three covered – which allows us to focus on our business and stay out of market timing. 

 ATLANTA UPDATE 

We just completed our unit walks for the new Atlanta property with the help of 15 amazing fellow investors who suffered through a beautiful sunny day to walk close to 300 units. It was a wonderful time to catch up, and I greatly appreciate each of them for taking some of their valuable time to help us with this new project. I always walk away from these due diligence tours feeling very blessed to have such amazing partners. We always learn a lot along the way, and in this case, we confirmed our assumptions that the property was in great condition overall but will need attention with the delinquency (front of the house) and HVAC maintenance (back of the house). These will be our two primary pain points to solve for success. 

The rent comps at this property are already proving $400/mo increases with no renovations. It’s a great start, but as is typical with our underwriting, we like to add some fudge factor so we’ve built in a modest renovation plan to ensure that even if the economy decides to go sideways for awhile, we’ll have the best product on the market (allowing us to maintain our occupancy while our competition may not). We’re excited to be expanding in Atlanta. 

SAN ANTONIO UPDATE

We are planning to close this week on the San Antonio development deal and get things moving with this beautiful 264-unit project.  For those who missed out on this one, we’re also working on a 72-acre mixed use opportunity that will give us the ability to develop 500-700 units along with the potential for commercial and retail amenities at the site.  We’ve started the initial due diligence process with the county and anticipate having some plans to share in Q42022.