High and rising inflation systematically poses a threat to the performance of traditional investment classes. With the Fed working furiously to respond to inflation and restore price stability through drastic interest rate hikes, many investors are concerned about the short- and long-term prospects for alternative investments as well.

Naturally, no investment is without risk. That said, for investors seeking a portfolio hedge as the economy moves into a period of unsettled interest rates, the resilient profile of strategic real estate investments can still offer strong returns.

As a vertically integrated real estate sponsor that has successfully navigated many real estate cycles and market fluctuations, we have identified the key fundamentals that make real estate investments, specifically multifamily, the most resilient in today’s macroeconomic climate.

Below we discuss these fundamentals and provide insight on how investors can combat inflation and rising interest rates to maximize returns:

1. Real estate investments continue to thrive despite relentlessly strong inflation. But not all property types fare the same.
When considering traditional investment assets such as bonds and stocks, inflation historically erodes principal value and pushes down the price investors are willing to pay. While in response, rising interest rates weigh on asset prices—sometimes reversing the wealth effect for investors.

Since the coupon on most bonds or fixed-income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.

For equity investors, market participants frequently discount future cash flows at a higher rate when inflation rises. The higher the level of inflation, the greater the discount rate applied to earnings, thus lowering the value the stock.

Despite peaked inflation and rising interest rates, over the past year, real estate investments have continued to produce steady, predictable income. That said, certain real estate property types are more vulnerable to inflation and climbing interest rates than others—with multifamily assets in particular standing apart. Characterized by short-duration leases, or by rents linked to revenues, multifamily assets provide the highest level of inflation protection.

Due to their ability to maintain dynamic cash flows, multifamily real estate assets are well-positioned for resilience. Leases for multifamily properties embody shorter terms of just one year, often followed by monthly lease extensions. This fundamental allows asset owners to quickly adjust rents to compensate for inflation and capitalize on increased demand.

2. An increase in Treasury rates does not always produce an equal increase in borrowing costs—they do not move in lockstep.
It is important to note the nuanced relationship between Treasury rates and borrowing costs. Margins, or loan spreads, charged by lenders can actually be reduced during periods of rising rates. Such narrowing of loan spreads is often seen in competitive lending markets—like multifamily, where agency lenders are active.

While rates are undoubtedly moving up, the Fed’s long-run estimate is for the rate to stabilize around 2.4%, leaving the 10-year Treasury below the 4% range.

From a multifamily sponsor’s perspective, staying attuned to borrowing costs is key to successful acquisitions during periods of rising rates. Targeted risk-adjusted returns on new acquisitions can be achieved by adjusting underwriting assumptions and applying stress tests and scenario analysis across a range of factors, including interest rates, inflation, and cap rates.

In an effort to control borrowing costs, seeking acquisitions with fixed-rate debt or using derivatives on existing floating-rate debt, such as swaps and swaptions, can limit rate risk over the life of the asset.

3. Multifamily assets with greater earnings potential, or NOI growth, should be able to withstand drastic rate hikes.
In today’s rising interest rate environment, a common real estate investment concern is that when Treasury yields rise, so do capitalization (cap) rates—which in turn declines property values and dampens total investment returns. In reality, rising rates have a complex impact on the performance of multifamily investments.

Historically, when examining multifamily cap rates and 10-year US Treasury rates, multifamily assets have shown a healthy potential for NOI growth amid a rising rate environment.

For example, a recent report from CBRE notes that over five quarters ending in Q3 2021, long term interest rates more than doubled, rising more than 70 basis points, while cap rates for the multifamily segment compressed by roughly 75 basis points over the same period.

Additionally, 2003-2006, 2012-2013, and 2016-2018 provide examples of prolonged upward rise in interest rates, where 10-year Treasury yields rose by more than 100 basis points each time, yet cap rates remained flat or even compressed.

How can the unquestionable rise in Treasury rates result in stabilized or compressed cap rates? In this case, investor appetite for multifamily investments was, and is now, the driving force behind asset valuation. When investor interest is high and the climate is competitive, it can lead to more aggressive valuations, offsetting interest rates through strong capital inflows.

4. It is of foremost importance to account for the current economic environment as well as geographic market when considering investment strategy.
In today’s environment, there are challenges on the horizon with the Fed’s bullish interest rate hikes, yet the outlook for the multifamily real estate sector in particular calls for continued growth.

Nationally, robust multifamily rental demand is being driven by a healthy labor market, rebounding household formations and would-be buyers exceedingly priced out of the single-family home market—with rising mortgage rates making homeownership even less affordable. Consequently, vacancy rates are near cyclical lows, renters are actively leasing apartments, and operators are implementing healthy rent increases.

In 2021, these healthy fundamentals supported unprecedented growth in multifamily NOIs, which climbed to nearly 18%. Experts project that rent growth will remain positive through the remainder of 2022, but will likely moderate to a more reasonable, yet still-elevated level.

However, on a geographic level, not all markets fare the same. Understanding the specifics of a region before developing investment strategy will determine the overall venture success.

With this objective, multifamily investment firms concentrated on vertical integration deliver the highest level of output. By maintaining a narrowed focus and comprehensive expertise in specific market regions, this fundamental encompasses a deep understanding of market values, cost-effective building and enhancement of living space, value-add strategies, and best management practices for the area—allowing the firm to invest more skillfully and efficiently.   

With a full scope of operations held under the same corporate umbrella, vertically integrated companies have the knowledge and ability to control costs and generate the greatest returns possible for their investors.

As a sponsor, successfully navigating the current macroeconomic environment characterized by peaked inflation and climbing interest rates takes finesse. But through careful examination of key fundamentals, and implementing a prudent vertically integrated investment approach, a multifamily portfolio can be built to withstand all economic cycles and provide stable, outsized returns.

Max Sharkansky is managing partner at Trion Properties, a private equity investment firm that primarily acquires value-add real estate properties with an emphasis on multifamily and currently has more than $1 billion in assets under management. Contact him at [email protected].