There’s no question rising interest rates present a challenge for development and construction. But in the multifamily market, they also could support continued high occupancy and ongoing demand from residents priced out of a continued tight single-family housing market. Against that mixed backdrop, Sioux Falls-based real estate investment firm Ernst Capital is pursuing a robust development pipeline with a strategic approach to the markets where it operates. We sat down with partner Chris Daugaard for a closer look at the market and what it means for investors.

How would you describe the conditions in the multifamily markets where you do business? The multifamily market is very strong locally and regionally in the markets where we focus. While there has been some rent growth slowing nationally, we continue to see stable rent growth, and that’s needed because we also have expense growth, especially the cost of maintenance and increased property taxes. What we saw after COVID was an unsustainable pace, so I think some moderating of rent growth is both expected and appropriate. We’ve had to actively manage rent a bit more, but when it’s set appropriately, the lease-up has been very strong in all our new communities. We’re seeing rent growth trend back to normal portfolio-wide to a couple percent or low single-digit annual increases for the most part. 

Do you sense more competitiveness in the multifamily market today? I think it will become more competitive as the units that have been permitted start to get delivered. In Sioux Falls, throughout this year and into next, you’ll see a fair number of additional units come on the market, and we’re seeing some of that already. It can vary. If you bring on a small number of town home units, you often see that lease-up quickly, but it can be different bringing on an 80-unit building all at once. That said, we just delivered a 50-unit building on the west side in January, and we’re seeing 20 units per month absorbed, which is very healthy. We don’t have any concerns about that. Of course, that’s one property, but in general we feel good about the rental demand.

What impacts has the interest rate environment had on your industry? It’s made projects more difficult to put together, and interest rates are rising faster than the expected return on real estate investments. So that’s a real challenge. I think most developers feel the higher interest rates are somewhat temporary and will come down in a few years. The fundamentals of our market are still very strong. So there continues to be momentum within the development community to continue to put together great projects for Sioux Falls because there’s that demand. I expect we’ll do less volume in new deals, but we will be raising more equity and less debt, and that will broaden our capital pool a little bit. Of course, the effect on returns is that they are lowered in the short term, but long-term investors are still owning valuable assets in strong markets that we expect will appreciate over time.

Does the impact of interest rates on homebuyers ultimately help the multifamily market? Definitely. In the short term, there are people who would like to move into single-family homes and are struggling with inventory and affordability. That continues to lend itself to a very strong multifamily market. But I also think you’ve seen multifamily developers react by building more town homes, where you can have a front door and a backyard and an attached garage, plus amenities like a clubhouse and swimming pool, and you don’t need to worry about lawn care and snow removal. So in these situations, people may rent longer and not feel as much of a need to move into a home, especially as the cost of a home mortgage changes dramatically.

Does the recent bank volatility have an impact on the commercial real estate investment market? It has somewhat. We’re always keeping a watchful eye on the markets generally, so what happens in the banking sector impacts rates for new projects and how banks look at lending dollars, especially as they are regulated. We have great relationships with local and regional lenders that have managed their business much more prudently than what you’ve seen in headlines from banks on the coasts. We take steps to make sure our deposits are protected, but we’re confident in our local and regional banks and their strength. I also encourage individuals to ensure their deposits are earning as much interest as possible. One thing we’ve done as a firm is more actively manage our cash to secure some interest and return on the cash deposits we hold for reserves and operations and capital projects. We’ve become more active in that, and I encourage others to do the same. 

Why does it make sense for investors to work with a firm like Ernst Capital given these kinds of market conditions? The difference begins with experience. Ernst Capital was started in 2007, and we’ve seen periods like the Great Recession as well as years when Sioux Falls had more multifamily units than the market was demanding. It helps us understand what it looks like when rates are higher or when there’s additional vacancy or when unforeseen costs come up. And that experience helps us to plan for those things. Keeping an eye on risk mitigation is important, and a capital firm like ours helps do that. Our eye is only on the investment, not the other parts of the deal, and it helps us stay focused on driving returns for our investors.

What are your expectations for the Sioux Falls market going forward? I expect continued population growth even if it’s not as hot as a year or two ago, and right now there is a challenge to start and complete new projects with interest rates this high. However, I think you will potentially see some pent-up demand a year or two from now if Sioux Falls isn’t able to start a lot of new multifamily work this year. Our hope is to not only maintain the type of investments we’re working on now but find new opportunities to start projects in Sioux Falls. We think the exceptional population growth and demand for quality housing units will support that, and we hope to position ourselves to meet the demand.

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