Look up. See those cranes? They represent the tremendous building boom happening from east coast to west. Tower after tower are going up, adding hundreds of apartments and condos to cities’ residential inventory. In many metros, it’s still not enough to meet demand and rents continue to climb. For most rental property owners, times are good, for sure.
But just how long will this rosy rental market last?
Interest rates have been artificially depressed for far too long. Debt is cheap. Novice investors are paying up to compete with the seasoned pros, and property values are reaching all-time highs in places like New York and the San Francisco Bay area. Speculation is through the roof. Multifamily permits have surged in recent years, and last year actually surpassed the 2005 peak. Foreign investors are driving much of this demand—the U.S. real estate market is considered a safe, long-term bet that produces sizable returns.
All good times must come to an end. When that end is, we don’t know. But real estate cycles typically last 10 years. Some simple math finds us eight years out from the 2008 housing crash. Savvy investors are growing skittish and indeed, there’s reason to believe we’re headed for a market correction.
Eric Rosengren, president of the Federal Reserve Bank of Boston, recently warned a group of business leaders that we could see the bubble burst sooner rather than later. “History shows that most periods of serious financial instability involve a scenario in which debt is high relative to a volatile underlying asset and the value of the asset subsequently declines,” he told the Greater Concord Chamber of Commerce in New Hampshire.
The Fed’s low interest rates are only compounding the problem. “One potential cost to keeping rates too low for too long is that doing so might encourage excessive risk-taking,” Rosengren said. That’s exactly what we’re seeing in today’s real estate market. Rock-bottom interest rates have lenders and investors chasing higher yields than they’d get with other investment vehicles. Smart investors are pulling back, opting to keep their powder dry for when the market invariably takes a dive.
What does all of this mean for you as a real estate investor? A few things to consider:
- Lower the cost of your debt by refinancing. Rates are still low but are expected to slowly climb. Many anticipate a rate hike this summer, ranging from 25 to 50 basis points. It’s a modest increase, but banks are already starting to tighten credit through wider spreads and stricter loan terms. If you haven’t refinanced since the downturn, now is a good time to lower your cost basis by placing long-term debt on properties.
- Now is a good time to invest in property improvements. Not only will refinancing lower the cost of your debt, it will also allow you to tap your equity to make improvements to your properties. Property values have continued to climb, so many investors that were once highly-levered now have equity they can tap into. Just don’t pull out equity at the risk of becoming highly-levered once again. Aim to keep your loan-to-value ratio at 70% or less. Rental properties have generated tremendous cash flow in recent years, but we’re already seeing rental rates taper off with several new projects forced to offer rental concessions.
- Be wary of overpaying for portfolio additions. Market speculation has driven multifamily housing prices to new highs. People are frantically bidding up properties for fear that the market will only climb higher in the future. It’s a classic case of hysteria. Don’t be a yield chaser. When a market is in correction mode, chasing yield is not as important as value preservation. You’ll have plenty of opportunity to add to your portfolio as the market corrects. Instead, protect your value by owning fundamentally sound real estate that will prove durable across market cycles.
- Consider selling non-strategic assets. Generally speaking, the yield spread between Class A and Class B properties is as narrow as it’s ever been. Those who invested in Class B properties are experiencing terrific returns right now. But during a market correction, investors typically flock to quality investments. If you own Class B properties that are performing well now, but that you don’t plan to hold through the next market cycle, consider selling now while the market is hot. Smart investors are using this strategy to remain liquid so they can jump on new opportunities when the market corrects.
Thankfully, a healthy job market and population growth is helping to drive demand for apartments. Few expect the next downturn to be anything like the most recent recession. But still, a changing cycle is inevitable. It’s important for multifamily property owners to protect their investments and preserve their portfolio’s underlying value.
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