Every investment under consideration will have return projections. Because after all, it wouldn’t make sense to invest in something if you have no idea whether it will be good or bad for your portfolio. Commonly called a pro-forma or underwrite in the world of commercial multifamily, this is the instrument investors use to determine their interest in a particular asset.
In the world of large apartment investing, assumptions about the trajectory of where we are and where we are going does not change rapidly. It is therefore quite interesting to be on the front lines as the new administration begins its journey. What impact will Trump have on the commercial multifamily world? Will new policies change how operators approach their assets? How will the underwriting standards change with these new expectations? We’ll look at the specific case of large apartment investing return projections and the Trump effect in this blog.
Multifamily Returns and the Trump Effect
As of this writing, Trump’s executive orders are flying of the desk at what could be a record pace. The topics of these executive orders are quite varied, but the apparent intent of making progress is evident. One area in which this blogger is confident of Trump’s policies is in economic stimulation. Trump has made no secret of the idea that he will work to stimulate the U.S. economy. Trump has claimed he will build a wall, cut taxes and fix our infrastructure. There is no doubt that these policies will stimulate our economy.
But with economic stimulation comes some side effects. And consequently, these side effects have direct impacts on the commercial multifamily investment space and underwriting assumptions.
First, and most obvious, is the impact on interest rates.
Interest rates are part of the equation in some large apartment investment deals. Financed deals will have accompanying interest rates charged for the cost of borrowing. Especially relevant, these interest rates will dictate how much of the project’s cash flow will be dedicated to debt service.
The higher the interest rates, the greater your repayment obligation. As a result, the resulting monthly and annual cash flow will be reduced by the amount paid out in additional interest. And the net effect will be lower cash-on-cash returns.
There is an advantage to rising interest rates and borrowing, however. That is, locking in a fixed rate of interest for any length of time in a rising interest rate environment will prevent further erosion of investment returns. The interest rate a borrower pays today is what a borrower will pay tomorrow and the full length of the fixed interest rate period.
A bit like a crystal ball exercise, financial projections must take into account where interest rates currently sit, where interest rates are headed and how these factors will influence the project.
Rent rate increases
Jobs, jobs, jobs. We love jobs in the large apartment investing space. Why? Because jobs are the single best indicator of how well your apartment investment will fair.
Especially relevant is how jobs impact the rental market and the cost of rent each and every month. A simplistic approach to the supply and demand of apartment units would look like this:
- New jobs = more people
- More people = more housing
- Scarce housing = increased rents
You’ll note that we went from “more housing” to “scarce housing” in our model. This is an important assumption. If new housing units are developed at the same rate new people arrive, this model breaks down.
Because this model holds true most of the time, and we can expect new jobs to be formed around Trump’s policies, we can conclude that upward pressure on rental rates will persist.
We can apply the same criteria to vacancy rates as we did to rent rate increases.
If our simple model holds up, including the assumption, then we’ll see downward pressure on vacancy rates given the Trump stimulative policies.
Capitalization rates (CAP rates) have been going down for some time now. This compression is not likely to continue under Trump policies, nor is rapid expansion.
There has always been a debate about the relationship between CAP rates and interest rates. But if we accept that the relationship between interest rates and CAP rates is positive, we can therefore make a logical argument for the direction of CAP rates looking forward.
After the election of Trump, the Federal Reserve moved to increase interest rates from zero and near zero after many years at this level. This and likely future increase in interest rates will ultimately result in increases in CAP rates overall.
The impact of this rise in CAP rates will ultimately be lower valuations of large apartment investments versus the same asset with a lower CAP rate. The saving grace in this scenario is that this phenomenon is likely not going to happen rapidly, and can therefore be managed by an investor for optimal investment performance.
Collectively, Trump’s new administration is looking to enact new policies that are generally speaking economically stimulative in nature. The side effects of these policies have to be placed in the context of your large apartment investment strategy. If understood and accounted for correctly, there is no reason why your commercial multifamily investments will not thrive over the next four years of Trump’s administration.Tags: exit CAPs, interest rates, jobs, rent rate increases, Trump policies, vacancy rates