Since interest rates are impossible to predict and can significantly affect a property’s value, they are one of the trickiest things to handle when investing in real estate. Borrowing money is an expensive proposition when interest rates are high. It can make a certain amount of money from a property, and all of it goes to the lender or the owner. Buyers are affected differently by a change in the valuation formula caused by higher borrowing costs. As a result, they are willing to offer lower prices for a given piece of real estate to attain the same return.
As interest rates rise, there will be other investment options that will look better than real estate. For example, if one could earn a yield of 5 percent on their investment in U.S. treasuries, there would be no reason to invest in real estate. The expected return on real estate rises in tandem with Treasury yields, and a lower purchase price is the simplest method to increase that return.
The possibility of an increase in interest rates is an unavoidable downside of real estate investing. A rise in interest rates could harm property values, and we believe that the key to smart investing is limiting risk.
We employ a seven-pronged strategy to cushion the blow of inflationary interest rates on its property holdings:
- Every Transaction Should be Stress Tested
When underwriting a contract, it’s vital to consider how rising interest rates may affect the finances involved. The proposed investment is put through its paces by simulating various adverse conditions, including higher cap and interest rates. How competitive is the cost? What’s the breaking point where we start losing money? An attractive investment would be one that could weather borrowing rates of 6% throughout the hold period and capitalization rate hikes of 20%-30% from the current level before being sold.
- Responsible Use of Leverage
Reducing the debt associated with the property is a simple strategy to protect against interest rate increases. No preferred equity or mezzanine debt is used; instead, they tailor borrowing to each transaction’s unique needs. They always utilize non-recourse financing, put up at least 30% of the capital, and never cross-collateralize. All assets are held by a separate legal company with no connection to the fund itself, meaning that the bank has no recourse to the fund’s assets should anything go wrong.
- Create a Safety Net by Increasing Value
As a result of the value-added nature of all of our transactions, they can improve cash flow and produce a yield above what would be possible from purchasing a stabilized property. Adding value, they insulate themselves from financial setbacks and interest rate hikes. A 20% rise in value through careful management may be enough to counteract the adverse effects of higher interest rates on cash flow and values. This raise doesn’t ensure a profit, but it should assist you in avoiding a loss.
- Put to Use Both Floating and Fixed-Rate Debt
They make an effort to spread out the maturity of our debt by using a mix of fixed and floating rate debt with varying maturities. In addition to being more affordable in the loan’s early years compared to fixed-rate loans, the cost of floating-rate debt fluctuates with interest rate fluctuations. Fixed-rate debt is not a magic bullet against interest-rate hikes, despite widespread perception to the contrary. In most cases, a property will not become bankrupt because it can’t make its monthly debt payments. They cannot refinance when their existing loan comes due to their high level of leverage.
- Provide a Wide Landing Strip
When deciding on the best financing for the property, its maturity and adaptability are crucial factors. Because of the rapid evolution of the capital markets, you must be able to refinance whenever you see fit. The added expense may be justified by the value of the flexibility it provides. They want to carry out their company strategy before the loan is due.
- Remove the Chips from the Table.
They make sales whenever possible rather than only when necessary. They do a hold vs. sell study and frequently sell a property after implementing the business plan. They can lower our overall fund investment risk by converting some assets into cash and selling them. The less money you have invested, the less risk there is that interest rates will change.
- Don’t Go Broke
One of my graduate school teachers taught me that the three most important laws of real estate investing are: never, never, never run out of cash. It is one of the most valuable real estate lessons. Recessions will occur, and the investor who can weather the storm will usually come out on top. Over ten years, institutional grade real estate has never lost money. An owner with serious money can hold property through difficult times. However, a cash-strapped owner will have few options and likely lose the property to the bank or be forced to sell in a down market.
You can never eliminate interest rate risk, no matter what you do. Rates that climb faster, further, and for a more extended period than your stress test are always feasible, and your stress testing may not capture all that can go wrong. On the other hand, higher rates are typically the result of solid economic growth, and you can easily create an environment in which property values rise in tandem with rising rates. It is also critical for investors to recognize the dangers in their particular investments. If rising interest rates do not auger well for private real estate, investors can search for other assets to combine with their real estate holdings to mitigate this risk.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.