Negative Correlation - A Slow Dance Between Multifamily Valuations and Monetary Policy

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“Some are already looking to capitalize on the carnage. Nuvo Capital Partners launched a fund in August to partner with syndicators, work out troubled deals ‘and keep them from losing it all,’ according to the firm’s head of analytics, Brian Underdahl.

Nuvo has underwritten about $500 million in acquisitions that emerged from mentorship programs; less than $100 million could be restructured. Underdahl said he was unaware if any were done by Sumrok students.

‘The reality is, the equity is gone,’ he concluded.”

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- Brian Underdahl, Chief Analytics Officer at Nuvo Capital Partners

Hi Nuvo Community,

_{In a world where numbers often speak louder than words, the relationship between the Multifamily Price Index YoY change and the Effective Federal Funds Rate is no exception. Our analysis reveals a negative correlation between these two metrics. In simpler terms, when one goes up, the other tends to go down, although the relationship is not extremely strong. The question then arises: what might this imply for investors, policy-makers, and stakeholders in the multifamily real estate sector?}

_{Let’s jump right in with a chart showing the Multifamily Price Index YoY change and the Effective Federal Funds Rate. For data availability sake, we used the Federal Funds rate as a proxy for SOFR (which closely tracks the Federal Funds rate). Notice how the Price Index crossed below the Fed Funds rate at the end of 2022, 2-3 quarters after rate hikes began. Now note that there’s one other time that the YoY change in the multifamily price index crossed well below the Federal Funds Rate – 2008.}

_{The Lagged Effect: A Delayed Reaction}

_{Correlation alone tells only half the story. When we introduced a time lag into our analysis, the negative correlation between the two variables strengthened. Specifically, the strongest negative correlation was observed at a lag of 3 quarters for the Spearman Correlation method (see chart below). In other words, imagine planting a seed and seeing it sprout—not immediately—but after some time has passed. Similarly, a change in the Federal Funds Rate today could likely show its full impact on the Multifamily Price Index a few quarters down the line. This delayed reaction could be the market's way of adjusting to new monetary conditions, affecting supply, demand, and pricing strategies in the multifamily real estate sector. The red bar (below) indicates the strongest negative correlation at about -.25. While not a 1 to 1 relationship, a negative .25 correlation is significant when you consider that much of the time, the Federal Funds rate is not moving at all. Typically, the larger the move up or down, the stronger the correlation. And that negative correlation remains just as strong for up to 6 quarters (18 months).}

_{With this in mind, the full implications of Federal Reserve rate hikes might not manifest immediately. Even after the Federal Reserve stops its rate-hiking cycle, the ripples can be felt for an extended period—our analysis suggests up to a year. Think of this as the after-effect or 'tail' of policy decisions. During this time, multifamily valuations could still be adjusting to the higher rate environment. This underscores the importance of not just monitoring current rate moves but also understanding the historical context of Federal Reserve actions.}

_{Visualizing the Decline}

_{Now let’s zoom in on the last time the multifamily price index crossed well below the Fed Funds rate. Red markers on the chart indicate when the Multifamily Price Index first crossed below the Fed Funds Rate. These markers serve as visual cues for critical market transitions, offering a snapshot of the interplay between monetary policy and real estate valuations. It took roughly 12 quarters (3 years) for the YoY change in the multifamily price index to turn positive again. The decline in 2008 took a while to develop and bottom out, but once the recovery began in 2010, prices rebounded relatively quickly (just 2 quarters).}

_{Implications for Multifamily Valuations}

_{The lagged effect and the potential for another rate hike by the Fed have pronounced implications for multifamily valuations. Should the Fed engage in another rate hike, it's crucial to understand that the most significant effects on multifamily property values may not be immediate. According to our findings, the bulk of the effects of rate hikes tend to surface 2-3 quarters after the Fed ceases its rate-hiking cycle. This period is likely when the market experiences 'true price discovery,' adjusting to the new normal of higher interest rates.}

_{Understanding this lagged effect has practical implications. For investors and portfolio managers, this knowledge can be invaluable for risk assessment and timing investment decisions. If the Federal Funds Rate increases, it may be prudent to anticipate a decrease in multifamily property valuations in the coming quarters, and vice versa. For valuers and assessors, this insight offers an additional dimension for property valuation models, allowing for a more nuanced approach that takes into account the lagged impact of monetary policy.}

_{Moreover, the lagged correlation could serve as an early warning system. When the Multifamily Price Index falls below the Federal Funds Rate, it may signal a period of tightening monetary policy, higher borrowing costs, and potentially softer property valuations. Identifying these inflection points can help stakeholders take preemptive measures to cushion any adverse impacts.}

_Conclusion

_{Crystal ball aside, it's essential to remember that multifamily real estate valuations are influenced by a number of factors, far beyond just the cyclical motions of Federal Funds Rates. Aspects such as financing conditions, bank lending policies, and supply-demand dynamics play pivotal roles in shaping the value of multifamily properties.}

_{While we're not in the business of timing the exact bottom of the market, we are diligently tracking these and other data points to maintain a comprehensive perspective. Our strategy remains focused on acquiring quality properties with strong fundamentals. This approach is not just about capitalizing on market opportunities but also carries a laser focus on protecting the downside. The lagged negative correlation between the Multifamily Price Index and the Effective Federal Funds Rate provides a valuable lens for understanding one dimension of the market, yet it's part of a larger, more intricate framework. With this nuanced, multifaceted understanding, we are positioned to make more informed, data-driven decisions that take into account the full scope of variables impacting multifamily real estate investment and valuation.}

Implications

For real estate investors- know the market you are investing in, or at least make sure your operating partner does. Does the submarket already have a high percentage of burdened households? A high debt service ratio? These are just 2 of the more than 100 data points Nuvo Capital Partners collects and analyzes before investing in a market.

Happy Real Estate!

All the best,

Yuri - Your Real Estate Investigator

Credit: Brian Underdahl, Chief Analytics Officer of Nuvo Capital Partners

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