Embracing “Normalization”

No surprise—the sharp rise in interest rates that commenced a year ago has begun to take its toll, leaving apartment owners, among other investors, pondering what lies ahead in what may be a transformational period for the US economy (we’ll address the impact on rental housing later in this article).

To clarify, Federal Reserve Chair, Jerome Powell clearly warned us in March of 2022 when the rate hikes were commencing that a six to twelve month lag time would likely ensue before steeper borrowing costs would more fully wash through the economy and begin impacting in tangible ways.

Seemingly on cue the first dramatic manifestation of the power of rate increases was revealed in the collapse of Silicon Valley Bank (SVB) on March 11th of this year.

The nation’s 16th largest bank toppled under the weight of a cumulative 450 basis point spike in interest rates rolled out over eleven months by the Fed starting in March of last year. The Fed Funds rate rose from about 0% (i.e. virtually no cost borrowing for banks at that time) to about 4.50% as this article goes to press on 3-11-23. The severe upward rate changes caused an enormous value decline in SVB’s super heavy concentration of investments in fixed rate treasury securities, leaving the bank effectively insolvent. It was too many eggs in one basket, a rather shocking strategic error for a bank.

On a more widespread basis, con- sumers, businesses and government entities with variable loans are beginning to feel the pain of substantially higher short term interest rates causing their debt service payments to rise sharply.

The Fed’s end game in jacking up interest rates is to slow overall buying demand on the back of these higher borrowing costs; in theory, reduced buying demand = disinflation. It is of course inflation, which became a huge concern in the first half of 2022 (CPI reached 9.1% in June), that precipitated the Fed’s rate hiking policy in this first place. Rate raises are the Fed’s sole tool to combat inflation.

How long for this inflation battle to run its course and where will interest rates land? One can only speculate. But as to why we are confronting this severe economic stress at this time, it may boil down to “normalization”, that is, a needed reversion to more traditional and natural economic fundamentals.

It’s entirely plausible that the period stretching from the great recession of 2008–2009 through the covid pandemic was in fact an aberration. And the predominant through line for that era can be found in the existence of government supported low interest rates, initially used to propel us out of recession, later maintained at borrower friendly levels under the Fed-coordinated “quantitative easing” program, and finally culminating with the covid phenomenon from 2020 through 2022, where even greater government subsidization of interest rates resulted in rates plummeting to all-time lows.

We note here that American homeowners that obtained 30 year fixed mortgages ranging from 2.625% to 4% during the 2009 to 2022 low rate window were fortunate considering that mortgage rates have actually averaged 7.75% since 1971.

As to the apartment marketplace, it will need to re-orient to the new normal of higher lending rates as we are weened away from artificially suppressed rates. The implication being that when carrying charges to acquire multifamily property goes up due to greater expenditures for mortgage debt, the purchase price presumably should decline in some proportionate way. Investors simply won’t buy if projected returns fall below the rate of inflation.

That said, the effect of higher interest rates has yet to dampen sale prices of Orange County apartments. On the contrary, in the fourth quarter of 2022 new highs were registered for gross rent multiplier at 18.44, price per SF at $504.64, and price per unit at $486,467. That’s a testament to the great esteem accorded to OC real estate, as well as the county’s ongoing housing shortage. However, it IS noteworthy that the number of sales in this past Q4 fell to 30 from 69 transactions in Q4 2021 and 55 in Q4 2020. This suggests that fewer and fewer investors are willing to buy in at such frothy prices.

My own view is that the marketplace