If rates rise and economy slows
Investor · Farmingdale, NY · Member since 2015 · 10 posts · 0 votes
If rates rise and economy slows
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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votesBeing overleveraged in the face of economic weakening is a sure way to incur losses, but as the guest of podcast #3 I can tell you how it happened to me in 2008. I had a hospitality property that I really wanted out of just before the collapse and the only buyer I could find could only do the deal if I took land in lieu of a down payment. So I took the land, and in the wake of the housing collapse land values became less than zero. That was painful, but it could have been worse, the buyer of my property ultimately lost it in foreclosure. I'd rather have worthless land than a foreclosure. Moral: stay out of land and you'll probably be OK.
My biggest pain on the multifamily front was a property that had high vacancy due to all of the job losses, resulting in the gross income only covering the operating expenses. I ended up servicing the loan out of my own pocket for a couple of years--another $400K down the drain but ultimately the rebounding prices will allow me to recover that when I sell someday.
Moving on to your questions, which are two distinct questions with different answers. What if rates rise? If you have fixed-rate financing your biggest exposure is the prevailing rate at the time of maturity. You might have to refinance into a higher cost loan if you don't sell.
Some people have said that if rates rise, cap rates will rise and that will cause the property's value to decline. Not necessarily true for two reasons. First, the spread between cap rates and the 10 year UST is presently historically wide. While interest rates and cap rates tend to trend in the same direction, they don't necessarily track in parallel. A slight rise in interest rates could result in level cap rates and simply a compression of the UST-CAP spread. Thus, no change in property value. Or, rates could rise say 3/4 of a percent and cap rates only 1/4 of a percent for example. Or not, there's just no way to know for sure. The second reason is that higher NOI due to rent growth could negate the loss of value resulting from a higher cap rate. In this case it's a headwind to appreciation, not a knock-out blow. Presumably, interest rates increase because the economy is strong, and strong economies tend to favor rent growth.
As to your second question about a weak economy, this can hurt you much more than interest rate risk (still assuming you have fixed-rate financing). Job losses can and will result in increased physical vacancy, higher credit losses and skips, and more concessions. Rising economic vacancy will impact your income and your cash flow. It's even possible to have declining rents (gasp!). How bad it gets will determine how hard you get hit. You could end up like I did on that one property where the income drops so low that it only covers payroll, maintenance, property taxes, etc or you might get lucky and only experience less cash coming into your pocket than you are used to.
Rising rates AND a bad economy would be an anomaly and likely wouldn't last, as monetary policy would likely reverse rates in an effort to stimulate the economy.
Self defense: Buy with conservative assumptions for economic vacancy. Forecast annual income for each year during your expected hold period and have a growth factor in your cap rate. For example, if similar properties are trading at a 6% cap rate right now, you might forecast your sale at a 7% cap rate in 10 years or some other number depending on your cap rate philosophy. Calculate your exit price and see if that's a scenario you can live with, and if you are so inclined, run a sensitivity analysis to calculate your IRR with a variety of income growth factors and exit cap rates.
22 Replies
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
The risk is very real. Underwrite your investment to the IRR and discount both rents and equity to accommodate this possibility. If it still works, then fine. Most things fall short :)
- Real Estate Broker · Fairfield, CT · Member since 2015 · 312 posts · 231 votes11y
Get your permanent financing (or at least 10 year fixed rate) financing in line. 10 years should be more than enough to see you through fluctuations in the market. Once you have that fixed, you know what you need to maintain.
There is something of an inverse relationship between interest rates and rentals. Rates go down, SFH purchases go up, and rentals ease. Rates to up, SFH purchases go down, rentals increase.
Run your model and 60, 70, and 80% vacancies. Can you cover expenses and financing? Find the break-even point. If it is not in the low-mid 60s, consider increasing your cash in the deal to reduce financing costs accordingly.
People that lost millions in 08 did not do so on large multis. They did so on spec houses, SFH, mcmansions, etc. And even if they did, had they been able to pay financing costs to "weather the storm" they would be sitting pretty right now.
- Rental Property Investor · Grand Rapids, MI · Member since 2014 · 12 posts · 4 votes11y
Mike,
you ask a good question, and its one that I've been trying to answer as well.
