What Happens if Inflation Continues?
As of December 2022, the U.S. inflation rate recorded 6.5 percent, while the 2022 year average was eight percent, heavily attributed to the notable and fast increase in inflation to 8.6 percent in the middle of the year. In response to the inflation rate increase, the Federal Reserve hiked interest rates and unanimously voted to raise the interest rate to 4.4 percent in December. The Fed is attempting to stabilize inflation to two percent annually by balancing employment and the federal funds rate. While rising inflation can signal an expanding economy, many speculate how it will impact property values and the opportunities for commercial real estate investors.
Multifamily stands out for its stability and performance during all economic cycles, thanks to the constant demand for housing. The same can be said for single-family rentals (SFR) and build-to-rent (BTR) properties. In fact, as Millennials and Gen Zers grow older and need more space for an affordable price, the demand for SFR and BTR homes will only continue to rise.
Inflation Effect on Multifamily Property Value
Though it is widely believed that inflation threatens the value of real estate, multifamily landlords often experience more demand and increased rental growth for apartments as consumers spend more on goods and services. When economic expansion fuels employment and wage growth, housing needs correlate. According to Habitat for Humanity, the U.S. has a deficit of 3.8 million homes, with the greatest supply shortages at low-income prices. These two conditions enable multifamily owners to push rents to offset construction, labor, insurance, and other costs.
Class A Real Estate Investments: Rents have grown prominently in luxury, or Class A, according to CoStar. Demand for housing is at record-high levels despite the hyperinflation, and the lifestyle renters’ are willing to pay more for their living quarters. The lack of additional housing options also contributes to the incredibly quick lease-ups in 2021 and 2022. The average annual rent for these units is $1,875 per month and takes up about 24 percent of the renter’s income. The demographic that can afford Class A rents can also afford the quickly rising rents as the economy recovers and benefits from accelerated wage growth.
Class B Real Estate Investments: Class B & C multifamily properties enjoy prolonged periods of growth as they are the affordable alternative to luxury apartments. Service sector employees often occupy lower-tier properties and were severely impacted by the pandemic’s restrictions. Rents in Class B real estate investments grew 10.8 percent year-over-year to $1,520 per month due to demand for affordability, according to CoStar data. Class B renters may still have some wiggle room in their budget to afford rent increases, with rents making up 29 percent of income.
Class C Real Estate Investments: The average rent for Class C properties rose 9.8 percent year-over-year, for an effective monthly rent of $1,168. Those who rent Class C communities could be limited by their ability to pay the new rents, as it accounts for over 40 percent of their median income. In contrast to Class A and B assets, Class C properties maintained rent growth during the height of the pandemic. Class C real estate investments don’t need to discount rents to lure in renters as they often ask for 40 percent less in rents than Class A communities. Only in situations where a new luxury apartment arrives in the market do Class C properties need to cut rents to appeal to renters. As a result, Class C real estate investments have been able to sustain rent growth to match the markets.
Will Rising Mortgage Rates Hurt the Housing Market?
Low-interest rates are positive for housing as they increase property demand, thus driving prices. In contrast, higher interest rates have the opposite effect driving interest payments on borrowers’ debt service even higher. As potential buyers are priced out of the housing market, investors fill in to unlock future rent growth and higher yields. Multifamily owners can enjoy annual rent increases. Unlike net lease properties, which have built-in increases in the lease, multifamily leases are often signed on a yearly basis, allowing landlords to adjust rents to match the market. Further, multifamily properties could have mortgage loans with fixed interest rates, so owners can benefit from stable debt payments while rents increase.
While rising mortgage rates often push costs up and put downward pressure on property value, other factors contribute to price growth, resulting in compressed cap rates. The risks associated with the housing market are minimal as the severe shortage plays a prominent role in the strong demand for housing. Experts predict cap rates to continue compressing in 2022 as a result.
According to Real Capital Analytics, the apartment sector had the lowest risk premium of 2.5 percent, a one percent increase compared to a year ago. Investors spent $63 billion in apartment trades in the U.S. in Q1 2022, a 56 percent increase compared to Q1 2021. Cap rates have an inverse relationship with pricing, corresponding to sharp increases in sales prices.
With these impressive accolades, multifamily will continue to see investment demand, helping sustain values and prevent interest rate spikes as lenders compete for deals by keeping a competitively low cost of capital. According to the Mortgage Bankers Association, total multifamily loans are expected to rise by six percent in 2023 to $442 billion. Though cap rates are projected to continue compressing, there are plentiful opportunities for yield in multifamily.
