As of late September 2024, we have officially entered a new era of easing in the Federal Reserve’s monetary policy. The U.S. Central Bank has surprised the market by cutting rates by 0.5%. While unexpected, this cut is undoubtedly a welcome development, and I’d like to outline how this move benefits the commercial real estate (CRE) industry and, by extension, our investments.
Immediate Impact on Floating Rate Mortgages:
This rate cut offers immediate relief for value-added projects that typically use floating-rate mortgages. For example, floating rate loans with interest rate of 9.5% will now be reduced to 9% rate, improving cash flow and reducing the cash burn for many projects. While this is a positive step, many such loans originated in the 4.5-6% initial interest rate range in 2022, so there’s still significant room for further improvement. This 0.5% cut is a good start, but the industry will need additional rate cuts to see a more substantial cumulative effect.
The Fed’s current forward guidance suggests more rate cuts—two more in November and December 2024, four in 2025, and two more in 2026. These cuts aim to bring the Federal Funds rate down to the target neutral rate of around 2.9%. With the current rate at 5%, there’s considerable room to drop by another 2.1%. If a recession looms, the Fed may accelerate its rate-cutting schedule, benefiting the commercial real estate market.
Market Dynamics:
This initial rate cut should encourage investors seeking “deep buys” or bargain assets to take more aggressive positions. There’s a classic real estate saying: “Buy when rates are high and sell or refinance when rates are low.” The 0.5% cut offers a tailwind for improving valuations and pricing in the CRE market, though it’s still difficult to determine if we’ve hit the bottom. Buyer activity is picking up, while many sellers wait for better conditions unless forced to sell. Sellers under financial strain are raising Mezzanine Debt or Preferred Equity to buy time for renovations and lease-ups, anticipating selling in a more favorable market in 1.5-2 years when rates should be lower.
Gradual Transaction Recovery:
As interest rates fall, transaction volume is expected to gradually increase as financing costs decrease and buyers and sellers close the gap between the “bid” and “ask.” This improvement in transaction volume is critical for liquidity, which in turn should support price recovery. As financing becomes more accessible, owners will have a better ability to meet Debt Service Coverage Ratios (DSCR), borrowing more based on the same NOI. This liquidity boost will help reinvigorate the market.
Again, the recent 0.5% Fed rate cut will positively affect multifamily (MF) and other CRE projects: supporting cap rate decreases and cash flow improvements. Both factors directly impact property valuations, driving them higher. Let’s look into how these effects work together to increase the value of multifamily properties in detail:
Cap Rate Decrease
A cap rate decrease typically occurs when interest rates fall, making financing more affordable. As borrowing costs decline, property demand increases, leading to higher asset prices. Lower cap rates result in higher property valuations because the same Net Operating Income (NOI) generates higher cash-flow after the mortgage payment.
For example, if a property is valued at $70M with a 6% cap rate, implied NOI $4.2M. Assuming, 0.25% decrease in the cap rate to 5.75% cap rate would cause the property’s value to rise to about $73M. Let’s say this property had $50M mortgage debt and $20M equity value.
$3M increase in value represents 15% increase in the value of the equity from $20M to $23M. Furthermore, it reduces LTV of the $50M mortgage from 71.4% to 68.5% given the increase in value of the property. This reduces the risk of the lenders and improves long-term outlook for the equity owners.
Cash Flow Improvement
The second effect of the Fed rate cut is improved cash flow due to lower debt payments. Properties with floating-rate loans will benefit directly from lower interest rates. For instance, let’s assume a property with a $50 million floating-rate loan. 0.5% interest rate cut saves the property $250,000 per year of interest costs. For example, 9.5% floating rate loan costing $4,750,000 in interest per year would now cost $4,500,000 with the new rates at 9%. As the FED continues to cut rates in the upcoming months and quarters, cumulative savings become very substantial.
Combined effect of improving cashflow and valuation
As cashflow improves and valuation gets better, equity owners’ confidence increases and their willingness to provide additional capital as needed improves too. Multiple rate cuts, over time, have the “snowball” effect. The initial 0.5% rate cut gives investors significant hope and a clear path forward given FED’s guidance on the upcoming cuts.
Best Investment Opportunities ahead
While the Fed’s 1st rate cut will improve borrowing conditions, the long-term effects won’t be immediate. Overall market conditions of multifamily and other CRE assets are still challenging, primarily due to “higher for longer” interest rates policy that the FED kept up for too long. Many projects still have significant liquidity pressures to pay primary mortgage lenders, set aside interest reserves, tax and insurance escrows, support construction budget over-runs and other cashflow needs.
Many projects find themselves being “equity rich, but cash poor”, with great long-term prospects, especially now as the FED started to cut, but still low on cash in the bank. These assets critically need to raise capital to “buy time” for the market conditions to recover over time with the FED cutting rates over the next 12-18 months. Furthermore, many properties still need some additional capital to complete renovations and other improvements to maximize NOI.
This opens the door for the best strategy today: Investment in funds that provide “recovery capital” in the form of Mezzanine debt or Preferred Equity. Mezz Debt or Pref Equity capital comes in between bank debt and existing Common Equity investors. It has higher safety that Common Equity, but still generates very attractive returns for the fairly moderate risk, simply driven by the market conditions.
Tempo Advantage Fund LLC is a leading fund focusing on this strategy.
As the rate-cutting policy continues, conditions for multifamily investments are expected to improve dramatically over the next 1-2 years. This long-term outlook makes Mezz debt and Pref equity investments particularly attractive now. As property valuations rise and cash flow strengthens, these investment positions will become more secure, giving investors confidence that they are entering a favorable point in the market cycle.