Here are my thoughts on rising interest rates and a slowing economy:
1. If rates rise, what happens? - It seems logical that rising interest rates will correlate with higher cap rates and a decrease in your property's value. However, this is not necessarily the case. According to Marcus & Millichap's Hessam Nadji, interest rates & cap rates do not always move in sync with each other. Hessam has also stated that as long as employment and the economy remain strong, cap rates may rise slightly, but not by much. (I'm paraphrasing here)
2. What if the economy slows? - The homeownership rate has fallen from 69% to 63% in the past ten years. The Millenial and Baby Boomer demographics are also increasingly choosing to rent. I don't see this changing if the economy slows down. In fact, I would expect even more renters in a slowing economy as more people choose not to buy a home. Your concern about your tenants moving out and leaving you to pay the mortgage is unlikely if you have professional management taking care of your investment.
3. Investors lost millions in the 2008 downturn, could this happen again? - I didn't listen to podcast #3, however I would suggest that the reason many investors lost so much during that period is because they were over leveraged and the banks called in their loans. Since that time, banks and lenders have been much more conservative requiring 65 to 80% Loan to Value ratios. If you do as @Ben Leybovich suggests and stay conservative in your numbers, you should be fine.
4. You're looking to invest $2.2Million in your next apartment investment. - If you're leveraging this investment with a loan over $3Million, you'll be able to get a ten year balloon at a still low fixed interest rate. If you're able to lock in a rate for ten years, I'd say that gives you plenty of time to enjoy your low payments even as interest rates rise.
Where I'm more concerned is the loans that will come due in the next five years, since they will be more affected if rates rise quickly. When given the choice, I always prefer a longer loan period.
Good luck with your investing. I understand your concerns and its good to remain cautious. However, if you find the right deal that meets all your other parameters, I wouldn't let the fear of rising interest rates hold you back.
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
Rates won't go up because economy is bad - rates will go up because economy is good. But, the main concern is how little it would take to derail things...
The people I am competing with (unsuccessfully) are playing the delta game - purchasing at 7 CAP in a lot of parts of the country, even Mid-West, and financing at 4.5% on 10-year non-recourse. Moreover, in most cases the underwriuting model is suspect, to say the least, so it's not at all clear that 7.5 CAP is really 7.5 CAP.
So - even if it is, what we have is delta of 3%. This is where people figure they'll make money - in this delta spread. What do you think happens if interest rates go up to 6%. Sure, the rates are fixed for 10 years for a lot of these people, but can they really make money if their delta compresses to 1.5% (which in reality is a lot less than that...)
FED knows this. Big private money as well as fund money knows this as well. So, the bet is that FED won't let this happen. So far FED is doing everything to accommodate, but...
All I can say is - underwrite wisely! @Serge S., @Brian Burke, @Brian Adams, @Account Closed
- care to jump in?
- 11yBrian BurkePro MemberInvestor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
Being overleveraged in the face of economic weakening is a sure way to incur losses, but as the guest of podcast #3 I can tell you how it happened to me in 2008. I had a hospitality property that I really wanted out of just before the collapse and the only buyer I could find could only do the deal if I took land in lieu of a down payment. So I took the land, and in the wake of the housing collapse land values became less than zero. That was painful, but it could have been worse, the buyer of my property ultimately lost it in foreclosure. I'd rather have worthless land than a foreclosure. Moral: stay out of land and you'll probably be OK.
My biggest pain on the multifamily front was a property that had high vacancy due to all of the job losses, resulting in the gross income only covering the operating expenses. I ended up servicing the loan out of my own pocket for a couple of years--another $400K down the drain but ultimately the rebounding prices will allow me to recover that when I sell someday.
Moving on to your questions, which are two distinct questions with different answers. What if rates rise? If you have fixed-rate financing your biggest exposure is the prevailing rate at the time of maturity. You might have to refinance into a higher cost loan if you don't sell.
Some people have said that if rates rise, cap rates will rise and that will cause the property's value to decline. Not necessarily true for two reasons. First, the spread between cap rates and the 10 year UST is presently historically wide. While interest rates and cap rates tend to trend in the same direction, they don't necessarily track in parallel. A slight rise in interest rates could result in level cap rates and simply a compression of the UST-CAP spread. Thus, no change in property value. Or, rates could rise say 3/4 of a percent and cap rates only 1/4 of a percent for example. Or not, there's just no way to know for sure. The second reason is that higher NOI due to rent growth could negate the loss of value resulting from a higher cap rate. In this case it's a headwind to appreciation, not a knock-out blow. Presumably, interest rates increase because the economy is strong, and strong economies tend to favor rent growth.
