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How the Latest Fed Rate Hike Affects the Apartment Market

The apartment industry should not be affected too much by the Federal Reserve System’s March 15 decision to raise the base funds interest rate by 25 basis points. However, the Fed has stated it would raise the rate three times in 2017, and the two future increases will move the apartment borrowing and cap rate slightly higher than Axiometrics has previously forecast.

The new federal funds target rate range of 0.75%-1.00% remains largely symbolic; it is still only a step on a long road of increases to reach the neutral rate of 3%, the point at which monetary policy neither stimulates nor slows the pace of economic growth. As we travel that path, gradual pace and lower magnitude of increases still remain entirely data driven.

The Bureau of Labor Statistics’ January and February employment report was the final nudge the Fed’s Open Market Committee needed to raise the base rate for the first time this year. The economy added 235,000 jobs during February and 238,000 in January, the BLS said.. Those results showed that the employment market is still in a position of strength. Further, the 4.7% unemployment rate – below the “natural rate” of 5% — and increasing wage-growth numbers added sufficient evidence of the U.S. economy’s strength to move the rates higher.

The headline Consumer Price Index (CPI) took a breather in February after six months of solid gains including 0.6% monthly growth in January. The headline CPI increased by its highest annual pace since March 2012 at a 2.7% year-over-year monthly growth. This pace is expected to remain around the Fed target rate of 2.0% this year. The median 12-month moving average wage growth as reported by the Atlanta Fed stood at 3.5% during January. Combined with the 2.8% increase in wage growth during the 12 months ending in February, as reported by the BLS, these metrics motivated the Fed to raise the base rate now.

The chart below shows how low most interest rates are at the present and where they’re headed in 2017.

The various interest rates will likely increase this year, but they should remain well below historical standards. Axiometrics forecasts an average jobs gain of over 200,000 per month 2017-2021.

Business interest rates are expected to remain low, which means employers will still be hiring. And apartment owners and managers won’t have to worry about the demand for their units subsiding – which could make them sigh in relief, since more than 372,000 new units have been forecast for delivery nationwide in 2017. A slight increase in borrowing costs will not have an impact this year, since properties slated for delivery have already been penciled in. However, as rates keep increasing, along with borrowing costs, expect new supply to decelerate during 2018 and 2019.

Investors in apartment and student housing properties also are unlikely to feel much effect from the Fed’s rate hikes this year. The annual average 10-year T-Bill, which is used on most underwriting and exit cap rate calculations, returned about 1.8% in 2016. The spread between the T-Bill and the average current value cap rate was about 290 basis points – well above the historical spread of about 140 basis points.

The T-Bill rate should climb close to the 3% range by the second half of 2017, reducing the spread between it and the cap rate, as measured by the National Council of Real Estate Investment Fiduciaries (NCREIF), to about 220 basis points. Cap rates for apartments remain the lowest among property types, so multifamily investment should continue to remain strong in 2017 after record-setting 2015-2016 strength.

The difference between cap rates for apartments and all commercial real estate.

Even if 10-year T-Bill rates increase, it will have little impact on cap rates. The reasons:

  • There has been a disconnect between the cap rate and the T-Bill since the recovery began, as T-Bill rate hikes have not moved cap rates by much.
  • Demand for apartment investments should be high, and it is expected to be preferred property type for a couple more years. The competition is expected to keep cap rates low. Given the fact that the global economy remains weaker than the U.S., it is expected to be seen as safe haven to attract capital from around the world at least through next year.
  • The increase in interest rates points to the Fed’s increased confidence in the U.S. economy. Apartment fundamentals have a correlation of over 85% with job growth. The confidence in expanding job gain/growth will carry the apartment market to moderately healthy fundamentals this year. The impact to apartment fundamentals will be primarily felt through increase in new supply.
  • Investors have been hard-pressed to find Class A apartment properties, but newly built apartments will start to trade toward the end of 2017 and early 2018. Class B and C+ apartments, whose cap rates will be higher than Class A apartments, have been very popular for investors, but the institutional product should remain competitive.

Impact to Single Family Market:

  • About 5.5 million existing homes were sold in 2016, and the annual pace of new homes sold averaged more than 563,000. We expect the pace of home sales to pick up moderately this year and next. First-time home buyers remain on the sidelines, and other structural issues surrounding the single-family market prevent robust growth. Existing home sales are expected to average 5.76 million per year over the next five years.
  • Housing months of supply remained low in 2016 at 4.5 months. We expect this rate to pick up during the next three years.
  • The pace of housing starts during the past few years has been dominated by multifamily. We expect this to change during the next three years, as the pace of single-family permits picks up.
  • Mortgage rates are expected to gradually increase over the next three years, yet remain low.
  • The increase in rates is a sign of increases in general economic conditions. Though there will be less savings and higher risk to consumers because of rising rates, higher income growth will mitigate some of the hurdle in the short-run.
  • Having said that, buyers today may be more sensitive to increased rates than in the past, because of higher requirements to qualify, sluggish income growth and rapid acceleration in prices over the past three years. Low interest rates helped offset these drags.

Though the Fed’s latest base-rate hike should not affect apartment market fundamentals in the short-run, future rate hikes could nudge cap rates slightly upward and help stem the flood of construction in 2018 and 2019. Of course, if the Fed is able to eventually lift the rate to the 3.0% predicted in the next few years, the impact will be more pronounced at that point.

Axiometrics’ specialty is monitoring the apartment and student housing markets to provide a granular view of volatile market trends through the interactive AXIOPortal.