4 Ways We Protect Our Funds from Inflation, Interest Rate Hikes
Stability and predictability: That’s what a lot of investors look for when they are considering where to put their cash. But after years of low interest rates and mostly steady inflation, things are feeling a lot less predictable. The Fed just raised interest rates—the first of up to six such increases this year—and the Consumer Price Index jumped 7.9% in February compared with the same period in 2021. That’s the biggest annualized growth in inflation since February 1982.
Increased consumer demand, along with COVID-19-related supply chain disruptions, labor shortages and rising energy costs, are all fanning the flame of inflation, which in turns increases the risk of a recession. As a measure to control runaway inflation, on March 16 the Federal Reserve voted to raise interest rates by a quarter percentage point, to between 0.25% and 0.5%, with more increases expected.
How does all this impact the outlook for multifamily real estate investment? At Origin, we monitor inflation and interest rates through the entire life cycle of an investment. In fact, Origin Co-CEO David Scherer put them at Nos. 1 and 2, respectively, on his 2022 list of private real estate investment trends. Here are four key ways that we are mitigating the risks in this inflationary environment:
1. Focusing on Multifamily
Inflation and construction costs aren’t the only things rising. If inflation increases, construction costs to build the assets may keep going up—but so, then, will rents. Assuming expenses, including the cost of debt, can be controlled, margins for multifamily investors will expand as higher rents increase revenue. By investing in multifamily, we are also in the position of repricing rents on an ongoing basis. That’s more difficult with, say, an office lease, where rent rates might be locked in for 10 years with a long-term lease. As rents rise, so will our net operating income; so even if cap rates expand, we are still likely to see values appreciate.
Returns are outpacing inflation. In 2021, both monthly rent and returns on multifamily investments grew more quickly than the rate of inflation, according to data from the Consumer Price Index, RealPage and the NCREIF NPI-Apartments Index. According to the National Association of Realtors, more than 700,000 new apartment units were absorbed by renters in 2021, representing 50% more units than the pre-pandemic high and outpacing the roughly 360,000 new apartments delivered in 2021.
Demographics and demand are in our favor. Our belief that multifamily real estate is the most effective hedge against inflation remains unchanged. Demographics and wage growth, among other trends, are extremely favorable to multifamily investment relative to office or retail. A growing portion of the population can choose where they live and work, and many are flocking to the high-growth southern and western states where we are investing. Baby boomers and recent empty nesters are looking for new flexibility; millennials are forming households later in life and delaying home purchases; and Gen Z, now entering the workforce, is creating demand for rental housing that is expected to continue beyond the next decade.
Housing—including rental housing—remains an essential need. Many people aspire to homeownership but can’t save enough to buy. Inflation exacerbates this problem, as personal savings lose value while housing costs increase. In a recessionary environment, consumers may cut back on travel, entertainment and retail spending, but housing is an essential need.
2. Fixing the Cost of Debt
Controlling costs on multifamily projects creates an attractive hedge against inflation through top-line growth. One major cost is debt, and the simplest approach to controlling this is fixing interest rates on long-term debt. Because so much of our portfolio is associated with development, we employ floating rate debt, much of which will not be fixed until two to three years after construction is complete and the project is stabilized. To address the possibility of higher interest rates in the future, we are deploying an array of strategies.
One of them is exploring opportunities to secure attractive fixed-rate construction financing from the U.S. Department of Housing and Urban Development (HUD). HUD’s 221(d)4 construction financing program allows for rates in line with rates applicable to debt available on stabilized assets. Such financing, which can be in place for 40 years, would mitigate the risk of higher future interest rate exposure relative to when traditional construction loans are refinanced to permanent debt.
3. Using Hedging Instruments
At both the property and Fund level, we are using hedges to help us reduce or limit risk in long-term interest rates. These include:
Forward-dated interest rate swaps that we have aligned with the expected dates of permanent debt refinancing. These instruments allow us to effectively fix all or a portion of the cost of debt on future, permanent financing. If interest rates increase above the fixed swap rate, we will receive payments offsetting the higher interest costs. If interest rates stay below the future fixed swap rate, our properties or Funds will owe additional payments; but despite this downside exposure, swaps allow for greater certainty of future cash flow.
Forward interest rate swaptions. These are essentially options to enter into an interest rate swap at a future date. If rates increase above the option strike price, we exercise the option and receive payments offsetting the higher interest rate expenditures. If rates stay below the option strike price, we don’t exercise the option and the premium is a sunk cost. While we generally prefer the use of swaps over swaptions in order to deploy as much capital as possible in real estate investments rather than hedging instruments, we were able to expedite swaption purchases ahead of expected near-term market movement.
4. Relying on Thorough Due Diligence and Underwriting
Our analytical approach to picking the best markets for multifamily real estate investing has been refined over many years and is informed by our real estate specialists, who live in the regions where we invest. Their relationships with our development partners give us competitive advantages that often include early access to the best off-market deals. We also employ MultilyticsSM, a proprietary model built by our in-house team of data scientists. It utilizes machine learning and millions of data points to develop block-by-block insights and forecasts, allowing us to spot trends in such factors as rent per square foot, lease renewal rates and rent growth, and to validate them at Origin properties.
Our rigorous underwriting increases our ability to make investments that meet or exceed our expectations. We stress-test by playing out different scenarios using multiple changing data points, including interest rates, inflation and cap rates, to calculate what it would take to still achieve appropriate risk-adjusted returns. As well, we study the environmental, legal, physical and financial aspects of a property, and benchmark opportunities against one another to determine which ones represent the best risk-adjusted investments. We use leverage responsibly and build value in deals to create a cushion.
While we hope that any interest rate increases happen in an orderly fashion, and that inflation remains in check, we aren’t sitting back and watching what happens. We think, plan and execute like risk managers. That approach removes as many unknowns as possible from the acquisition, development and management of every asset in our Funds, and it’s these core approaches that have helped us reap top-decile returns over the years for our investors.