How the Fed rate increase impacts your real estate

Interest rates have become breaking news, nobody expected them to raise this much and this fast. The market is paying the price and real estate deals are falling out of contract left and right. Brokers are calling ME for once. There are a few different ways things can play out, and my company is actively preparing for what may lie ahead.

My thoughts and game plan

I’ve spoken to a lot of smart people this week, folks worth tens of millions of dollars and with a lot of real estate, and none of them know what is going to happen. Frankly, neither do I. This article is an overview of where my head is at right now when it comes to risk, planning, and the actions we’re taking inside our real estate firm to navigate the uncertainty.

A 75 basis point increase is the largest since 1994 and put in the simplest way it’s going to make borrowing money more expensive.

The Fed is doing this to fight inflation by taking money out of the system. How does it work? Watch this video by Ray Dalio. It’s an excellent overview of our economy and an explanation of how our GDP is supported largely by credit. Credit gets more expensive, less spending happens, and thus less money exists in the system. In the video, you’ll see that higher rates are part of the cycle and lead to deleveraging and a contraction, which is normal.

A lot of people think that this is temporary and rates will be cut back down to nothing. One argument stems from the value of capital in our economy and its decreasing worth. The other argument is based on the fact that higher interest rates crush our government’s ability to pay back its debts, and inflation is good for the folks who call the shots.

I have $44 million of floating debt, meaning the debt payment adjusts each month as key lending indicators change. My debt is floating at 30 bps over WSJP. Rates have risen 1.5% in the past 3 months. We are paying $660,000 more annually right now for our debt than we were 3 months ago. Ouch.

Will this hurt my business?

It depends on what you mean by hurt. Cash flow in the near term? Yes absolutely. We’ll have less cash in our pockets in the near term as more of it goes to service debt.

Losing properties? Not at this point. Debt yield is a critical figure for us. How much profit is your total debt yielding? How much can you afford to pay in debt service before you go cash flow negative across the board?

(A free mini-course here if you’re interested in digging into what I consider the most important factor in real estate)

Right now our debt yield is well north of 12% across our portfolio. That means we could take a 10% interest rate loan amortization over 25 years before we’re cash-flow negative. I don’t see rates getting that high so I think we’re safe for now. But there are other factors outside of our control: expenses, revenue, move-ins, move-outs, and rental rates.

We’ve been extremely disciplined over the past 6 months. We don’t have a single deal in the pipeline or recently acquired that keeps us up at night. We’ve lost out on 95% of deals we’ve put offers on. Protecting the downside has been more important to me recently than maximizing the upside. Investors don’t pay us the big bucks to be bulls! They pay us to protect the downside.

A few things we’ve done to protect our downside (and will continue to do):

  • Low leverage – we’re bringing more cash to every deal (45-50% of the cost) and using less debt.
  • Focusing on in-place cash flow – we don’t have any heavy value-add deals in our portfolio right now. We don’t have any new ground-up development underway.
  • Conservative underwriting – we want to have some wiggle room!

All of these things make it harder to buy deals, and it’s why 2022 is off to a slower start than 2021 was from a “volume of acquisitions” standpoint at my company. Good deals are hard to find when the market is getting a bit frothy and everyone is getting extremely aggressive.

That’s the funny thing about a bull market – the higher prices get, the more confident other investors get and the more risk everyone is willing to take.

The lower prices go, the less confident everyone gets, and the less risk everyone is willing to take.

Funny how it works that way…

Will it hurt my business in the long term?

I think change is good. The opportunity to buy good properties and hold them for a long time could be right around the corner. Cap rates won’t widen as fast as the rates have gone up, and they may never catch up. We’re entering a time period of negative leverage where to buy assets our near-term cash-on-cash yield is very low. But the long-term gains can be very good for patient investors.

Commercial real estate prices aren’t directly correlated with interest rates because interest rates are transient. They go up and down over time. Investors who are confident in their ability to drive revenue and yield know that someday, at some point, rates will go back down. And they’ll go up again. And then back down. They aren’t worried about what they are right this second if they’re investing on a 10 or 20-year time horizon.

What does keep me up at night:

We have a few loans that are about 22 months away from maturity. A few more loans are 25 months out. A few more 30 months out. While they’re worth (by today’s cap rates) about 2x what we paid for them, it still poses a risk.

If scenario #3 below is the path forward, the doomsday scenario, we’ll have some trouble placing some of this debt. I’ll explain more on this below.

Okay, time for my predictions:

3 things could happen. We are preparing for the two worst-case scenarios (and have been preparing for months).

We know rates will continue to go up. That is a given because the Fed has said they are going to raise them another 50-75 bps at the next meeting and even more afterward to get inflation under control. Almost all investors think the second half of 2022 could be a very difficult time for investors.

  1. Rates could go up a little more, quickly drop a bit, and stay right around here for a few years. (20% chance case)
  2. Rates could go up and then come right back down to 2021 levels (quickly) once we enter a recession and inflation numbers slow down and real estate picks up steam. (50% chance case)
  3. (doomsday scenario) Rates could go up as the Fed has said they are going to do and they could stay higher (7-9% rates for real estate investors) for a few years. (30% chance case)

#1 would be rough for a few over-leveraged investors with floating debt on bridge loans. We’d lose a few developers or undercapitalized syndicators to foreclosure. Prices would slowly relax and life would carry on with the new normal. A lot of deals acquired in the past two years by investors would miss projections because they likely overpaid.

#2 would be rough for another 6 months or so before the market continues to roar once rates drop. This is the best-case scenario and one that I don’t spend a lot of time thinking about or preparing for.

#3 is the doomsday scenario and the one we are planning for. A lot of real estate deals would go belly-up. Banks would get spooked and a debt crunch would emerge. Cap rates would widen by 2 or 400 basis points and we’d be able to buy 7-8 cap self-storage again. It would be a dark time.

Back to my bridge loans and the term on those loans. Everybody thinks 2009 was hard for real estate investors because they couldn’t afford their payments and there wasn’t enough cash flow to cover the debt so owners lost properties to foreclosure.

That isn’t the case. It was the TERM that got most investors.

Every loan has an interest rate, an amortization schedule (how long you pay back principal), and a term. A term is how many years the loan is good for until it needs to be replaced by a new loan or paid back. A bridge loan is a short-term loan that investors take when they buy something that needs stabilization or if they build a new property.

If a loan is a 3-year term, you have 3 years to find a new loan. The bank that made the loan doesn’t want a long-duration loan on the balance sheet. When that time is up the bank can call your loan.

That is what happened in 2009. Banks started saying “hey, we aren’t going to replace this loan so you need to give us the money back”.

The market to get new loans was terrible because every bank was overextended and didn’t want any new real estate loans. The market to sell was terrible because real estate was worth 1/2 of what it was in the past. Real estate investors lost a lot of money and banks wrote off a lot of loans.

Where does it put me?

We’ve driven NOI quickly and in a big way, so we don’t have much debt on these properties relative to the income. For now, banks are still loaning money in responsible ways. I am confident we can find new debt, even if not at the best terms, in any situation. But you never know!

I’m a little nervous, but also excited. I know we’re well-positioned relative to a lot of other groups. Our investors and bankers are great partners who trust our vision and company. Our assets are performing well and customers are renting units. I know our properties make money and I’m confident that will continue. We have a healthy management company with strong fee income and so we can afford good people even when we’re not doing deals.

I’m excited to take on the challenge, whatever it brings. Say a little prayer for me and for all of the landlords out there.

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About Me

I started the Sweaty Startup in December of 2018 because I believe the Shark Tank and Tech Crunch culture is ruining the real spirit of low-risk entrepreneurship.