CORRELATION BETWEEN INTEREST RATES AND CAP RATES?
Written by Peter Strauss of Iconic Investments
With the U.S. economy at full employment, fears that inflation is firming will cause the Federal Reserve to raise interest rates. Jerome Powell, the newly appointed Federal Reserve Chair, seems to have policy views similar to outgoing Chair Janet Yellen. He has yet to announce, however, whether there will be three or four rate hikes in 2018.
One certainty is that interest rates will rise this year.
So, what does this mean for values of apartment buildings? Some economists will debunk the idea that there is a correlation between rising interest rates and CAP rates, while others believe that, as interest rates increase, so will CAP rates. Theoretically, it makes sense that cash flow decreases as interest rates increase. Therefore, a buyer needs to either come in with a larger down payment or apartment values need to decrease to maintain the same cash flow. Will rent growth be enough to maintain these historically low CAP rates?
Iconic decided to seek the opinions of David Shulman, senior economist at UCLA Anderson, and Todd Leslie, executive director-multifamily lending at JPMorgan Chase. This article provides the perspective of an economist who tracks and understand trends based on economic principles and the perspective of a lender who handles a majority of JPMorgan Chase's apartment loans in Los Angeles.
David Shulman/Senior Economist at UCLA Anderson
Peter: What effect will rising interest rates have on CAP rates on Los Angeles apartment buildings?
David: Real estate asset values are sensitive to long-term interest rates. The reason cap rates are so low is that long-term interest rates are low. As interest rates rise, cap rates will increase, but not on a one-for-one basis. Interest rates, which were a tailwind behind real estate, are now a headwind.
Peter: Will investors seek alternative investments to real estate as interest rates increase?
David: As interest rates rise, bonds and real estate debt become more competitive with real estate equity.
Todd Leslie/Executive Director at JPMorgan Chase
Peter: On average, how much cash is required for down payments on multi-family deals in Los Angeles today?
Todd: The required down payment is based on the cash flow or debt coverage on any particular building. And while most lenders have a maximum loan to value of 75%, the reality in today's market is the loan to value percentage is much lower on most deals. Based on where cap rates are today, the average down payment is typically in the 40–50% range but does vary from building to building.
Peter: Where do you see the money coming from? Private individuals, syndicators, borrowed/refinance money?
Todd: During the past few years, we have seen a large increase in syndicated transactions as well as borrowers capitalizing on high values to pull cash out of existing buildings through refinances and redeploy the capital back into the market through acquisitions.
Peter: Are lenders currently stress-testing cash flow? What is the required DCR (debt coverage ratio) on JPMorgan Chase loans today?
Todd: Most lenders will stress-test the cash flow using the higher of the actual rate or an underwriting rate. As an example, at JPMorgan Chase we calculate the DCR using a minimum 4.50% underwriting rate and a 1.15 DCR on most transactions in infill Los Angeles submarkets. Another important thing to note is that, when lenders underwrite transactions, they typically use minimum “market” figures for items such as maintenance and management.
Peter: Some would argue that there is no correlation between rising interest rates and cap rates. What are your thoughts?
Todd: Although not a perfect correlation, I think there is certainly some relationship between rising interest rates and cap rates. This is driven by a reduction in cash-on-cash returns and higher down payment requirements as interest rates increase. As a result of recent rate increases, I would expect prices to potentially adjust downward in the near term. That being said, if inflation increases and rents can be increased as a result, the price per unit valuations can hold or even gain value -- even in a higher cap rate environment.
Peter: As interest rates increase, do you think buyers would be willing to put down 60–70% vs. 40–50% today to debt cover? That’s assuming no correlation between rising interest rates and CAP rates.
Todd: As required down payments have increased, we have seen some clients look for alternative investments with lower cash requirements or sit on the sidelines in anticipation that the market may adjust. I think this trend would only increase if required down payments were to get in the 60–70% range.
Peter: What are the biggest obstacles to getting deals done in the next six to 12 months?
Todd: The biggest obstacle we have run up against recently has been the increase in interest rates driven by the U.S. Treasury market and, as a result, the reduction in loan proceeds -- particularly on purchase transactions. Deals that were underwriting at 65% loan to value late last year are now closer to 55% loan to value. Moving forward, I think this will continue to be watched closely by would-be buyers, especially if cap rates do not adjust accordingly.
Todd Leslie - Chase Bank todd.leslie@chase.com (O) 310-341-1903 (C) 310-945-7256
ICONIC WANTS TO HELP
At Iconic Investments, we pride ourselves on being more than just a brokerage firm. We are also a valued information resource and an advocate for property owners. We write articles to provide original, quality and timely content that will help owners improve the management of their buildings and make more insightful decisions.