As to your second question about a weak economy, this can hurt you much more than interest rate risk (still assuming you have fixed-rate financing). Job losses can and will result in increased physical vacancy, higher credit losses and skips, and more concessions. Rising economic vacancy will impact your income and your cash flow. It's even possible to have declining rents (gasp!). How bad it gets will determine how hard you get hit. You could end up like I did on that one property where the income drops so low that it only covers payroll, maintenance, property taxes, etc or you might get lucky and only experience less cash coming into your pocket than you are used to.
Rising rates AND a bad economy would be an anomaly and likely wouldn't last, as monetary policy would likely reverse rates in an effort to stimulate the economy.
Self defense: Buy with conservative assumptions for economic vacancy. Forecast annual income for each year during your expected hold period and have a growth factor in your cap rate. For example, if similar properties are trading at a 6% cap rate right now, you might forecast your sale at a 7% cap rate in 10 years or some other number depending on your cap rate philosophy. Calculate your exit price and see if that's a scenario you can live with, and if you are so inclined, run a sensitivity analysis to calculate your IRR with a variety of income growth factors and exit cap rates.
- Syndicator of Large Apartment Buildings · Glen Mills, PA · Member since 2009 · 1k+ posts · 1k+ votes11y
@Mike Migliaccio, you have no idea how valuable this thread is and the answers the others gave like @Brian Burke, @Ben Leybovich
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
While it's true that there's no way to tell what a lot of the dynamics will be in the future, we do have factual data as it relates to today. What are the things that we know?
1. Underwriting models are generally too aggressive, resulting in valuations that defy logic
2. Interest only Fannie/Freddie financing is prevalent today according to the data I look at
3. Nobody is underwriting to the IRR, which says a lot. Most specifically this says that nobody is projecting the exit, and valuations are simply capitalization of CF, which is subject...
Put all three items together, and what we have is the reality that cash flow is the sole driver of worth of the investments people are making and the valuations people are paying. This cash flow is a function of the delta, and in many cases the basis for this delta is interest only debt. 1% increase in rates will compress the delta enough so that 80% of today's buyers will be negative gearing, which, in turn, will induce selling, rising cap rates, and lower valuations. I don't see a calamity necessarily, but when delta is as skimpy as it currently is, it won't take a calamity to cause big issues...
Thoughts?
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
08 took down many players in all asset class's.. there were foreclosures of multi all over the place.. Vegas was Hammered so was PHX. those who pre 08 leveraged to a break even of 20% vacancy got hammered. ... and well a lot of these units fell far below that. and owners could not hold on. And of course every market will have the failed landlord syndrome. Our little world here in PDX stayed relatively stable... and of course those that pay cash or had very little debt rode it out fine....
- Real Estate Broker · Fairfield, CT · Member since 2015 · 312 posts · 231 votes11y
@Jay Hinrichs absolutely over-leveraged owners of all classes took the hit. The market fall's underpinnings were all about over-leveraging coming loose. Couldn't agree more. That is why I suggest going into a deal with enough cash to keep the financing costs in line with a low-mid 60% occupancy. For our projects, we are putting as much cap-x in as we can now, getting as much corrected with the properties as possible, and getting permanent financing in place.
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
well lenders allowed this.... pre 08 I think most folks were just playing with what the lending hand that was dealt them with no forethought to the massive wipe out that happened.
We are seeing that creep back into the SFR rental house space , you know that space Ben loves so much... lenders are right back to 75% with cash out ext. This will set up the next round... undercapitalized landlords is the greatest risk to loss.. But they don't know what they don't know.
- Real Estate Broker · Fairfield, CT · Member since 2015 · 312 posts · 231 votes11y
@Jay Hinrichs you mean the 'market doesn't always go up'??? haha. I see that in SFH, and it is one of the reasons I campaign against these "no money down" house flips even. When the music stops, someone is held holding the potato. Don't be it.
- 11yChris WoodPro MemberContractor · Greenwood, IN · Member since 2014 · 200 posts · 33 votes
I just posted a thread on dealing with a 26 unit. After read this most of my questions are answered. Let me make sure I understand. So everyone in this thread is running their numbers on 60% occupancy and high cap-x? If not what are the best numbers to put me in a winning situation?
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
along with this pearl.... " I only buy for cash flow appreciation is just icing on the cake"
that mentality has led many undercapitalized folks starting with their first rental house.. the banks may require some reserves when the loan is made then they do what most other red blooded Americans do and go buy stuff LOL not all but many.
Back pre 08 when I was really heavily involved with financing TK operators clients A and D loans... it was not uncommon for investors to buy 4 homes at once ( use up their mortgage slots) refi them out all at once and pocket 20 to 30k .. Most of these folks had less than 5k in reserves to start with but had great fico's and W 2 jobs.. the conventional lenders were of the mind RE always goes up and now they have some cash reserves.. well fast forward the 20 or 30k is probably the biggest check most of these folks ever got at one time ( remember a w 2 employee).. and I suspect many a car and boat or jet ski was bought ... maybe that fabulous trip they always wanted to take and deserved.
