Client Corner: Higher Interest Rates Affect Apartment Market
Central Denver Apartment Market Report: Page 2 & 4 of our 2018 Q1 newsletter
Higher interest rates are likely to persist through the remainder of 2018, so we should understand both the positive and negative affects this will have on the Denver apartment market. Let’s start with the good news, the impact on rents.
Higher interest rates will make it more expensive for people to buy homes. This should increase the demand for apartments and other rental housing, because tenants are forced to delay the transition to home ownership due to cost. As the gap widens between the cost of renting and buying, rents may have room to increase.
Apartment investors have seen rates stubbornly remain above 4.75% since the beginning of the year. As a result, transactions are becoming more difficult to finance with conventional loan terms. Lenders often focus on the “debt coverage ratio” when considering a new loan. The debt coverage ratio is how much higher the cashflow of the property must be than the loan payment. Because buildings continue to sell for a 5.25% CAP rate (an approximation of cashflow), there is very little cushion when the loan has an interest rate of 4.75%. Remember, loan payments are interest plus principal, which makes the cushion in the debt coverage ratio even tighter.
To compensate for the tight financial calculations, lenders have begun to reduce the size of loans they are willing to make. It is becoming more common to see loans being capped at 65% of the purchase price, due to the constraints of the debt coverage ratio and the increasingly conservative approach of lenders at this point in the market cycle.
With tighter lending parameters, we expect to see cash and 1031 exchange buyers have a greater advantage over investors that finance their acquisitions. Long term, higher interest rates and constrained loan amounts should put downward pressure on pricing. It is going to be much more difficult to sell buildings offering only a 5.25% CAP rate; and as CAP rates rise, prices fall.
by Greg Johnson