{"id":157972,"date":"2023-09-08T07:00:00","date_gmt":"2023-09-08T13:00:00","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=157972"},"modified":"2023-09-08T07:13:31","modified_gmt":"2023-09-08T13:13:31","slug":"what-are-investors-ignoring","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/what-are-investors-ignoring","title":{"rendered":"Today’s Real Estate Risks: What Are Investors Ignoring?"},"content":{"rendered":"\n

They say military generals spend too much time preparing for the last war rather than the next one. I fear the same goes for real estate investors. <\/p>\n\n\n\n

For the last 18 months, investors and pundits alike have hyperfocused on rising interest rates. Sure, commercial investors should buy interest rate caps, and all investors should find creative ways to borrow at low rates. But the time to protect against rising interest rates was two years ago\u2014before they surged. <\/p>\n\n\n\n

When I interview professional real estate investors and syndicators, I love to ask how they mitigate risk on their deals. I\u2019ve particularly started asking, \u201cWhat risks do you see in today\u2019s real estate market\u2014the ones no one\u2019s talking about, but should be?\u201d<\/p>\n\n\n\n

I want to invest with people who understand not just what went wrong last time, but what\u2019s likely to go wrong next time. Consider the following risks<\/a> that too few investors are currently thinking about.<\/p>\n\n\n\n

1. Interest Rates Staying High for Years<\/h2>\n\n\n\n

The consensus view among many economists and pundits for the last 18 months has been that we\u2019ll likely have a sharp, but hopefully short, recession. Such a recession would reset the tight labor market, slash inflation, and prompt the Federal Reserve to cut interest rates<\/a> back to the low levels we\u2019ve all grown accustomed to in the 21st century. <\/p>\n\n\n\n

That hasn\u2019t happened. It still might, of course, but for now, the extremely tight labor market has kept inflation running strong. The current economy could continue well into 2024 and beyond, until something unexpected shakes it up. <\/p>\n\n\n\n

The longer interest rates stay high<\/a>, the greater the risk to commercial real estate markets. Many real estate syndications use short-term loans, such as three-year loan terms with available extensions. When their current loans and interest rate caps expire, these syndications could find themselves with crushed cash flow upon refinancing. The general partner could sell instead of refinancing. <\/p>\n\n\n\n

But prolonged high interest rates also mean higher exit cap rates. <\/p>\n\n\n\n

2. Expanding Cap Rates<\/h2>\n\n\n\n

High cap rates<\/a> are great for buyers, who buy properties with greater annual income for the same purchase price. But they mean slimmer profits for sellers\u2014if any at all. <\/p>\n\n\n\n

Commercial cap rates rose from a narrow 4.13% in the first quarter of 2022 to just under 5% this year, ending the second quarter at 4.94%<\/a>. That\u2019s less than the federal funds rate<\/a>, currently 5.25% to 5.50%, and which has shot up from just over 0%. <\/p>\n\n\n\n

\"chart
Federal Funds Effective Rate (2010-2023) \u2014 St. Louis Federal Reserve<\/a><\/em><\/figcaption><\/figure>\n\n\n\n

In other words, cap rates haven\u2019t risen nearly as fast as interest rates. This makes sense, if everyone assumes interest rates will fall back down in 2024. But again, what if they don\u2019t? <\/p>\n\n\n\n

If interest rates stay high for years, they\u2019ll eventually force cap rates up too. Read: much lower profits and returns for sellers, who underwrote their deals assuming a low exit cap rate. <\/p>\n\n\n\n

It would leave sellers caught between an unprofitable sale and an expensive refinance, perhaps with little to no cash flow. <\/p>\n\n\n\n

3. Spiking Insurance Costs<\/h2>\n\n\n\n

I\u2019ve started hearing horror stories about insurance premiums jumping 40% to 125% in a single year. <\/p>\n\n\n\n

Insurance companies have paid out billions over the last few years in the wake of natural disasters, from wildfires<\/a> to hurricanes<\/a> and beyond\u2014billions more than usual, that is. And they\u2019ve started hiking policy premiums to recoup those losses. <\/p>\n\n\n\n

Insurance companies appear to be raising premiums faster in the lowest-cost states rather than those with the highest actual claim costs<\/a> (e.g., California, Texas, Florida, and New York). This should bother everyone living in a safe area who finds themselves subsidizing the insurance clients along Florida beaches or California fire alleys. <\/p>\n\n\n\n

Few investors underwrite their deals with such enormous insurance rate hikes. That means many sponsors are finding themselves with slimmer cash flow than they projected, which will, in turn, reduce their profits upon sale. <\/p>\n\n\n\n

Blame climate change or El Ni\u00f1o or angry gods shaking their tridents at us. But what you should <\/em>do is start asking hard questions about insurance premiums<\/a> before investing in a real estate deal. <\/p>\n\n\n\n

And insurance isn\u2019t the only cost rising quickly, either.<\/p>\n\n\n\n\n\n\n

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