Next thing you know the 25% margin and 100 a month positive cash flow was really negative 100 a month and within a few short years they lose it all.. one turn over were it cost 7k they don't have the funds... saw it happen hundreds of times... failed landlords in the mid west SF space create 50% of todays new inventory.. its just recycled.
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes11y
Most of my clients now go ten year debt non-recourse with standard carve outs. For multifamily on some programs there is long term financing for 20 or 30 years.
There is a balance between what interest rate you lock and when the loan comes due. Is it worth it to the investor to get 20 or 30 years fixed but pay 100 basis point more in some cases?? Only the investor can answer. I see most properties re-trade within a span of ten years or less. If you look at most larger commercial properties there are only so many people with high wealth so many properties are owned by partnerships or syndicates. By their nature that shows asset disposal under the 10 year mark generally from acquisition. I do not like regular bank loans with short loan maturities. Those are ticking time bombs with a short fuse. Those make sense on turn around deals with no pre-pay penalties. You are starting so low that you have built in upside to sell at a higher cap exit or refi even with a higher interest rate and still cash flow.
Having locked long term debt gives you flexibility within the asset class cycles. This way you are not forced to do something at an inopportune time but can dispose of the asset when it makes the most sense.
Mike I wouldn't care about 90% currently rented. That means nothing. Show me the trailing past 24 months and what the averages are, turn rate of the units, and how much occupancy has fluctuated versus stabilized. Has it been over 24 months 40% to 90% or has it been average at 70% and recently just went to 90%??
What did the sellers have to do to get it to 90% if it wasn't there in the past?? Slam questionable tenants in, offers waiver of security deposit or rent specials??
Is this property in a rent control area of New York?? I have heard some of those places are nightmares. Also investor owners there have told me sometimes it can take 4 to 6 months in certain areas to get a tenant out in New York because the judges give them chance after chance. Sounds like that area is very pro-tenant.
What vintage is this 28 unit?? Are the rentals more upscale or low income?? The more problem an investment is the more it should throw off in cash for the risk and headache. Being 28 units it is harder to bake in the numbers for a full time repair person which can cause a bunch of issues.
We can all take numbers to such a worst case level that we never buy anything while others end up making millions. You need to be conservative but to be in the game have to take some calculated risks.
Biggest thing I see as a mistake is buying based on market growth and pushing rents. A newly rehabbed asset will usually draw tenants and higher rents pushing close to the top of the market. If conditions of oversaturation occur with new product around, recently rehabbed, and the market rents soften then unless you have an unbeatable location renters will try to move elsewhere where it is cheaper.
So the strategy I see employed by many larger owners is to push rents but stay in that middle 50% and not the top of the market. This way if the market softens you can still raise rents and still have a waiting list.
My mom lives in a 800 sq ft villa type ranch built in the 80's with no tenants below or above only single level and great location. Owner raises rents every year but is still the cheapest game in town almost. Newer apartment complex up the street is raising rents almost 100 a month now that economy is healthier and stopping specials. The place my mom stays is older but stays full. It's important to eliminate as much turnover as possible. People stay and you don't spend thousands in constant per door unit turnover. Tenants are more willing to accept older but clean living conditions in exchange for middle market rents that are manageable for their budget.
While some complexes might enjoy a few years of very strong rent increases in the market they can also bottom out from pushing it to hard when the market changes and a mass exodus happens with their property when renters flock to safety in a down turn.
- Real Estate Broker · Fairfield, CT · Member since 2015 · 312 posts · 231 votes11y
@Jay Hinrichs that's quite a gem! "Back in '08" I was doing my best to stay out of the family business (heard of Countrywide?) but now here I am working in Real Estate from a different angle (and not for the family).
@Joel Owens You are absolutely correct that it can be easy to over analyze and under assume to make any deal look bad. I am in no way proposing to adjust the deal acquisition / reposition based on a 60% occupancy. Simply to adjust the amount of cash in the deal vs. loan amount accordingly. But that's just me.
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
C/W probably refied no less than 1,000 of my HML s in the day and I suspect 500 of those or more went bad over time. But I was just the MEZZ
- Real Estate Broker · Fairfield, CT · Member since 2015 · 312 posts · 231 votes11y
@Jay Hinrichs ya I'm fairly certain Uncle Dave is STILL rolling in his grave from Angelo's changes. Fun old stories!
