Negative leverage in multifamily is now widespread

Another red flag reminiscent of the epic housing market crash of 2008 has appeared in the multifamily sector in recent weeks as interest rates have risen: negative leverage is back .

Negative leverage is a phenomenon that occurs when asset prices rise rapidly, reducing rates of return for buyers despite record high rent increases. Then, interest rates rise rapidly, creating an imbalance that causes initial rates of return on new multifamily investments to fall a percentage point or more below the interest rate on the property’s mortgages.

In other words, landlords make less money on their properties than their banks.

In the first quarter of 2022, according to CBRE, investors spent a record $63 billion on multifamily properties; at the same time, prices paid for apartment buildings rose 22.4% in the first quarter compared to the first quarter of 2021, according to MSCI Real Assets.

Meanwhile, the Federal Reserve has released the first salvoes of what could be a bombardment of up to seven rate hikes this year it says are needed to quell the inflationary spiral gripping the United States. A 25 basis point rise in March was followed by a 50 basis point rise this month.

According to a recent report by The Wall Street Journalnegative leverage hasn’t been so prevalent in the multifamily sector since the subprime mortgage crisis that triggered the financial meltdown in 2008. When the music stopped on the overleveraged and highly speculative real estate market in 2008, an avalanche of defaults on mortgage loans has occurred.

According to CBRE, the annual volume of multi-family purchases has nearly doubled during the pandemic, but profit margins for investors have shrunk: rental apartment profits as a share of house prices, which measured about 5.5% in the second half of 2019 , fell to 4.6% at the end of 2021.

As of this week, the average interest rate on a 30-year fixed rate mortgage is above 5%.

Investors calculate the capitalization rate of a building by dividing the profits from the property before the mortgage payment by the purchase price. A cap rate lower than the mortgage interest rate is usually a red line in terms of risk.

As the housing shortage drove prices up, institutional investors in multifamily and SFR bet that rents had no choice but to rise.

New multi-family landlords facing negative leverage may want to increase rents to compensate for the imbalance, but the record pace of rent increases over the past year – the tip of an inflationary spiral that has pushed the price gasoline at $5/gallon – can test consumers breaking point.

According to Realtor.com, the average asking rent in the United States in April reached a record $1,827 in April, a 17% increase over the previous year. Based on the standard measure of affordability — that your rent or mortgage payment should cost no more than 30% of your salary — the median income in 44 states is currently not enough to pay those prices.

Outstanding mortgage debt backed by multi-family buildings now stands at more than $1.8 trillion, according to the Mortgage Bankers Association, double what it was in 2008.