Should I Buy Apartment Building or more SRF - Interest Rate Fears
OK, I have built portfolio of SFR, duplex, triplex income producing properties, and I have been thinking of making the jump to buying apartment buildings. I listened to Grant Cardone's podcast and I like the idea of scale and easy financing of apartment buildings. Say I have another $500k to put into acquisitions - should I make the jump to buying apartments, or stick with SFR type properties?
Two words give me pause when considering making the jump to apartment buildings -- INTEREST RATES.
As a real estate lawyer, I have seen several of my clients get very, very rich buying apartments. In virtually every case, they rode interest rates and cap rates down, which has a massively positive impact on value. It almost goes without saying that cap rates have massive impact on value, but look at this example to see just how massive.
If you buy an apartment with $100k net annual cash flow at a 7% cap rate, and then cap rate decline to 4%, the asset you acquired for $1.42M increases in value to $2.5M without ever raising rents one penny. So if you leveraged yourself and bought a portfolio of apartment buildings while cap rates are going down, voila, you are very wealthy.
Cap rates and interest rates are at historic lows for apartments, and it seems likely both will increase in future. But research shows the correlation between cap and interest rates is imperfect, so lets assume over my projected five year hold interest rates go up but cap rates stay at these historic lows.
Interest rates have almost as dramatic an impact on value as cap rates.
Say I buy a $2M apartment building and use my $500k as down payment on this single building, financing $1.5M. Let's say I get Freddie Mac financing as just a little worse than Grant Cardone talked about -- he got three point something but I get 4%. My monthly debt service payment is $7,161. Now assume I buy an apartment building today at 5 cap, which I think is about right. That means that for a $2M asset I assume an un-leveraged return of $100k after expenses. (Because my debt service is cheaper than my cap rate, the leverage created by my 75% financing should juice my return, but only slightly so let's ignore this.) Point is, that $100k a year net cash flow should be more than enough to finance my debt service payment of $7,161/mo and $85,932 per year.
But now assume during my five year hold, Freddie Mac and other lender interest rates go from 4% to a more historic average of 8%. That means for my end buyer in five years, assuming rents are about the same and cap rates are about the same, the asset would still be valued at $2M since it generates $100k of net cash flow. BUT, my buyer's debt service for his new loan would be $11,006 per month or $132k per year. Obviously, people don't pay $2M for an asset that they cannot finance, which is why no one except cash buyers would even consider buying this asset at $2M. (**see note below) And their aren't many cash buyers in the apartment business.
My bottom line - if you think interest rates will increase over the coming years, as nearly everyone does, why in the world are all these smart people buying apartment buildings? Single family houses do not trade on cap rate, although some people buy them that way; they trade on competitive market analysis (i.e., what people paid for the house next door). So they are somewhat of a refuge against rising interest rates (admittedly rising rates keep some potential buyers out of the market, but there are extraordinary research studies that show, paradoxically, underlying house values often INCREASE during times of rising interest rates).
So, all you smart BPers, what am I missing? Should I be following Grant and others and get into apartment buildings as my next play, or should I believe the simple math above?
** note - I used unleveraged cap rates to simplify the example. Apartment buildings often trade on cap rates calculated on a leveraged basis, i.e., rate of return on deposit rather than fully asset value. But the end result is the same -- rising interest rates for apartment debt directly reduces the market value of the asset.