How low interest rates are changing the multifamily market
Had a quick conversation with a loan broker last night about the loans available on 5+ unit apartment buildings right now.
You can now get a 5 year fixed, non-recourse bank loan for 3.62% interest.
Let’s take a look at what that means by using the example of a 5% cap deal, which is a pretty expensive deal for all but the most desirable parts of LA:
- Price of $1MM
- Downpayment of 25% or $250k
- Borrow $750k
- Net operating income of $50k (5% of $1MM)
- Annual debt service of $41k
- Free cashflow of $50k – $41k = $9k
You’re only earning $9k in cash against your $250k downpayment, which is a cash-on-cash return of $9k / $250k = 3.6%. Not great. But that doesn’t consider the amortization of the loan.
By making the monthly payments for 12 months on a $750k loan at 3.62%, you reduce the principal (what you owe the bank) by roughly $12k. To fairly calculate your return, you do need to consider the effect of this principal pay-down, particularly if you plan to hold the building for a while.
If you add the $9k cash plus the $12k principal paydown, you’re looking at a return of $21k on your $250k downpayment, or 8.4% in year one. And, as we’ve discussed before, because of the way that loans work, the amount of principal you retire increases every year (basically, more and more of your fixed monthly payment goes to pay down the debt rather than pay interest on it). So the total return gets better every year.
Am I advocating that everyone rush out and buy 5% caps with lots of cheap leverage? Definitely not. I don’t think the deal above provides enough of a margin of safety for most investors.
But the numbers above do help explain why the market for apartment buildings is so hot right now. With debt that cheap, even bad deals start looking pretty good.
The problem is that the rates are artificially low, and will likely revert back to normal levels at some point. If we’re at 5.5% interest rates in five years, and CAP rates are at 7.5, even with 5% rent growth over 5 years, you’re still stuck refinancing your low-interest note at a valuation of $810k, which probably means you’re looking at another cash infusion to pay down your original note.
Paul
10/10/2012 at 8:19 am
On the same note, would a 5-year loan even make sense? What’s the longest fixed-rate loan you can get now for the same type of building and are the interest rates comparable?
David Brundige
10/10/2012 at 9:55 am
Longest fixed rate loan you can get for a 5+ unit building right now is 10 years (from Fannie Mae), except if you’re talking about a huge complex, where you can sometimes get 35 year fixed leverage from HUD.
Moses Kagan
10/10/2012 at 7:48 pm
David: the loans amortize over 30 years – it’s just that the fixed rate period is only 3, 5, 7, or 10 years (with 10 being a fannie mae loan). The rates go higher as the fixed rate goes longer.
Paul: Totally true that you can get screwed if the rates re-set higher and you don’t have the NOI to cover the debt service. That said, you have to assume that rents 5 yrs from now will be higher, too, leading to higher NOI. I’m still not saying levering all the way up is the safest play, but it’s not quite as bad as it looks at first blush.
mjkagan
10/10/2012 at 9:42 pm
Fair point. However, you do have to factor in rent growth over the 5 year period. If you’re buying something in LA with below market, rent-controlled tenants, you’re guaranteed a 3% / year annual rent increase. So your NOI will be higher, too.
Moses Kagan
10/10/2012 at 7:47 pm
Are you talking about a 3.62% interest-only loan? If you are the principle pay down isn’t in play. Even if it is I prefer 4-plexes because the financing is 30 year fixed like a house. Right now you can get under 4% principle and interest, for 30 years non-recourse. A 5-plex or above is considered “commercial” for lending purposes with the note coming due in 5 years. If interest rates jump, then what? Your cash flow will be shot and that’s assuming you can refinance. Property values sink as interest rates rise so it would be a painful double whammy.
LA guy
10/10/2012 at 2:15 pm
3.62% is for a fully-amortizing loan on a 5+ unit building.
Obviously, the leverage is much better on a 4plex. However, the prices reflect that – most 4plexes in decent areas are asking 11-14+ GRM. So you’re accepting a lower return for more certainty.
For 5+ unit deals, you can take 7- or 10 year fixed at probably 4.5%. It’s true that rates will rise when you re-finance, but you’re also buying at 10-12 GRM (so the return is better now) and rents will go up over the period of the loan.
mjkagan
10/10/2012 at 10:45 pm