How to act in a rising interest rate environment

Over the past few days, we’ve been discussing the rising interest rate environment and how it is changing the real estate market. We spent a bunch of time on a strategy investors should avoid.

Today, we’re going to focus on strategies that make sense in an environment where:

  1. The economy is improving; and
  2. Interest rates are rising

Let’s take these conditions apart, see how they affect the apartment business, and then see what strategies make sense.

1. An improving economy

With the economy improving, we should expect to see rents increase, because:

  • As young people get jobs, the first thing they do is move out of their parents’ homes / the shared apartments they’ve been living in. This will increase demand;
  • As employment increases in the construction trades, I expect we will see increased immigration (legal and otherwise) from Mexico. This will increase demand;
  • Nothing was built between 2009-11, meaning that supply is pretty constrained.

Increasing demand and constrained supply should cause rents to continue to increase, which is great news, if you own apartment buildings. Except…

It’s not good news if you own rent controlled buildings with rents that are substantially below market. For those apartments, not only will you only be able to increase the rents by 3%, but, as the surrounding rents increase faster, your tenants will become increasingly entrenched (a $500 apartment where market is $650 is very different from a $500 apartment where market is $1500).

So, when you expect rents to climb, you want to either own non-rent controlled assets or else rent controlled assets where the tenants are at or near market (so that you get the normal amount of turnover and can therefore keep your rents rising as the market rises).

2. Rising interest rates

There are two problems with rising interest rates, from a landlord’s perspective.

A. Decreased cashflow

If you have a variable rate mortgage, increasing interest rates will have the immediate and painful effect on your cashflow. For example, if your net operating income is $100k / year and your debt service is $70k, you’re clearing $30k in free cash. If the debt service spikes to $85k, you’re only going to clear $15k.

The way to avoid this problem, of course, is to immediately refinance into some kind of fixed rate loan. If this is a 2-4 unit deal, you can get a 30 year fix. If it’s 5+, you’re looking at a maximum of 7 years (from a bank) or 10 years (through the Fannie Mae program).

B. Decreased value

This one you can’t protect against. When interest rates rise, prices fall (assuming constant net operating income). For example, with ultra-low rates, paying 13x the rents, while ridiculously pricey, is still semi-sane. With higher rates, it’s entirely nuts, because the cashflow falls to almost nothing.

As a buyer, if you know rates are increasing, you need to plan for the very real possibility that your property will decrease in value. Sounds bad, right?

It’s not really, as long as you aren’t going to be forced to sell any time soon. As long as you are happy to own the property for an indefinite period, you don’t care about valuations. After all, values are cyclical, going up and down. If you are happy to own forever, you can just wait to sell until the market is high.

So, the key is to finance the deal in such a way as to ensure that you will never be forced to sell. And that means keeping the price reasonable, the loan-to-value as low as possible (so, putting down more cash) and getting the longest fixed-rate loan you can get.

The best stuff to buy

Putting it all together, in this environment, you want:

  • Non-rent controlled or rents at or near market;
  • Bought for a reasonable price – say 11x (maybe up to 12x if 2-4 units);
  • Relatively low leverage (say, 65-70% LTV);
  • As long a fixed rate period as possible… meaning ideally 2-4 units (for a 30 year fix);

If you do a deal like this, you will enjoy increasing rents, mostly fixed costs (or, at least, costs that grow more slowly than the rents), and therefore increasing profit margins. And, since you will never be forced to sell, you can almost guarantee that you will not lose money on exit, even if interest rates continue to rise.

How not to act in a rising interest rate environment

We’re living in a world of rising interest rates, which are already fundamentally changing the real estate market.

As discussed yesterday, as interest rates rise, prices should fall, all other things being equal. That’s because more expensive debt means reduced cashflow and lower returns at a given price.

But, all things are not equal. In general, assuming a normal economy, interest rates should only rise when things are improving. Why? Interest rates are effectively the price of borrowing money. When the economy is bad, and there is not much opportunity, no one wants to invest in new opportunities, so the demand for money is low and the price (the interest rate) falls.

On the other hand, when the economy is promising, everyone wants to borrow to expand their businesses, buy assets, fund consumption (cars, boats, etc.) So, demand for money increases and interest rates rise.

The fact that interest rates are going up isn’t necessarily such a terrible thing. It is, in fact, a strong signal that the economy is improving.

The trick for real estate investors is to figure out how to benefit from an improving economy without being hurt unduly by the rising rates.

Here’s an example of what not to do:

  • Pay a high price (say, over 11x) for a rent controlled property with tenants at below market rents
  • Use a 3- or 5-year fixed rate loan for a very large portion of the purchase price (say, 75%)

Why is that a bad play?

