Bobby Lee, president of the investment division of Los Angeles–based JRK Property Holdings, has gotten a number of calls from brokers this week. They haven’t been shopping new properties or inquiring about sales opportunities. Instead, they’re checking to see if Lee would still be interested in buying properties that he had finished second or third on originally.
“For a lot of deals [on which] we finished second, third, fourth, and fifth earlier in the year, we're starting to hear scuttlebutt from brokers asking if we're still there,” Lee says. “Many are deals awarded in the last month where brokers are concerned about fallout resulting from either trouble raising equity or returns getting squashed because of rising interest rates.”
With the movement of the 10-year Treasury rate jumping from 1.98 percent on March 7 to 2.24 percent on March 23, a lot of buyers got spooked. Because of that, Lee says he’d be surprised if more than half of the deals in the pipeline right now get closed. The wider the spread between the yield on the 10-year Treasury and a cap rate, the better. So when the 10-year goes up, that shrinks.
“An increase in Treasury yields has dampened or killed some potential acquisitions or dispositions,” says Kevin Smith, a director at New York–based Centerline Capital Group. “When you’re underwriting assets at the tight cap rates many of the core markets have been trading at, a widening of Treasuries by 15 or more basis points can really kill a deal. With this dramatic move in rates, it will have a negative impact on the feeding frenzy that we’ve seen in the multifamily industry over the last 12 months.”
Gary Mozer, principal and managing director at Los Angeles–based George Smith Partners, says when the 10-year rate moves up, buyers lose proceeds and the cost of capital goes up. “There have been some retrades,” he says.
“When people thought they were buying something and trying to generate a 13 to 15 percent total return with 8 to 10 percent current, and the cost of debt has gone up by 26 basis points with 75 percent leverage, they're worse off on a pure cash-on-cash and IRR basis by a full point,” he says.
If the buyer adds 25 basis points to the cap rate to offset the cost of higher debt, the corresponding price decline is 4 percent to 5 percent. “Those are huge numbers,” Lee says. “We're seeing that certain groups are sensitive to every last drop of IRR and sellers are not willing to absorb this level of pricing concession to make those groups whole.”
Limited Effects So Far
Ben Thypin, director of market analysis at New York–based research firm Real Capital Analytics, hasn’t seen the rise in rates kill deals, but he adds that it’s something he’s watching. Not surprisingly, brokers say they haven’t seen deals blow up yet either. ARA’s offices in Boston, Houston, Denver, and Kansas City all say they haven’t seen all deals fall apart. Nicholas Michael Ingle, director of capital markets for Los Angeles–based Hendricks & Partners, says the same thing. “We’ve not seen deals fall apart, but I think everyone certainly recognizes the risk,” he says. “On the capital markets side of our business, we’ve seen much more interest in conventional bank debt and life company loans based on their ability to lock rates.”
Representatives from Bellwether Enterprise Real Estate Capital haven’t seen any deals fall out, but they also say it’s early in the process and time will tell. There are a couple of factors that make a 35 basis point rise in the 10-year not entirely disruptive—mainly, rates are still really, really low from a historical perspective. The other thing is, if the 10-year does rise too much for a deal to pencil out, borrowers will just do a seven-year loan, which has a lower rate. Smith says investors could ultimately look for floating-rate debt opportunities if the 10-year continues to rise.
But Lee thinks some buyers will be more exposed than others. “It's the guys who are trying to JV or syndicate equity that will have the most difficulty with the rate volatility. You will see that discretionary funds like ours and REITs will be much more aggressive in this environment,” he says.