Interest rates are one of the most difficult aspects to manage in real estate investing because they are impossible to predict and can impact property values greatly. Higher interest rates make the cost of borrowing capital more expensive. A property will only produce so much cash flow and that money either goes to the bank or the owner. Higher borrowing costs also change the valuation formula for those people looking to buy real estate, leading them to bid lower prices to achieve the same return.
Rising interest rates also make alternative investment choices look more attractive, as compared to real estate. After all, why would someone invest in real estate to generate a 5% yield if they could generate a similar yield in U.S. treasuries? As treasury yields rise, so does the expected return on real estate and the easiest way to generate a higher return on a property is paying a lower price.
Interest rate risk is part of real estate investing and can’t fully be mitigated. Higher rates may or may not adversely impact values but successful investing is about protecting the downside, and this is what we focus on at Origin.
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There are seven actions we take at Origin to minimize the impact of rising interest rates on our real estate investments:
1. Stress Test Every Deal: It’s important to evaluate the impact of rising interest rates when underwriting a deal. We stress test a potential investment by subjecting it to higher cap rates and interest rates. How does the value stand up? At what point do we lose money? A good investment should be able to withstand 6% borrowing costs during the hold period and cap rate increases of 20% to 30% higher at exit than where they are today.
2. Use Leverage Responsibly: One of the easiest ways to mitigate the risk of rising rates is by using less debt on the property. We match our debt to the business plan and don’t use preferred equity or mezzanine debt to finance a deal. We typically put in 30% or more of equity, use non-recourse debt, and never cross collateralize our assets. What this means is that every asset is owned in a special purpose entity so that if something goes wrong, the bank only has recourse to the individual asset and not the fund’s assets.
3. Build Value to Create a Cushion: All of our deals have a value-added component, which means we have the ability to increase cash flow and generate yield well beyond what we could generate by acquiring a stabilized property. We create value which, in turn, creates a cushion against loss and rising interest rates. If rising interest rates cause cash flow and values to deteriorate, a 20% increase in value through hands-on management may be able to offset this. It doesn’t mean we are guaranteed to make money, but it does help to not lose money.
4. Use Floating and Fixed Rate Debt: We use both fixed and floating rate debt and do our best to make sure our maturities are staggered. The cost of floating rate debt varies with changes in interest rates, but also tends to be much less expensive in the first couple of years than fixed rate debt. Contrary to popular belief, fixed rate debt is not the panacea to guard against rising rates. Properties generally don’t fail because they can’t meet their monthly debt obligations. They fail because of high leverage and the inability to refinance when the loan matures.
5. Give Ourselves a Long Runway: Loan maturity and loan flexibility are two of the most important considerations when selecting the right loan for the property. Capital markets change quickly and having the flexibility to refinance when we want is vital; we look for loans longer than we may need so we have flexibility. The cost may be slightly more but that optionality is important. Our goal is to execute our business plan well before the loan matures. At Origin, our typical value-add business plan takes 24 to 36 months to execute and we pair properties with loans of five or more years. This gives us plenty of runway in the event the capital markets environment is not favorable when we are done with our improvements.
6. Take Chips off the Table: We sell when we can versus when we have to. Once our business plan is executed, we evaluate a hold vs. sell analysis and often times sell a property. By selling certain assets, we reduce our overall fund investment exposure by turning the investment into cash. The less capital invested, the less exposure we have to rates moving.
7. Never Run Out of Cash: One of my graduate school professors told me the three most important rules of real estate investing are: never run out of cash, never run out of cash and never run out of cash. This is one of the best lessons of real estate. Recessions will happen and the investor who can ride out the storm will usually be fine on the other side. Institutional grade real estate has never lost money over a ten-year period. An owner with deep pockets can hold a property through rough times, while a cash-strapped owner will have few choices and most likely either lose the property to the bank or be forced to sell in a bad market.
Despite the actions we take, interest rate risk can never be fully mitigated. Rates that rise faster, farther and longer than we stress test are always possible, and our stress tests simply may not capture all that can go wrong. The flipside to this is that higher rates are usually a product of robust economic growth and we can easily have an environment where property values increase with rising rates. It’s important for investors to understand the risks within their own personal portfolios as well. If rising rates don’t bode well for private real estate, then investors should look to other assets they can pair their real estate holdings with to offset this risk.