  • You paid a high price, so your cashflow is pretty slim to begin with;
  • Your tenants aren’t leaving, so you’re limited to increasing the rent by the city-mandated 3% / year, meaning that you’re not really benefitting that much from improvements in the economy;
  • Interest rates go up in the interim, maybe to 6-7% (they were that high as recently as 2008);
  • After 3 or 5 years, your rate comes unlocked and your debt payments increase, eating up most/all of your slim cashflow;
  • When you go to refinance, depending upon how much multiples have dropped as a result of the increased interest rates, you may find that you lack the equity necessary to refinance and are therefore stuck with whatever rate your loan has adjusted to.

The above is pretty obvious to me, and yet I see poorly advised investors buying exactly this type of deal all the time.

Tomorrow, we’ll talk about some better strategies for investing in a rising interest rate environment.

In the midst of a market disjunction

Had breakfast with a really experienced broker this morning, a guy who I think of as kind of a mentor. He started in real estate in the early 1980s and has bought and sold an unbelievable number of properties in the Echo Park area since then.

I complained to him that the market feels pretty weird right now, with almost all sellers of apartment buildings asking for insane prices (GRMs of 13x, 14x and up – for more on this, see this post), given the change in interest rates over the past 1-2 months. (Note: The triplex I have on the market, 1142 N. Virgil, is priced appropriately for the interest rate environment, because my sellers are pros. And, as you would expect, we’ve seen plenty of action.)

Why  should prices decrease when interest rates increase? There are a number of reasons, but here’s how I like to think about it:

  • Properties are ultimately valued based on the cashflow they generate for their (prospective) buyers
  • Higher interest rates mean higher debt payments, given the same loan size
  • High debt payments mean less free cashflow left over for the buyer
  • Less cashflow left over for the buyer implies a lower return on the downpayment she has invested
  • Assuming the buyer is seeking a certain minimum percentage return, the only way to get there is to lower the price (and thereby reduce both the amount borrowed and the downpayment)

So, when interest rates go up, you should expect prices to go down.

My broker friend explained that this does happen, but usually only after a few months with very few transactions. This is because:

  • Buyers immediately get the memo about higher interest rates (they hear it directly from their lenders), and therefore adjust what they are willing to pay;
  • Sellers don’t get the same feedback (they typically aren’t speaking with any lenders), so they are much slower to adjust the amounts they are willing to accept;
  • So, nothing happens until sellers get the memo (due to getting only low-ball offers or, indeed, no offers) and reduce their prices.

That’s what’s going on right now, and I expect it will continue for several months. Meanwhile, I’m probably going to be the guy low-balling sellers.

Whole lotta building going on…

In our areas (Silver Lake / Echo Park / etc.), there are tons of small lot subdivision projects in the works.

Off the top of my head, I can think of at least four projects going in right now, and there are definitely more that I’m forgetting.

So, the question for all of us apartment people, is: What will be the effect on rents in our neighborhoods from the coming wave of for-sale single family homes on tiny lots?

To answer that question, we need to be able to compare the monthly expense of renting to owning.

From speaking with a lot of developers of this kind of product, the pricing developers expect is generally in the $650k+ range for a 1500 sq ft home ($433 / sq ft). At 4.5% interest, the monthly payment required for a $520,000 mortgage (80% of $650k) is around $2,634. Property tax is around $680. Insurance is probably $150. And there are probably home owners’ association dues of $50. That’s a total of around $3,500 / month.

It’s important to remember that almost all of that is pre-tax money (since both mortgage interest and property tax are tax deductible) – so that $3500 is equivalent to paying something like $2000 in after tax money.

If you know our area at all, you know that renting a 1500 sq ft home in very good condition is likely to be $3,000+ / month in after-tax money (since rent is not tax deductible).

That means there’s roughly $1,000 / month in after tax savings if you buy. That’s $12,000 / year on your downpayment of $130k (20% of $650k), or 9%.

Bottom line: If you’re looking for a large place, you’re probably going to be better-off buying rather than renting, assuming you have the dough and the credit. So all of us in the apartment business need to be considering whether the rents we are getting on larger units are sustainable.

How increasing interest rates are changing the market

Had an amazing thing happen a few days ago: One of my agents was representing a buyer in a deal. When the buyer saw how much interest rates had moved in the last week or so, he changed his mind about the deal. In an effort to try to keep the deal together, my agent asked what it would take for the buyer to stay in. Buyer requested a $30k price reduction, prior to inspections.

Here’s where things got weird: When my agent called the listing agent to explain the situation, the listing agent explained that he had had two other deals blow up over the interest rate change and that he’d talk to the seller and see what he could do.

Pause for a moment to consider how crazy that is: What kind of seller agrees to a price decrease BEFORE the inspection, knowing full-well that the buyer may come back with a request for another reduction after getting back the inspection report?

The answer is: A realistic seller who actually wants to make a deal. When rates go from 4% to 4.5%, the numbers on the deal change for the buyer. If you’re a seller who wants to make a deal, you need to be willing to be somewhat flexible.

Rates can’t stay this low forever. We’re in for increasing interest rates for the foreseeable future. And everyone in our world needs to consider what that means for their deals.