In light of the Federal Reserve's recent position on interest rates and the changing market conditions, I felt there is no better time to begin our bi-monthly memos and share valuable insights with you. As I write this first memo, my primary goal is to provide you with a thorough understanding of current events and how they relate to the world of real estate. It is my sincere wish that this publication not only offers information but also strengthens our bond. It embodies Golden Knob Residential's dedication to supporting you in your investment journey.
WHAT’S UP (DOWN) WITH INTEREST RATES?
Since December 2008 to December 2015, and again from March 2020 to March 2022 because of the COVID-19 pandemic, the United States adopted a policy of zero interest rates (ZIRP). By the end of 2020, the average 30-year fixed mortgage rate was 2.67%, reaching a record low of 2.65% in January 2021. Fast forward to October 2023, and the rate rose to 7.79%, stabilizing between 6.6% and 6.7% in the last four weeks of December. This sudden change, with rates over 3% after more than 10 years of artificially low interest rates, brings both challenges and opportunities.
The prolonged period of low interest rates resulted in excessive borrowing, asset overvaluation, and misallocation of resources. These factors have the potential to negatively impact productivity and economic growth. Inevitably, inflation had begun to rear its ugly head, prompting the Federal Reserve to aggressively hike rates, reminiscent of the 1980s, causing panic in the markets due to monetary tightening.
Chairman Powell recognizes the impact of human behavior on markets. Initially, he signaled a tightening policy, causing panic among those who were not prepared for such rate hikes. However, in a surprising turn of events, he announced in December, there would be three rate cuts in 2024. This was indeed a Christmas miracle for the markets. This announcement led to record highs in the DOW and sparked movement in inventory and activity in the real estate market, which had been stagnant in 2023.
The expectation of future rate cuts has already brought optimism to the commercial real estate (CRE) market. Transactional activity has seen a significant increase, as revealed by a recent CBRE survey. More than 60% of respondents plan to increase their real estate acquisitions in 2024 compared to the previous year. This positive sentiment is shared across various investor types, including developers, private equity funds, real estate funds, and real estate investment trusts (REITs).
SOME PROMISES ARE MEANT TO BE BROKEN
However, in the first meeting of 2024, the Federal Reserve decided to maintain interest rates without any plans for cuts. This decision comes as inflation continues to exceed the central bank's target. As interest rates begin to rise from historically low levels, a significant number of inexperienced investors who were enticed by the allure of real estate investments are now confronting a new and challenging reality. These investors had taken on risky loans at the peak of the market in 2021 and 2022, leaving them exposed and vulnerable to potential financial difficulties.
According to an article published by BizNow on January 30th, 2024, landlords are facing increased financial strain due to a combination of rising operational costs and a surge in new supply. This has resulted in a higher risk of loan defaults, as more apartment owners find themselves unable to meet their loan obligations. The delinquency rate on multifamily CMBS loans has significantly increased, rising from 1.6% six months earlier to 2.6% in December. This increase reflects the growing financial pressure on property owners.
Fitch Ratings predicts that apartment defaults will increase significantly in 2024. This highlights the importance of doing thorough research, managing risks, and thinking ahead in the current investment climate. While low interest rates have been helpful during crises, they have also shown the dangers of being too complacent in risk management and susceptible to financial shocks. In finance, there's a saying that goes, "There's no such thing as a free lunch," meaning that when things are too easy, there's usually a catch later on.
Between 2023 and 2025, a total of $682 billion in multifamily loans will mature. Banks account for 32% of debt maturities in the period from 2023 to 2032, but their share increases to 52% for the 2023 to 2025 timeframe. Debt fund maturities and securitized lending also show a similar front-loading trend, representing 20% and 12% respectively of near-term maturities compared to the full period.
THE THREE MOST HATED WORDS: WOULDA, COULDA, SHOULDA
As investors, we should focus on three things: sustainability, fairness, and caution. Instead of seeing the increase in interest rates as a problem, we should see it as a chance to create a more stable and fair real estate investment environment. This change encourages us to invest in projects that are strong and meet the real needs of the community, such as affordable housing and commercial spaces, at reasonable prices.
