Real estate credit investors have benefited from higher interest rates since the Federal Reserve began hiking them nearly three years ago. At that time, inflation was rampant, real estate values were at all-time highs, and equity investors were chasing returns in the mid-teens or even low 20% range. As rates continued to rise, investors generated mid-teens returns in credit investments—in many cases, higher than the expected return for equity investing.
As a result, the market has seen an influx of firms, including BlackRock and Blue Owl, and moves by banks such as HSBC and JPMorgan Chase, all aiming to increase their footprint in the space. Now that inflation has moderated, interest rates are relatively stable and the market is saturated with credit funds, how much longer can the good times in credit investing last, and what could push investors back into equity investments?
Inflation and Perception
Credit investments, through their structure and position within the capital stack, are naturally less risky than equity investments in real estate. However, over the past few years, credit investments have provided higher returns than equity investments, throwing shade on the adage of “more risk, more return.” For multifamily real estate specifically, a change in interest rates, rent growth, or the cost to build new units could reverse the narrative to a more normalized expectation for returns given risk.
Interest rates, specifically SOFR (the secured funding overnight rate), is the primary index used to determine a borrower’s interest payment in the commercial real estate market. As SOFR goes, so goes a borrower’s interest payment. SOFR is dictated not only by actual inflation but by people’s expectations for future inflation.
January’s 3.1% inflation rate is roughly where it was in June (3.0%) and July (2.9%) 2024, but investors’ current expectations for SOFR over the next few years are very different than they were early last summer (see chart below). This is being driven, in turn, by expectations that inflation will continue at the current rate, which is above the Fed’s 2% target. As long as SOFR remains elevated, credit returns are expected to outpace equity returns over the near and medium term, keeping the credit party going.
Source: Pensford LLC
A Win-Win for Credit and Equity?
In the multifamily space, we expect that meaningful rent growth over the next five years will bring equity investors off the sidelines and provide them with the potential to generate returns in line with, or even greater than, current credit returns. Increasing rents is the easiest way to increase a property’s total net operating income, or NOI. All else equal, increasing NOI raises the property’s value and enhances total investor returns. The cost of housing, including rent, makes up roughly 30% of the Consumer Price Index (CPI) on which the inflation rate is based. This means rent growth would usher in sticky inflation and keep interest rates elevated—bringing a rare win-win for both credit and equity: strong risk-adjusted returns for both groups.
Materials and labor costs to build new apartment communities, like most everything else, skyrocketed during late 2021 and 2022. If that wasn’t enough, general contractors used those busy times to inflate their profit margins and make up for COVID-related losses in 2020 and early 2021. This confluence of pricing increases squeezed returns of apartment developers to levels that made the cost of new projects untenable and pushing borrowers out of traditional lending and into the credit space.
Tailwinds for Credit Investing
Over the past 12 to 18 months, we have seen construction pricing flatten and even dip lower in many markets. If these costs continue to decline, expected returns could increase to levels that would entice developers to start developing again. Interestingly, lower construction costs would have a negative inflationary effect on the CPI and potentially pull interest rates down, making it a win for equity investors but a more challenging environment for credit investors.
It’s impossible to know what tomorrow holds. Will interest rates stay steady or increase, putting pressure on equity investors but continuing to reward credit investors handsomely? Or will increasing rents and decreasing costs provide the requisite fuel for equity investors’ fire? I believe “higher for longer” interest rates are here to stay for at least the next six to 12 months, providing strong tailwinds for credit investing. I’ll look forward to a mid-year check-in.
