29 Jun How To Maximize Returns as The Fed Responds to Economic Uncertainty

By Jack Mullen, Founder & Managing Director, Summer Street Advisors

The original version of this article appears on Summer Street Advisors’ blog.

Key Take-Aways

• The Federal Reserve’s shift to quantitative tightening to rein in inflation is injecting more risk into real estate transactions.
• Rising interest rates are prompting some multifamily buyers to re-price deals, and some transactions have fallen apart.
• Some apartment investors are pursuing negative leverage deals in anticipation that rental rates will continue to climb, but record-high gas prices and rising food prices may limit the ability of consumers to pay more for housing.

After raising the benchmark federal funds rate seventy-five basis points this month and promising more hikes, the Federal Reserve is continuing to shrink its balance sheet by $47.5 billion a month through August and then by double that amount beginning in September. This is to combat high inflation and wind down the quantitative easing launched in the face of COVID-19: Since early 2020, the Fed’s balance sheet has more than doubled to $9 trillion and the money supply has skyrocketed 415 percent to $20.6 trillion.

The Fed says it is strongly committed to bringing inflation back down and is moving expeditiously to do so. That may well be the case, but real estate is particularly vulnerable to bearing the brunt of the Fed’s solution. Single-family homes, multifamily properties, and  industrial assets – the darlings of the current cycle – are priced to perfection. But that moment of “perfection” is fading as the cost of capital rises.

Existing home sales declined almost 7.7 percent in May from the prior year, although tight supply raised the median price to $414,200, a year-over-year increase of 14.6 percent. The sales reflected contracts signed just as mortgage rates began their latest rise upward, so investors should anticipate a broader slowdown in sales and appreciation in the coming months.

For investor’s focused on commercial properties (multi-family) – there have been instances where buyers have returned to sellers seeking a price discount because the deal’s economics no longer meet the investor’s return expectations. Many of these transactions have fallen apart, but some of these tractions have closed and investors have accepted lower returns. But some multifamily buyers are pursuing negative leverage (occurs when the borrowing costs are greater than the overall return) transactions, wagering that rent growth will outpace the cost of capital. That is certainly plausible. CBRE reported that rental rates grew 15.5 percent nationwide in the first quarter this year versus last year as the vacancy rate fell to a record low 2.3 percent.

But banking on rent growth to justify an acquisition in which the mortgage rate is higher than the cap rate reminds investors of the runup to the financial crisis, when lenders underwrote projected rent growth to justify high-leverage loans and bubbly asset prices. Investors know how that turned out. While lenders have been much more disciplined over the past several years, many economists have predicted that this is not a repeat of the financial crisis and investors are heading down a different path. However, other factors in the macro environment including a slumping economy, inflation and geopolitical tensions must be taken into consideration here when it comes to what the future holds.

Meanwhile, inflation has been most noticeable in fuel prices, which have more than doubled over the last two years, and in grocery prices, which have increased nearly 11 percent over the last year. Perhaps an assessment that wage growth cooled to an annual pace of 4.5 percent in May from 6 percent a year ago should give us some confidence that the Fed’s prescription to break inflation is succeeding. Workers who see their purchasing power continue to erode may not share that sentiment, however. The surge in prices will force them to slash spending soon if they have not already. Consumers may take fewer trips, eat out less or cancel Netflix. They may also leave higher priced apartments that an investor recently bought with negative leverage, opting for something more affordable instead.

Is this missive a bit bearish? Yes. Does it mean that real estate investors should crawl under a rock? No. Property investments that make economic sense still exist today, just as they do in every cycle, and physical assets have historically been an effective hedge against inflation. Investors need to be disciplined in their approach in selecting investments – focusing on properties and markets where they have expertise and executing the game.

But cap rates have yet to materially adjust to the changing rate and economic environment. Consequently, financeable deals today are those that exude as much certainty as possible. That means sponsors need to focus on properties with strong locations, healthy cash flow, high occupancy, and no near-term lease expirations for conventional acquisitions. For value-add deals, they should avoid marginal markets and credits. A good rule of thumb is: The less hair, the better. Investors that adopt this philosophy will put themselves in the best position to ride out the turbulence ahead.