- 11yDana WhickerPro MemberInvestor · Fernandina Beach, FL · Member since 2014 · 557 posts · 374 votes
This thread gets my vote for "Thread of the Month" so far.
That's a thing right?
Happy Independence Day BP!
- Buy & Hold Investor · Milwaukee, WI · Member since 2012 · 378 posts · 179 votes11y
I suggest running a "shocked" version of your deal analysis spreadsheet. Fast forward your figures to your first refi point, say in 5 years. Now apply some negative factors - maybe a 20% vacancy and 7% interest rate, or whatever reasonable scenarios you need to guard against.
If your debt service ratio is still 1.2 or better, you're golden. If it's 1.0-1.2 you're probably ok but not great. Less than 1.0 and you should be concerned.
- 11yEric FernwoodBusiness MemberRealtor · Las Vegas, NV · Member since 2014 · 995 posts · 1k+ votes
Hello @Mike Migliaccio
A very interesting question but I think it is a lot more complex that just term and rates. I don't have the answer but I can tell you our thoughts on a similar type of property. We are currently working on a $2.4M purchase of an apartment complex and we've spent far more time on what the local (sub-metro) economy is likely to do in the foreseeable future than on return rates and financing. I am not saying return rates and financing aren't important, they are. But what is likely to happen in the area is more important because it can change a performing investment into a nightmare.
For the apartment complex we are considering we've done a lot of research into how the 4 block area surrounding the property is likely to change in the foreseeable future. We've looked at all the on-line data available and spent a lot of time with city officials including planning, building, zoning and other relevant city departments. We talked to the current tenants to understand what they value and where they think the location is going. We also talked to representatives for all the major landholders in the area to understand their plans and directions. We now feel we have a reasonable idea of how the 4 block area is likely to change in the foreseeable future. We are now investigating job quality and quantity for the businesses where current and future tenants are likely to be employed. After all, rental properties are no better than the available jobs.
Based on our research to date we believe that with reasonable rehab costs we can increase profitability to a very acceptable level. And, based on our discussions with all the major area stake holders, we believe that in 5 to 7 years the property will likely be re-purposed and become much more valuable in it's new role. Based on what we know today and can foresee, we believe that our client is likely to own the property for at most 15 years. So, we are probably going for 20 year financing.
In Summary we spent a lot of time to get a handle on the following:
Short term:
• Local population trend
• Local job quality and quantity trend
• Local crime trend
• Rehab vs. rental rates
• Maintenance costsLonger term:
• Local area direction
• Infrastructure
• City planning directions
• Future uses
• Re-purpose costsI think you should let your research along similar lines dictate your financing decisions.
I hope this helped.
FERNWOOD Team, KW VIP Realty520 Reviews - Investor · Farmingdale, NY · Member since 2015 · 10 posts · 0 votes11y
Thanks to everyone that replied.. I am thankful for BP and the investors that are willing to share their knowledge. I co-authored a book (Missed Ops) with my real estate partner and we spoke about learning from others experiences so that you could shorten the road to success and avoid pitfalls that were previously made in similar situations. (Experience is the best teacher as long as it is someone else's experience)..BP helps us as young investors to do just that..
My next question: From Podcast # 7: Hedge funds and large investment companies have bought millions in housing. What percentage of the whole (if possible to know within reason) did they buy, and when they decide to sell, how will it impact pricing (more inventory on the market). Will they likely release their inventory in small numbers or all at once etc ??
- 11yBrian BurkePro MemberInvestor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
Originally posted by @Mike Migliaccio:
My next question: From Podcast # 7: Hedge funds and large investment companies have bought millions in housing. What percentage of the whole (if possible to know within reason) did they buy, and when they decide to sell, how will it impact pricing (more inventory on the market). Will they likely release their inventory in small numbers or all at once etc ??
The total, relative to total housing stock, isn't that significant. For example, in Sacramento the funds bought around 2,000 houses. That's a lot of homes, but if you think back to the building boom builders were constructing hundreds of homes per year and that didn't saturate the market. Household formation is on the rise and inventory is in short supply, not sitting vacant in most areas where the funds were most active.
Another consideration is that portfolio liquidation is unlikely to happen all at once. Lease expirations tend to be spread out throughout the year and sales to end users would have to be delivered contemporaneous with lease expirations. Not to mention that not all firms will liquidate to end users. Some will liquidate via REIT roll ups or bulk sales to other firms who intend to maintain them as rentals so they'll never hit the market.
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