The increase in interest rates, after a long time of borrowing at low costs, requires us to be more careful when it comes to borrowing and risk in real estate investments. It's important to prioritize assets with good income potential and use safe financing strategies to successfully navigate any changes.
NOW WHAT?
The expected rise in distressed sales in the apartment sector creates opportunities for strategic purchases. These situations may be appealing for investors who can assess risks thoroughly and manage assets strategically. Although the current economic situation is difficult, it also offers opportunities to take a proactive approach by using knowledge and expertise to find undervalued assets that can generate long-term profits.
Warren Buffett once said that it's wise for investors “to be fearful when others are greedy and to be greedy only when others are fearful.” This principle can also be applied in real estate investments. When there is widespread enthusiasm, prices often become too high and it's important for prudent investors to be watchful and avoid paying too much, which could lead to lower returns or constrained finances. On the other hand, when fear dominates market sentiment, it can reveal good opportunities for value investing.
For investors, this is a great opportunity to buy valuable assets at prices much lower than their original cost. This can give them a competitive advantage in the market. One effective strategy is to use low loan-to-value (LTV) ratios to get favorable financing, even with higher interest rates. It's also a good idea to target properties that were bought at high prices in recent years but are now in distress because their loans are maturing, and increasing operational costs, or higher vacancies prevent them from fulfilling their obligations to the bank and/or their investors. As they become exposed, you are positioned to invest at a significant discount.
These approaches take advantage of the current market conditions and align with the long-term growth of the multifamily sector. By focusing on assets that can be bought below their replacement cost, investors can benefit from having built-in equity and less competition. This puts them in a good position for when the market improves. This strategy, combined with a smart financial structure, can maximize profits, and reduce risk.
We should prioritize making investments that are sustainable and focus on sectors that are expected to benefit from a shift towards a more balanced economic model.
LET'S BREAK IT DOWN
Acquiring Below Replacement Cost
- Purchase properties at prices significantly lower than their estimated replacement cost, allowing for immediate equity and a competitive advantage in rent rates. For example, buying a property for $4,000,000 that would cost $5,000,000 to build from scratch.
Leveraging Low LTV Ratios
- Opt for financing with low loan-to-value ratios, which means borrowing a smaller percentage of the property's value. This can lead to more favorable loan terms and lower debt service costs. For instance, securing a mortgage for 60% of the property value instead of 75%.
Utilizing Available Equity:
- Use existing equity from private investors or equity groups to expedite deal closures. This avoids relying heavily on expensive debt financing. For example, partnering with an equity group that contributes $1 million towards the purchase of a property.
Targeting Distressed Properties:
- Focus on properties that were bought at high prices in recent years but are now distressed due to expiring loans or rate caps. This allows for acquiring the properties at significant discounts. For instance, purchasing a property for $800,000 that was originally bought for $1 million.
Capitalizing on Market Conditions:
- Take advantage of the current economic climate, characterized by cautious lending and pricing paralysis, to find unique buying opportunities. For example, purchasing properties from motivated sellers who are willing to negotiate lower prices with more realistic cap rates.
Aligning with Long-Term Growth:
- Align investment strategies with the anticipated long-term growth of the local market and the multifamily sector. This requires due diligence! The key is to invest in areas with favorable demographics and potential for future market recovery. For instance, targeting neighborhoods with growing populations and limited housing supply.
Strategic Financial Structuring:
- Implement a prudent financial structure to maximize returns and minimize risks in uncertain markets. This can involve using various financing options, such as fixed-rate mortgages, or purchasing a rate cap to mitigate the impact of interest rate fluctuations for the intended hold period.
OUR PROMISE: Riding the Waves of Change with Strategic Foresight
As we adapt to these changes and face the realities of a changing economy, influenced by the Federal Reserve's decisions on interest rates and how they affect the overall economy, we are dedicated to making wise investments. We recognize the significance of being proactive and flexible, continuously evaluating our strategies to match the changing market conditions. By doing this, we can successfully navigate the intricacies of the market and take advantage of opportunities that come our way, guaranteeing sustainable growth and lasting value for our clients and investors.
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