Investment sales in a rising interest rate environment
The inversion of urban flight
Since the third quarter of 2021, there has been a significant demand for rental apartments, leading to an increase in lease signings, with monthly rents returning to and even exceeding pre-pandemic levels. This spike has continued throughout what is typically a difficult winter rental cycle and shows no signs of stopping as of the end of the first quarter of 2022. According to Miller Samuel Market Reports, February median rent 2022 of $3,700 in Manhattan is up 33% from the previous year and is about 5% above pre-pandemic rent levels as of February 2020. Average rents are even more exaggerated by the flight towards quality.
The rebound in the rental market boosted market momentum for investment sales, as evidenced by the fact that the fourth quarter of 2021 reached the highest level of sales since the third quarter of 2018. Buyers who had remained at the gap with dry powder since the start of the pandemic were finally ready to confidently underwrite and roll back. in the fold. Capital began to flow back into New York City as buyers recognized that a market run with a tangible correction was on the horizon, and they didn’t want to miss it. Simultaneously, sellers who wanted to diversify out of New York but were crippled by pandemic-depressed rents were finally able to act on the recovery and transact at levels they believed reflected long-term value. of their property. It was the perfect storm for the narrowest bid-ask price spread we’ve seen in 6 years. In turn, the Manhattan multifamily and mixed-use market in the fourth quarter recorded 46 transactions for just over $1.47 billion in total volume, an increase of 98% and 190% compared to the average for last 4 quarters, respectively.
The impact of rising interest rates
After a strong first quarter of 2022 and into the second quarter of 2022, the New York investment sales market is at a critical inflection point. There are so many reasons to be positive: apartment rents continue to soar; commercial spaces are finally let at healthy rents; luxury residential condominiums are snapped up day by day; and big companies like Apple, Google, Microsoft and other giants are forcing a return to the office. On the other hand, the Fed raised interest rates for the first time since 2018 and plans six more increases in 2022, which would take the Fed’s near-zero rate to almost 2%.
For lenders, the consideration of these increases has already begun and the rates available last quarter are not there today, and today’s rates likely won’t be there in a month or two. For buyers, it’s a race to lock in before more increases are underwritten.
Debt is typically sized on a few different tests, including LTV, Yield on Debt, and DSCR. In an example where the LTV is the constraint (Exhibit 1), the loan proceeds remain constant as the rate increases. Yet the actual debt service payment is higher, leading to lower cash flow after debt service. For the same amount of equity invested, fewer dollars are distributed, resulting in a lower cash-to-cash return and leveraged IRR.
Exhibit 1. Loan sizing with LTV constraint | Comparison of cash returns
Similarly, if DSCR is the active constraint (Figure 2), the amount of loan proceeds is reduced while debt service and post-debt service cash flows remain constant. However, the investment will require greater equity for the same cash distribution, which will again result in a lower return cash on cash and leveraged IRR.
Exhibit 2. DSCR constrained loan sizing | Comparison of cash returns
In summary, to maintain equity returns, prices must adjust accordingly.
The story repeats itself
In the 5 months between November 2021 (1.35%) and today (2.35%), the 10-year Treasury rate has increased by 100 basis points. We have seen this before.
In the 5 months from July 2016 to December 2016, the 10-year Treasury rate increased by 122 basis points from 1.37% to 2.59%, which remained firm until March 2017. As a result, we observed a drastic drop in sales volume from 616 sales in 2016 to 300 sales in 2017. was a major factor.
What to watch
So, will history repeat itself? Most would agree that rising interest rates have a negative impact on property values. Nevertheless, some additional factors are worth considering and can mitigate the impact of rising rates, such as:
- Continuous increase in rents. If the spike in rental rates continues, the value of many properties could continue to rise despite rising interest rates.
- Capital flight to real estate. Due to the heightened inflationary environment, there is a significant amount of capital competing for transactions. Strong demand can keep prices stable for some assets despite rising rates.
- Low cost equity providers. Historically, New York City has been a haven for ultra-high net worth investors, overseas buyers, and other low-cost stock providers. Sponsors or buyers who have access to less expensive sources of equity will do well because the equity component of the equity stack is magnified.
At Avison Young, we closely monitor the bid-ask spread. On the one hand, sellers have raised their price expectations due to all the positive factors at the property level. Simultaneously, as buyers buy into this growth, they are also receiving more expensive debt which leads to lower valuations. These two factors can lead to a widening of the bid-ask spread, which would lead to a reduction in the speed of sale.
We expect countless owners to be evaluating their options right now. Most will test the selling waters this year with refinancing on the horizon (say, in 2023) in anticipation of rising rates. The real question is whether buyers will match their price.
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