On the back of the Fed raising federal funds interest rates 0.75% in June, all indications are that it will raise them a further 0.50%-0.75% at the Central Bank meeting in July. The Fed continues to attempt to combat inflation markers still hovering around 3x its desired goal of 2%. Fears of a recession have now become palpable, and we’re beginning to see the manifestations of that across the housing market as buyer activity cools off in response.
What does this mean for residential real estate entrepreneurs?
While the federal funds rate does not directly dictate mortgage rates, it does profoundly influence market activity of which the mortgage rates are a byproduct. This influence, combined with the Fed’s ongoing effort to reduce its balance sheet including mortgage-backed securities, has been a considerable driver behind the recent gradual rise of mortgage rates. It’s conceivable that, if the Fed’s measures fail to slow the inflation train, we could, for example, see 30-year fixed conventional mortgage rates, currently sitting around 6.5% at the time of the writing of this article, continue to push to 7% and beyond based on historical precedent.
Subsequently, increased mortgage rates make it less advantageous for real estate entrepreneurs utilizing them to fund a significant amount of their project costs via debt.
The private money sector, driven by the capital markets, is more complicated, with products within the private money sector being affected differently from others. DSCR products for example, which were used primarily by investors with portfolios of single family or multifamily residences that could afford the debt coverage, and whose rates hovered fairly close to the conventional space, have dried up in the face of rising inflation. This is especially true in rent-capped states, such as California. New construction and bridge products have seen an increasing migration to adjustable-rate notes in the face of market uncertainty, and lenders are becoming increasingly cautious when underwriting larger, more complex projects.
Entrepreneurs utilizing products in the private debt space should familiarize themselves with activity in the capital markets and become knowledgeable of the various market factors affecting the products they typically leverage for their projects. They should understand the implications of recourse and non-recourse loans. Additionally, and perhaps most importantly, they should prepare themselves for the possibility of needing to pivot their exit strategy as we move into a real estate market where driving inflation/appreciation may no longer atone for inefficiency.
Part of the goal of the June hike was to reduce the amount of people applying for, and being approved for, mortgages, and the metrics say this goal was, in large part, accomplished. We anticipate that the buyer pool will continue to shrink on the back of increasing mortgage rates and recession fears. This, combined with seller fears of losing the equity they’ve gained as markets surged to their peak in the first half of 2022, should bring a lot of inventory to the market in the short term – inventory that should be expected to sit on the market for considerably longer than the average over the past several months.
This will lead to some of the hotter housing markets in 2022 beginning to cool off. High acquisition costs combined with high construction costs have kept margins in hot markets tighter than usual as of late, and the upcoming market may begin to loosen that to some degree. This is especially true for entrepreneurs undertaking new developments, where lack of supply has kept construction costs high and creeping land acquisition costs have been making fewer and fewer opportunities make sense.
As a general rule, project risk rises when cost of capital increases. That said, investors whose strategy is focused on asset appreciation and value-add are less impacted than entrepreneurs focused on short term exits.
Short-term project margins become thinner and are made even thinner for entrepreneurs leveraging equity investment in an environment where those investors are prioritizing yield to combat inflation. Strict and conservative underwriting becomes even more critical. This applies all aspects of the process, from cost modeling all the way through to ARV comparison. Discipline is a flipper’s best friend in terms of market volatility and uncertainty.
Entrepreneurs focused on new developments are also affected, albeit differently depending on their endgame. Those building new single family homes might feel the tightening grip of the market and be more judicious in their project selection, while entrepreneurs building rental housing may experience success as the market conditions push more renters to the market and raise rental rates.
There is likely to be an uptick in market rents as the Fed continues its rate hike march. Investors leveraging conventional mortgage and private debt products to purchase homes for rent, specifically in states not rent-capped, are very likely to transfer the cost of capital incurred along to renters in the form of higher rent rates. Coupled with a resulting rise in rental demand as prospective buyers either choose or are forced to enter the rental market, and you have a recipe for rents to rise.
We anticipate there may be as many as 3 or 4 additional rate hikes to occur before the end of the year. As market volatility increases, being smart and diligent as a real estate entrepreneur as well as efficiently deploying your capital becomes critical. Becoming knowledgeable about the ripple effects of various market factors will position you one step ahead of your counterparts and give you the tools to remain successful as the market presents opportunity and uncertainty in equal measure.
Coinvest by Fund.me procures debt and equity funding for your projects and lowers your capital contribution on a per-project basis to as low as 5.5% of the acquisition price. In a true joint venture partnership, you also gain from Fund.me’s market expertise and experience in your underwriting process, handle minimal administrative responsibilities and paperwork, and get to focus on what you do best - executing projects.
Sound like exactly what you need heading into this market? We agree. Share your opportunity with us today to start the discussion about funding your project with Fund.me