Inflation, Interest Rates, and Real Estate 

Unemployment has dropped again.

Wages have continued to rise. And the Fed is poised to keep up the fight, even if the banking crisis in March 2023 has tempered expectations. 

Following the pandemic-related bottlenecks and disruptions, the war in Ukraine and sanctions against Russia have driven up food, shelter, and energy prices even more. When these basic goods see pronounced price increases, the rest of the economy tends to follow suit. Inflation in most sectors has thus been remarkably persistent despite the Fed’s initial effort to slow it down. This has forced the Fed to keep hiking rates (50bps in December 2022, 25bps in February 2023, and 25bps in March 2023).

Although nothing points to the emergence of 1970s-like stagflation, nothing indicates significant disinflation either. The resilience of consumers and the strength of the job market suggest that the economy is not falling into a recession. This could enable businesses to keep charging more, which in turn could force the Fed to get so aggressive that it induces a recession.

Impact on Real Estate

To complicate the matter, inflation may actually be lower than it appears. Housing accounts for 30% of the Consumer Price Index and the Bureau of Labor Statistics (BLS) — which publishes the CPI — does not measure housing inflation in real time. It extrapolates from what renters are paying as per lease agreements, which can be nearly a year old. However, despite the possibility that inflation may be lower than it appears, the Fed has made clear — through interest rate hikes — that it’s not taking any chances. 

Zillow’s monthly rent index is not perfectly representative of housing inflation either. However, it is up-to-date and it shows that nationwide rents are down slightly from their peak in August, 2022. As net operating incomes (NOIs) drop while interest rates rise, property owners with lower NOIs can’t afford to refinance at higher interest rates. This indicates that the multifamily commercial real estate (CRE) market is due for disruption: as the volume of distressed sales increases, well-funded firms can capitalize on these buying opportunities to secure lucrative long-term multifamily investments.

Inflation Expectations

How much longer will the Fed maintain these high interest rates? It depends on the future rate of inflation, which in turn depends largely on expectations of future inflation (assuming the pandemic-related disruptions and war-related shocks keep waning). Unlike the late 1970s and early 1980s, inflation expectations are still relatively low for the longer run. 

Hence, the steady decline in the Federal Open Market Committee’s (FOMC) latest interest rate projections.

Inflation will come down eventually, if for no other reason than that the Fed is determined to make it come down. But there is no concrete evidence that it will happen rapidly. We can expect comparatively high interest rates for the foreseeable future. 

Falling Commercial Real Estate Valuations

When borrowing costs go up, the true cost of commercial real estate goes up as well. This naturally depresses sales until list prices decline enough for market equilibrium. It’s no surprise then that after peaking in early 2022, CRE valuations have declined significantly over the last year. 

Normally, a decline in CRE valuations wouldn’t be a remarkable event in a high interest rate environment. But a decline of this degree (5.5% in a single quarter last year) has only occurred twice since the Great Recession. Although the main cause in this instance is higher interest rates, there are other factors reinforcing the pressure that higher interest rates are creating. The upshot for long-term investors is clear: multifamily investing opportunities will increase as property owners who can’t afford to refinance are forced to sell.

Refinancing in an Inflationary Environment

One of the other compounding factors is that approximately $2.4 trillion in multifamily and CRE loans are scheduled to mature between 2023 and 2027. In San Francisco, only 7.5% of multifamily loans originated in the first nine months of last year. According to John Manning, a veteran real estate financing executive with Marcus & Millishap, 2023 should be a big year for real estate refinancing. Consequently, many borrowers will need to refinance at the current high rates, which may be too expensive a proposition. Large apartment owner Veritas recently defaulted on a massive $448 million loan. Is Veritas a canary in the coal mine? 

We can see the effect of increased borrowing costs in the widening spreads of commercial mortgage backed securities (CMBS) and the falling prices of publicly traded real estate investment trusts (REITs). Spreads of BBB rated CMBS have widened by over 360 bps year to date, as shown in the chart below. Consequently, new CMBS issuance has dried up as spreads have blown out.

Rising interest rates have had a dramatic impact on real estate equity valuations as well. Publicly traded REIT prices have dropped over 25% year to date, with some asset sectors down over 35%, as shown in the chart below.

A Rise in Distressed Assets

Higher interest rates are putting pressure on existing debt, leading to widening credit spreads and lower transaction volumes. This creates a vicious cycle as higher financing costs and debt volatility lead to lower equity valuations, which puts yet more pressure on debt valuations, extending the cycle. As a result, the CRE sector has cooled substantially, despite an otherwise growing economy with robust consumer demand, low unemployment, and rising wages. 

To the extent that the recent banking crisis has given Fed officials pause, it’s because banks have reduced their lending to safeguard a sufficiency of assets, in which case, banks are essentially doing the Fed’s job. So even if the banking crisis tempers the Fed’s campaign in the months ahead, distress in the multifamily CRE market will persist. Property owners faced with declining asset valuations and unable to refinance at higher interest rates will be forced to liquidate their assets. 

This growing distress in the sector presents rare buying opportunities for well capitalized long-term real estate investors looking for attractive entry points.