Best investment opportunities in rising interest rate environment

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Best investment opportunities in rising interest rate environment

Shane Clark
Commercial Real Estate Agent · Sacramento, CA · Member since 2014 · 30 posts · 9 votes

Hello,

I have been investing in real estate since 2012. I have been purchasing value add apartments for the purpose of capital (or asset) growth. My company buys apartments with management deficiencies and also in need of physical updates. The plan has been to make capital improvements to increase the net operating income over the course of 5-7 years. At the end of this period, we will exchange into a larger commercial property with a similar value add component. Over the course of the next 20 to 30 years we will build up our portfolio until we reach the point of exchanging into more passive triple net lease class A properties requiring less intensive management. 

In light of increasing interest rates and the expectation for interest rates to continue to rise over the next several years, I am hesitant to continue the above strategy. If rising interest rates cause local cap rates to increase by 1.5-2.5% over the next 5 years, my projected internal rates of return for my apartments will be decimated. I am looking for capital growth opportunities at this stage of my investing career. For some of the veteran investors in the BP community who have lived through multiple RE cycles, what types of growth investments do you recommend in this rising interest rate environment? 

Very Respectfully,

Shane 

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David Thompson
Investor · Austin, TX · Member since 2013 · 933 posts · 1k+ votes
9y

Shane,

Good value add players will create massive value in the first couple years then refinance and pull a lot of equity back to investors so that will limit your risk somewhat.  Then they'll put the property up for sale so goal is not to be in 5 years or more.  Example, my partners have a property in their portfolio where they just did a cash out refinance on a property they had only owned for 16mos, investors have received $46K on a $100K investment including distributions along the way. Syndicates say 5 year hold is target in the Private Placement Memorandum (PPM) but makes little sense to hold an investment after that massive value is created in year two...otherwise from year 3 - 5 you are essentially just growing at market rent growth rates 3-5%.  So, they want to make money, get out and go find another play.  

Keep in mind cap rates are anyone's guess.  A strong market (demand for apts exceeding supply of B/C) will contract cap rates all things being equal. There are many components to cap rates -  interest rates and supply / demand factors are probably the most prevalent.  So, it won't be lock step.  Also, good syndicates should be conservative in their underwriting and should at least be putting exit cap rates up 500 basis points above where they purchased.  Regards to direct interest rates on your the plans mortgage, you could review to see if its fixed or sponsor has a way of capping rates w/the lender.  We actually like to continue to play variable rates but w/opportunities to lock annually and in our last deal we actually purchased a hedge giving us the option to lock anytime over the holding period.  

So, I would not panic. Review your deals, talk to the syndicates and ask them directly what plans they have in place. We do sensitivity analysis for instance and show investors changes in occupancy, rents prices, interest rates and cap rates and impacts to CoC and IRR for each project. Syndicates should be open, honest and educate you on how they will handle changing market conditions. No guarantees but use logic and I'm sure by doing this you will feel better about your investments.

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  • Roy N.Pro Member
    Rental Property Investor · Fredericton, New Brunswick · Member since 2013 · 7k+ posts · 4k+ votes
    9y

    @Shane Clark

    Despite the recent interest rate increase south of the 49th and those projected for the next couple of years, interest rates are still low by historical measure.

    For the past couple of years we have not purchased very much (three small properties) as we have been underwriting with the assumption that the property must be able to service a finance rate 2.5 - 3.5% over what we are presently paying (2.25 - 2.9%).   This drastically reduces the shopping experience as property prices here in our end of Canada long ago swelled to compensate for the cheap money.

    On the bright side, rising interest rates will create shopping opportunities for those who are cash-ready and not overly leveraged.   Many who {over}paid for real estate with no consideration made for a possible return to historical rates of financing, eventually will be compelled to part ways with their properties.

    1Reply
  • David Thompson
    Investor · Austin, TX · Member since 2013 · 933 posts · 1k+ votes
    9y

    Shane,

    Good value add players will create massive value in the first couple years then refinance and pull a lot of equity back to investors so that will limit your risk somewhat.  Then they'll put the property up for sale so goal is not to be in 5 years or more.  Example, my partners have a property in their portfolio where they just did a cash out refinance on a property they had only owned for 16mos, investors have received $46K on a $100K investment including distributions along the way. Syndicates say 5 year hold is target in the Private Placement Memorandum (PPM) but makes little sense to hold an investment after that massive value is created in year two...otherwise from year 3 - 5 you are essentially just growing at market rent growth rates 3-5%.  So, they want to make money, get out and go find another play.  

    Keep in mind cap rates are anyone's guess.  A strong market (demand for apts exceeding supply of B/C) will contract cap rates all things being equal. There are many components to cap rates -  interest rates and supply / demand factors are probably the most prevalent.  So, it won't be lock step.  Also, good syndicates should be conservative in their underwriting and should at least be putting exit cap rates up 500 basis points above where they purchased.  Regards to direct interest rates on your the plans mortgage, you could review to see if its fixed or sponsor has a way of capping rates w/the lender.  We actually like to continue to play variable rates but w/opportunities to lock annually and in our last deal we actually purchased a hedge giving us the option to lock anytime over the holding period.  

