With the Fed poised to begin interest rate hikes later this year, investors are asking," How will rising interest rates effect my multifamily investments?" First, interest rates are likely to remain very low for several years. Careful selection of property class, performance and funding instruments provide continued safety in real property investing.
Properties operating at capitalization rates that are two percentage points (200 basis points) higher than the interest rate paid on the property mortgage will typically have enough income to yield acceptable cash flow returns to investors. For example class C properties in many markets in US cities can be purchased with 4% mortgages and repositioned to operate with capitalization rates near 10. That spread of 6 percent (600 basis point) between operating cap rate and mortgage interest rate gives a good cushion to maintain high cash flow in times of rising interest rates.
Class A and B properties often operate with narrow margins between the debt service interest rate and the capitalization rate. These properties may operate at capitalization rates in the range of 5% or less in high value markets like California and New York. Typical interest rates on large core real estate loans from Fannie Mae may be in the 2% range leaving just 3% margin between mortgage interest and capitalization rate. If mortgage rates go up, then rent hikes will be significant in these property types to maintain cash flow and debt service coverage ratio. Rent increases leads to increasing vacancy and further cash flow problems.
Institutional investors and their operator managers in class A real estate minimize these risks by lowering leverage, seeking long term debt, and by planning the timing of refinance and releasing events to prepare for changes in finance costs.