The Cap Rate/Interest Rate Dilemma
By: J SCOTT
A big refrain I'm hearing these days is that, because interest rates are higher than cap rates, it's impossible to get multifamily/commercial real estate deals to work.
And while it's definitely true that high interest rates are bad for commercial investors (and all investors), it's not so simple that interest rates being higher than cap rates means profitable deals can't get done.
In the article, I want to take a look at a more nuanced view of what high interest rates mean for multifamily/commercial investments and how investors can still get these deals done...and done profitably.
High Interest Rates Hurt Deals
First, I’m not going to pretend that higher interest rates don’t impact us as operators. They reduce opportunity and take investment options off the table that might otherwise be there. And this is due to a few very specific nuances in how commercial (and all) debt is structured.
1. High interest rates mean lower cash flow
First, and probably not surprisingly, higher interest rates mean higher mortgage/interest payments, and therefore lower cash flow each month. This translates to lower projected distributions to investors, who can earn equivalent – or maybe even better – cash flow from other investments.
These days, it’s not uncommon to see multifamily deals penciling out with cash flow in the early years at between 4-6%, a good bit lower than the 8%+ annual returns we were seeing just a year or two ago. Passive investors recognize that they can find the same level of annual cash flow in lower-risk investments, such as treasury bonds and high-yield savings accounts.
And this makes it harder for operators to both be conservative in their underwriting and attract investors to their deals.
2. High interest rates mean lower DSCR (and lower LTV/LTC)
DSCR (Debt Service Coverage Ratio) is a metric that the banks use to determine how big of a loan they can provide against a property and still have confidence that the operator will be making enough cash flow each month to safely pay the mortgage. As interest rates increase, the DSCR for a project will go down, resulting in banks not being willing to lend as much money.
It used to be that commercial lenders would lend up to about 75% of the total cost of a project. These days, thanks to higher interest rates and lower DSCRs, many deals can only qualify for 55-65% loan to value/cost, and we’re seeing some deals much lower than that.
This means that operators are forced to make up the difference by raising more equity (money from passive investors), which is traditionally much more expensive than bank debt. For this reason, it’s harder to get deals to pencil out, as the cost of capital for these deals is much higher.
3. High interest rates mean negative leverage
This is where the relationship between cap rates and interest rates does come into play. When interest rates are higher than cap rates, loans product negative leverage.
What that means is that for every dollar that is borrowed from the bank, the ROI on the deal decreases.
One of the nice things about leverage (a fancy word for debt), and the reason it's called leverage, is that when returns are higher than interest rates, borrowing money can actually increase the ROI of the project. But when interest rates rise above cap rates, the opposite happens, and investors are penalized (in the form of lower ROI) for borrowing money.
Long story short, with cap rates higher than interest rates, operators don’t get nearly as much benefit from bank debt as they were getting just a year ago, and operators need to structure their deals carefully to avoid debt driving down returns so far as to make deals unworkable.
Operators Still Get Deals To Work
But, here’s the good news:
Even in an environment where interest rates are high, and even in cases where interest rates are higher than cap rates, it's still possible to get deals to work.
It’s harder. But it’s still possible.
Here are a couple strategies that operators should be thinking about these days to get deals to pencil in the current high interest rate environment.
1. Find investors less reliant on cash flow
The big negative impact on deals from higher interest rates is in the monthly cash flow. Again, because more money is being paid to the banks and interest, there's less money available to investors.
But, cash flow is just one part of the equation. Many deals may be seeing lower cash flow these days, but that doesn’t mean that the total return on projects (over the life of the deal and including the profits at sale) can’t still be strong. And we’re still seeing tremendous tax benefits from many of these projects thanks to bonus depreciation.
If operators can attract investors who are okay with lower cash flow for a couple years, those investors can still get paid handsomely down the road when the property sells or when interest rates drop and the operator can refinance. While putting money in bonds or a savings account might generate short-term cash flow just as strong as a syndication, the overall risk-adjusted returns from multifamily/commercial real estate is still looking much more attractive.
2. Focus on repositioning and value add
Cap rates being lower than interest rates is very much a concern if a property is stabilized. If an operator were to buy a stabilized asset today with a 4% cap rate, much/all of the income generated by the property is going to go to the bank, and investors are likely to be disappointed in their results.
But, an operator buying a value add (distressed) property today at a 3% or 4% going-in cap rate can hopefully reposition the property by doing physical renovations and management improvements that will result in a much higher return a year or two down the road once the property is stabilized.
If the operator is successful at increasing income and reducing expenses to the point where they can get the unleveraged return to 6% or 7%, that should cover the extra cost of the high interest rate loan, and still allow investors some cash flow.
3. Be creative with financing and capital stacks
While many operators simply think in terms of debt (bank loans) and equity (passive investors), there are other forms of financing and creative ways of structuring capital that can improve returns.
For example, using preferred equity or mezzanine debt will allow operators to lower their monthly payments, while still creating strong profit potential for all investors further down the road. Likewise, offering multiple classes of equity shares in deals can provide different return structures for different investors – based on their personal preferences/needs – while providing a lower blended cost of capital for the operator than a single common equity class.
Operators who know how to creative structure their capital stacks in terms of debt and equity will have a huge advantage over those operators who only know how to continue doing the same things they’ve done for the past decade.
4. Be willing to consider new exit strategies
Many operators in the multifamily/commercial space have become accustomed to a 3-5 year hold period for their investments. This makes sense, as it typically takes about 3 years to perform a full repositioning and stabilization, and operators recognize that they can maximize the compounded returns offered to their investors by getting selling as quickly as possible after stabilization.
But, these days, many operators are recognizing that increasing the projected hold period on their deals is offering a number of potential benefits to them and their investors in terms of higher proforma projections. Not only do longer hold periods offer more options – and sometimes safer options – when it comes to financing, but longer hold periods reduce the risk of short-term economic fluctuations that can crush a deal.
Additionally, these long-term hold periods are offering some creative options for structuring equity investments. For example, several operators are starting to structure deals where they return invested capital to their investors earlier in a deal, while holding the property longer-term and continuing to provide returns far into the future, long after the investors have received their capital back.
Long story short, while there are certainly risks associated with investing in a high interest rate environment, understanding the nuances of those risks and building strategies to mitigate those risks will allow experienced investors to continue doing profitable and successful deals.