Investors are keeping a sharp eye on interest rates as they are a major factor to leverage returns. Rates have rapidly climbed over the last few months, and it is expected this trend will continue through 2022 and well into 2023. At the start of the year, interest rates for investment properties were between 3.5% and 4%. In four short months, we are seeing rates inching closer to 8%.
What does this mean for real estate?
Increasing interest rates make borrowing more expensive, therefore impacting investors’ desired return. Investors are forced to offset the higher cost of financing with a lower purchase price on real estate. As rates climb, cap rates usually follow, which puts downward pressure on pricing. Unlike the 10-year treasury and interest rates, cap rates do not see daily volatility. There is usually a lag between the time it takes the market to see cap rates increase from interest rate hikes alone.
The aggressive interest-rate increases are a direct move to combat inflation, the highest we’ve seen in four decades. The general rule of thumb is that higher interest rates are usually a response to higher inflation, which could have a positive impact on real estate income growth. Even though rates are trending upwards, which impacts what investors can pay, they will be focused on pushing rents to keep valuations high.
Economists expect rates to continue rising over the next 1-2 years, potentially reaching the 6% – 8% range. This could have a drastic impact on cap rates. Luckily, with low vacancy and little new construction in commercial real estate, it doesn’t create the same problem we saw during the Great Recession with over-supply. Investors will be more focused on increasing rents than being cap rate driven for values, which caused cap rate compression over the last few years.
An increase in values over the past twelve months have forced lenders to tighten their underwriting — the loan-to-values (LTV — amount of a loan compared to appraised value) we have seen in the past no longer worked! Currently we are seeing 55% – 65% LTV rather than the 65% – 75% during the last few years. Lenders are being more cautious with rising rates, cap rate compression, increased values, and the changing environment we face with headwinds in the debt markets.
Increasing interest rates make borrowing more expensive, therefore impacting investors’ desired return.
Positive vs negative leverage
Sellers can anticipate investors showing more caution and patience if they need debt until 2022 unfolds and the impact on values is revealed. It becomes difficult to use debt today if it creates negative leverage, meaning debt is at a cost that eats into cash flow, reducing the cash-on-cash return compared to an all cash return. Typically, debt is used to maximize the return, which means investors need positive leverage. That doesn’t happen when you are buying at a 5% cap rate and borrowing at a 4.75% interest rate. To determine positive or negative leverage, you divide your annual loan payment by your loan amount to generate a loan constant. Based on the loan constant, you will know the minimum cap rate needed to generate positive leverage.
For example, if you bought a $5,000,000 property with 60% LTV, your loan would be $3,250,000. If you had a 30-year amortization with a 4% interest rate your annual debt service is $186,192 [$186,192 debt service/$3,250,000 loan amount = 5.73% loan constant]. This means you must buy a property at a higher cap rate than 5.73% to get positive leverage.
A 5.50% cap rate on $5,000,000 generates $275,000 of net income, less the $186,192 debt service, would leave you with $88,808 in cash flow. Take that $88,808 and divide it by your down payment of $1,750,000 and you have a 5.07% cash-on-cash return – which is less than the 5.50% cap rate, meaning that loan generated negative leverage.
On the other hand, a 6.00% cap rate on a $5,000,000 property would generate $300,000 of net income, less the $186,192 of debt service and you have $113,808 in cash flow. Divide that by the $1,750,000 down payment and you have a 6.50% cash-on-cash return – which is more than the 6.00% cap rate, meaning that loan generated positive leverage.
This concept is important to understand because it is what drives buyers to pay lower prices and have higher cap rates – making debt work to get positive leverage. Otherwise, bringing debt into a deal may not be advantageous to the borrower at current pricing and interest rates.
As we move forward in 2022, we may not see the movement in values right away, but sellers and buyers will soon enough find themselves at a crossroad of having to understand debt market pressure of increased interest rates and what buyers can (and will) actually pay. Sellers still find themselves in a great position to sell, as the amount of capital in the market is aggressively looking for real estate to hedge inflation. Today’s environment of changing rates and inflation causes uncertainty in stocks, cash, and other alternatives, whereas real estate is viewed as a much safer investment alternative.