As inflation pressures continue to push interest rates higher, the multifamily sector of commercial real estate will likely face pressure as cap rates in the sector drop to historic lows. Real Capital Analytics reports that U.S. commercial mortgages originated in 2021 had an average coupon rate of 3.7% for 7/10-year fixed rate product, and as of March 2022, this rate has increased by 60 basis points to 4.3%. Historically, U.S. commercial mortgage rates have averaged 55 basis points higher than residential mortgage rates, and as of April of this year, the 30-year fixed rate residential average from Freddie Mac climbed to 5.0%. This historical trend would imply that commercial mortgage rates could see rates jump from the current 4.3% to 5.5%-5.6%, though the lack of supply of housing could keep rates from reaching this high.
This trend is alarming for investors in the multifamily space. According to CBRE’s National Multifamily Cap Rate Report, the national average cap rate for multifamily hit 4.59% as of Q4 2021.
The reason for alarm comes from investor’s purchasing these multifamily assets at historically low cap rates and using shorter term debt at rates near the 3.7% quoted above and now in the coming years facing significantly higher interest rates as they look to refinance. For example, a property purchased at a 4.59% cap rate, with a loan LTV of 50% and an interest rate of 3.7%, would have a leveraged cash-on-cash return of approximately 5.48% (excluding acquisition costs, financing costs, and capital expenditures). As rates move towards the current commercial mortgage rates of 4.3%, the same scenario yields a leveraged cash-on-cash of 4.88%. If the move to 5.5% interest rates occurs, the same scenario yields a leveraged cash-on-cash of 3.68%.
If the income generated by the property does not rise to accommodate for the rise in interest rates, property values will not be able to sustain the valuations at their purchased cap rates. Investors may be forced to sacrifice considerable cash returns due to increased interest rates, or worse, be forced to sell properties at a loss due to decreased valuations.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Assistant Vice President, Acquisitions
Boyd Watterson Asset Management, LLC