    So, I would not panic. Review your deals, talk to the syndicates and ask them directly what plans they have in place. We do sensitivity analysis for instance and show investors changes in occupancy, rents prices, interest rates and cap rates and impacts to CoC and IRR for each project. Syndicates should be open, honest and educate you on how they will handle changing market conditions. No guarantees but use logic and I'm sure by doing this you will feel better about your investments.

    2Reply
  • Account Closed
    Minneapolis, MN · Member since 2014 · 332 posts · 288 votes
    9y
    David Thompson 500 basis points on the exit cap? How do the returns work with that projection?
    0Reply
  • David Thompson
    Investor · Austin, TX · Member since 2013 · 933 posts · 1k+ votes
    9y

    Sorry Sean nice catch, its getting late, extra zero makes a big difference...50 basis points.  So if we enter at a 6 cap we should be showing an exit of at least 6.5 cap.  

    0Reply
  • Mark Allen
    Real Estate Investor/Broker · Irving, TX · Member since 2015 · 520 posts · 263 votes
    9y
    Here's an article I enjoyed on the subject: https://www.multihousingnews.com/post/how-will-rising-interest-rates-affect-cre/?utm_source=whatcountsemail&utm_medium=finance%20&%20investment&utm_campaign=finance%20&%20investment
    1Reply
  • Shane Clark
    OP
    Commercial Real Estate Agent · Sacramento, CA · Member since 2014 · 30 posts · 9 votes
    9y

    Thank you @Roy N. for your insights from Canada and thanks @Mark Allen for the article. @David Thompson, I really appreciate your in-depth insight. I'm currently a CCIM candidate and just learned how to perform sensitivity analysis. I have also been projecting my disposition cap rates with 50 to even 100 basis point increases from the acquisition cap rate. I have always thought in terms of 5 years for my forced equity plays. Considering the headwind of rising interest rates, compressing that hold period and making the capital expenditures early to increase NOI and then get out in year 2 or 3 makes a lot of sense. I have only been joint venturing with equity partners and have not yet begun to syndicate. My plan has been to take more of the risk myself and really learn the ropes of value add apartment investing before raising larger amounts of outside capital. Over the next two years I will personally acquire several more investment properties while educating myself on the syndication process. Do you have any recommendations for syndication classes or training seminars?

    Very Respectfully,

    Shane

    0Reply
  • David Thompson
    Investor · Austin, TX · Member since 2013 · 933 posts · 1k+ votes
    9y

    Shane,

    I'm more than happy to chat with you and discuss what I see working to accelerate your growth, just PM me. Btw, your initial question was very timely.  Applaud you for embarking on the CCIM and yes, sensitivity analysis is something that is very valuable I find when sharing w/our more sophisticated investors that are reviewing our deals.  Mark's article was also a nice supplement here and is appreciated.  Overall, we feel good about the markets and deals we are in, the strategies we are deploying and think there's more than enough going for us to sufficiently counter interest rate headwinds and still making our investors solid returns.   We have purchased over 700 units and 3 properties over the last month so that should also tell you something about our position on the market.

    0Reply
  • Mark Allen
    Real Estate Investor/Broker · Irving, TX · Member since 2015 · 520 posts · 263 votes
    9y

    @Shane Clark reach out to @tamiel kenney (tag isn't working for some reason, but they're BP members) - Mark and Tami run a 2-day multifamily syndication event here in Dallas-Ft. Worth. I was able to attend their walk-through and hear their plans for the event in 2 weeks, and definitely worth the time/money. You can message me for more details.

    0Reply
  • Paul MoorePro Member
    Commercial Real Estate Fund Manager · Lynchburg, VA · Member since 2015 · 1k+ posts · 1k+ votes
    9y

    Hi @Shane Clark.  I really appreciate many of the answers.  Thanks @David Thompson and 

    @Mark Allen for your insight as always.    

    This discussion needs to include the critical issue of Market Selection. Go to IRR.com and review the cap rate history for your class in various cities. Selecting the right market plus the right property manager probably account for well over half of your success in this business. Larger, growing markets with a more significant pool of ready buyers will experience less volatile cap rate swings in declining markets, and as David T said, projects with steep value-add opportunities can overcome the losses due to cap rate expansion in many cases.

    Podcast Guest on Show #533
    2Reply
  • Shane Clark
    OP
    Commercial Real Estate Agent · Sacramento, CA · Member since 2014 · 30 posts · 9 votes
    9y

    Hi @Paul Moore. Thank you for your comments and additional information. I was not familiar with IRR.com, very good resource!

    1Reply
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