What do syndicators plan to do with rising rates?

Question

Just curious what some of you syndicators plan to do where you have been buying 3, 4, 5  cap "value add" deals. If rates move against you, what is the plan? I have no dog in the fight but aside from the 100% bonus depreciation play on apartment buildings I have been scratching my head who/why people are buying 4 caps.

Brian Burke · Answer

Market cap rates have less to do with interest rates than rent growth.  So the real question is “what will we do when rent growth tapers off.”  The answer is simple—buy at a higher cap rate.  It’s the only way to achieve the returns that attract capital.

The only reason 4% cap rates make any sense at all is because in some markets rents are climbing 20% or more in a year. Income will be far greater in years 2 & 3 which means that the resale value is considerably higher even if sold at a higher cap rate. It isn’t low borrowing rates driving the bus here…that’s just the backseat driver.

Arn Cenedella · Answer

@Peter Tverdov

I’ve been investing in real estate for over 40 years and while relatively new to MF, I’ve been through numerous economic cycles. I am bullish on RE and continue to acquire as much as I can. But I adjust to market and economic conditions as warranted.

And with all due respect to the very knowledge apartment investors on this thread, I am not as sanguine about increases in interest rates and cap rates as some in this thread.

Yes, rents have increased dramatically the past few years but can one reasonably expect these 10% 15% 20% 25% annual rent increases to continue for the next 5 years?

To tout rent growth as the answer to any increase in interest rates and cap rates is problematic from my perspective.

We already know housing affordability is a major issue in most metro areas in the country. Is it reasonable to believe investors can push rents another 50% to 100% over the next few years (even with value add)? Wages haven’t kept up with these recent rent increases - is it reasonable to expect with a potential recession, wages will continue to increase fast enough to support another huge increase in rent? Inflation one says, let’s not forget inflation impacts expenses too.

Yes one can increase NOI in a variety of ways.

But let’s look at what it will actually take to triple NOI in five years.

Let’s assume a 50% operating expense ratio.

$100,000 gross rent $50,000 expenses yields $50,000 net operating income.

To get to $150,000 net operating income, rents need to double to $200,000 and expenses need to remain fixed at $50,000. And of course, expenses won’t stay fixed at $50,000 but for ease of math, let’s say they do. In this example, one will need to double rent (average annual increase of 20% for five years) to triple NOI assuming the dollar cost of expenses remain the same (which they won’t).

To be clear, I am not predicting doom and gloom but increasing interest rates, potential recession and an increase in cap rates (from historical lows) is a legitimate reason for concern.

@Mike Dymski notes let’s evaluate sensitivity tables with 6% 7% 8% cap rates and see what returns look like. I’m seeing a lot of investment summaries with sub 4% entry caps and sensitivity tables that go from 3.5% to 4.5% exit cap for a five year hold. That simply is not a wide enough range in my opinion.

I closed a smaller apartment deal (1998 build $70,000 median HHI area solid property condition 100% occupancy rents $100 below current market with no fix up located in a growth market - rated #1 emerging MF market for 2022) a few weeks ago and I used a 6% exit cap for a five year hold. Entry cap was 5% so by industry standard practice (add 0.1% per year for every year of hold) I could have used 5.5% exit cap. But I didn’t.

I felt using 6% was a “conservative” approach to exit cap but I won’t know whether 6% was “conservative or optimistic” for 5 years.

We obtained a 10 year fixed rate note at 3.95% with 20 year amortization 65% LTV (the bank would have given us 75% LTV) from a local bank. My investors and I happily gave up any cash flow we could have obtained from some sort of variable rate bridge interest only debt in exchange for the safety and security of a long term fixed rate - no prepay either. (I’m also a contrarian on “cash flow is king”. 😀)

Absent current economic and market conditions, absent Fed stated policy to increase rates 6 or 7 more times over the next two years, we may have been more aggressive with our debt structure - higher LTV variable IO bridge debt - but given expectations, I believe our more conservative approach is warranted. My investors and I don’t have to worry what rates are in 2 or 3 years when a refi of short term Bridge debt would be required. 10 years 3.95% fixed - that loan in and of itself will make our investors money.

I see a flashing yellow light ahead and investors IMHO will do well to pay attention and adjust their approach and expectations. Caution is warranted.

The great thing about investing is that each investor makes their own assessment and invests their cash according to their beliefs. I’m just expressing my opinion here. A good discussions helps us all.

I’m 67 years old and was taught investing by my father who was born 1921 and lived thru the Depression as a kid. It’s Old School all the way - proper use of fixed rate leverage ample cash reserves - aim to hit line drive base hit after base hit not the Grand Slam. I understand others may approach investing differently.

Spencer Gray · Answer

@Brian Briscoe and @Brian Burke make great points.

The level of risk related to interest rate volatility has added an incredible amount of additional risk to MF investing, and it is a non-linear change.

@Josh Edwards You're correct that to get higher returns in todays market you need to use floating rate bridge loans with the highest leverage possible. In a declining interest rate environment that was an attractive risk proposition. The increased risk in today's market utilizing that strategy is exponential, it is not linear. You may receive higher returns, however there is substantial increased risk.

The #1 rule is to preserve principal. By using long term fixed debt you nearly eliminate interest rate and market timing risk. Lower leverage reduces returns, however in this market the risk/return profile of a lower leverage deal is much more attractive.

