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.