For commercial real estate investors, a healthy economy can be a mixed bag. A strong outlook is likely to yield higher rents in and around big cities, but also raises worries about rising interest rates. The Federal Reserve—in the wake of strong gross domestic product growth, low unemployment and soaring consumer confidence—in September raised the target rate (charged by banks to each other for overnight loans) to 2.25 percent. The hike comes as no surprise to buyers, as the Fed has pursued the policy of gradual increases since December, 2015, but will raise the cost of financing.
For multifamily market participants, the trend reflects business as usual—a series of preemptive strikes by the Fed to keep inflation in check. With that in mind, investors should stay the course with ownership while shifting strategies accordingly.
Here are five ways in which the value of multifamily investments outweighs rising rates that, by historic standards, still remain appealingly low:
1. Rising Rents Lift All
The ability to command higher rents in most major metropolitan areas gives investors the potential to realize optimal cap rates on new deals or boost net operating income (NOI) on existing assets. Therefore, demand for housing that continues to propel rental prices upward negates pricier funding options for multifamily properties.
Nationally, rents increased about 4 percent from June, 2017, through June, 2018. However, the trend wasn't uniform across all markets. One-bedroom prices slipped 3.1 percent in New York City while comparable units in Seattle rose by 4.2 percent over the same time frame. Should that aggregate growth press on, buyers shouldn't be discouraged by current rates or the possibility that one more rate increase is projected for 2018, with three more forecast by the end of 2019.
2. High Occupancy Rates, Heated Demand Boost Climate
As 2019 approaches, the favorable economic climate has buoyed two market conditions that should compel startup or additional capital investment. Occupancy rates hit 95.8 percent in the third quarter of 2018 even though developers brought a large number of new units online. New market-rate projects have created more than 300,000 units this year. While Victor Canalog, the chief economist for Reis, Inc., believes "the onslaught of new supply is certainly testing the ability of the multifamily market to absorb incoming projects," other analysts are more bullish: They believe the market can absorb the additional units, such that occupancy rates and rents will rebound in 2019.
Even as supply looks to outpace demand in the near term, the latter phenomenon appears strong enough to support higher rents and multifamily prices, which increased 11.3 percent through the year ending in July, 2018. These signals point to a rosy investment picture overall through 2019 and into next year.
3. Value-Add Strategies Pay Off
It's difficult to predict the impact of market forces but one can always count on tried-and-true methods to bolster NOI and cap rates. The practice of acquiring undervalued properties—and renovating them and/or retooling managerial philosophies—has gained traction with multifamily investors. Buyers in the value-add space typically look to increase the market price of a property and potential ROI through one or more strategies.
Operational enhancement involves basic moves that include reducing overhead and increasing rents. Capital improvements leverage the unique traits of older properties with modern upgrades in kitchens or bathrooms, melding character with convenience. If the target ROI is 18 percent, a $5,000 capital expenditure should, therefore, yield an additional $900 in rental income. Despite the recent upturn in commercial property lending rates, it's important to note that investors can acquire inexpensive funding for improvements.
4. Tax Benefits Help Balance Out Rates
There allegedly are only two certainties in life—and paying taxes is the more preferable one. Investors can use tax law to their advantage: If you surrender a percentage of income and capital gains on one side of the equation, you can take full advantage of deductions on the other end.
Depreciation on real property is one of the biggest deductions for a real estate owner. Investors may amortize depreciation over 27.5 years on the dwelling itself. For a property valued at $3.75 million and land accounting for $1 million of that total, deductions from NOI amount to $100,000 annually. In addition, any assets—appliances, furniture, etc.—not attached to the property can be similarly depreciated albeit through shorter time spans of five to seven years. This potent formula can help investors ease the burden of incrementally rising interest rates.
5. Use Financial Planning to Your Future Advantage
For owners wanting to preserve a well-constructed multifamily portfolio, certain methodologies pass holdings to the next generation—and estate planners recommend starting early rather than waiting for unexpected circumstances to force the action.
Family-owned entities may look to future generations and involve children or grandchildren in the business. An intentionally defective grantor trust (IDGT) essentially transfers property ownership to heirs while allowing said grantors to maintain some control over operations. Among other benefits, this irrevocable trust reduces the taxable estate of the grantor and gives successors a chance to gain experience in the industry.
Rising short-term rates merit portfolio adjustments but shouldn't deter investors from pursuing their ultimate goals. In a cost-benefit analysis, the advantages of real estate investing outweigh the disadvantages—and we can all hope that central banks around the globe will tailor monetary policy to keep inflation from rearing its ugly head.