I've syndicated over a dozen MF projects utilizing a floating bridge loan, however in this market we are only closing with fixed rate, lower leverage debt. While we are underwriting for a 10 year hold we will most likely refinance in Y 2-4 in a less volatile, possibly lower rate market.

You can buy a cap for floating rate loans, including bridge loans, however they are very expensive at the moment.

Arn Cenedella · Answer

@Peter Tverdov

I concur with both Brians. 😀

And would just add a query:

Investing capital involves choosing between options:

If not real estate, then where would you invest your capital?

Is there a better place to invest that will provide higher risk adjusted returns?

I guess one could stay in cash and hope for a downtown, might happen, might not.

I believe strongly in diversification. I’m a real estate guy so acknowledging that bias, I believe a sizable chunk of everyone’s portfolio should be in real estate.

Severe housing shortage plus growing population lays a pretty strong foundation for real estate.

Paul Moore · Answer

@Peter Tverdov you got some wonderful responses above.  I agree with many and I want to highlight what @Lane Kawaoka said. It’s possible for some operators in some asset classes in any location to find assets with latent intrinsic value.  Extracting that value forces appreciation.  This essentially means the net operating income (numerator of value equation)  will outrun the cap rate (denominator) and @Brian Burke’s backseat driver (interest rate).

Value = NOI / Cap Rate

I’ve written about this a lot. Here is one example: https://www.biggerpockets.com/...

Evan Polaski · Answer

@Peter Tverdov, I know others mentioned it, but cap rates are next to meaningless, particularly in value-add deals. You are not valuing an asset based on cash flow today, but where you think cash flow is going.  As @Brian Burke mentioned, strong market rent growth means you can buy at 3 cap property today and in under a year be earning a 4+ cap without doing a thing but renewing leases at market rents, and that 4 cap moves to a 5 or 6, even with conservative growth in 3-5 years, not even counting any opportunity for rent growth driven by unit renovations.

Then combine that with market forces pushing many people into the same areas of the country, where you cannot build fast enough to satiate demand for the next 5-10 yrs, and construction costs rising meaning new supply will have to charge a lot more to be financially feasible, conflicting government sentiment to help alleviate the costs (whether it be not subsidizing developers, or not subsidizing tenants).

Finally, there are general demand drivers that will not change immediately, and therefore keep sentiment low: inflationary environment pushes more capital to hard assets, recessions push money to hard assets, news outlets running stories about how this millennial or that has made a killing in real estate pushing more people to real estate in all forms, office and retail money moving to multifamily and industrial as the pandemic and consumer patterns have shifted for the long term.

Will there be a correction, or at least a slow down, yes.  But for many of the low cap rate acquisitions, the rent growth will not fall off a cliff if you are buying in well located areas.

Josh Edwards · Answer

I agree with all of the above, however, it's a lot easier said than done to say put more money down and use long-term debt. A lot of deals being done in the multifamily value-add space right now are being down with floating rate bridge debt. This is due to the high loan proceeds bridge debt provides, along with 36-month interest-only periods.

Many passive investors looking to invest in Multifamily Real Estate syndications aren't looking to invest in deals with low IRRs. IRR will inevitably fall when loan proceeds go down and hold periods are longer. Thus, the only way smaller syndicators can compete with other groups right now is by utilizing bridge debt. If you're looking to buy core or core+ assets in a primary market with a high physical barrier to entry (which is what investors should theoretically be doing), you're IRR is in the 4-10% range. It's quite challenging to sell these returns to everyday investors. Institutions can accept these types of returns because they are working with more money. So what's to be done? That's the magic question that I think every syndicator should be asking themselves, as I don't think anyone truly knows how to move forward with new acquisitions. It's a fascinating, yet kind of concerning topic, so it should hold some weight to it.

Brian Burke · Answer

I might be happy selling at an 8 cap even. Like I said above, interest rates aren’t driving the vehicle.  Instead, think of it like an airline cockpit—there’s a captain and a first officer. Sometimes the captain is flying while the first officer watches, and other times the first officer is flying while the captain watches.

Right now rent growth is doing the flying.  That’s why cap rates are in the 3s and 4s. It won’t be long before rent growth slows and interest rates play a greater role, and caps start to rise.

If I buy a property today at a 4 cap and sell in 5 years at an 8 cap, have I made or lost money?  Well, there’s no way to tell without more information.  You need to know what happened to the income during the hold period.  If the income tripled, thanks to rent growth (rents wouldn’t have to triple for that to happen, BTW), the property would still be worth 50% more than I paid for it.  Assuming I put 30% down, I’d more than double my money in 5 years, and that’s not even counting the cash flow during the hold.

This is why I couldn’t care less about cap rate.  Used alone, it tells you nothing.  A full analysis of the total picture is necessary when evaluating whether a property is worth the investment.

Mike Dymski · Answer

The risk is not in the interest rate, it's in the rents.  There are so many business plans where rents HAVE to go up for the property to be successful...and there are market fact patterns where that will not occur, even with value added.  Look at and audit the rent and exit cap sensitivity table or calculate it (along with validating rent comps) to ensure that the property will do fine if rents don't increase.

Excess government actions have inflated everything, including rents, and they are just playing whack-a-mole by now smashing the interest rate button to course correct.

Lane Kawaoka · Answer

Interest rate really matter when you have the buy/hope/pray model. When you are doing forced appreciation model of rehabbing and bumping rents to increase the NOI and value you are creating so much value it greatly trumps the debt service.

What do syndicators plan to do with rising rates?

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