Thank you to everyone who commented on last months article (click here to read it). I was a little surprised by how much interest there was in well… interest, but upon reflection, interest rates do matter, and changes to interest rates, especially from extremes of historical norms, affects our business and our lives. This month we will continue on the interest rate theme and look at a few of the reasons that interest rates do, in fact, matter. The following discussion is only a part, and certainly a simplification, of the overall picture, but it touches on three different reasons interest rates matter to us as alternative investors.

1. Affordability

• The median home price in the US is $188,900 (January data) and in California it’s $440,000 (March data).
• The median income in the US is $51,939 and in California it’s $61,320.

Under current Fannie Mae guidelines a borrower can qualify for a loan payment including taxes and insurance of up to 45% of their gross income, although 36% of their gross income is more standard. Based on the median incomes above, and assuming no other consumer debt (car loans, credit cards, student debt, etc), Fannie Mae would finance up to $18,694 and $22,075 in annual PITI payments respectively. Based on the current 30 year fixed rate mortgage of 3.85%, that equates to average borrowing power of roughly $250,000 for the US and $300,000 for California. This means that while the median family can still afford a median home on average across the US, the median family in California cannot, and it isn’t even close. California is the country’s most populous state and interest rates are at historic lows.

What happens when interest rates kick up half of a percent? The amount that can be borrowed drops to $235,000 and $285,000 respectively (US and California), a loss in purchasing power of ~5%. Do you think that would have an effect on the single family markets? And that is only a 1/2 percent increase in rates. Even with a 1/2 percent increase we would still be far closer to all-time lows than historical norms. In many markets inventory is so tight that it may not slow down the activity as much as it would in more “normal” real estate markets, but the stability would only be temporary. The faster rates move up, the shorter the continued stability.

One thing that I have talked industry experts about is how much it seems the mid-priced home prices have been getting squeezed. What you can buy for 10 or 15% more in price seems to get you far more than 10 – 15% more in value. I believe this is due to so many people maxing out their borrowing ability and still being only able to purchase lower priced homes. Interest rate increases are likely to affect buyers at the lower end of the price spectrum more than the mid and upper ends therefore interest rate increases may bring back some value pricing normality. As a caveat, our single family experience is in Northern California and some of the market dynamics that we take as truth are certainly not universal in other markets across the country.  This affordability question is of special interest to us from the perspective of multifamily investing. Even as raising interest rates can affect valuations (see below), the reduced affordability in purchasing a home results in a larger tenant base and should increase upward pressure on rents.

2. Valuations

Most investments are valued based on either a capitalization rate (cap rate) or a price to earnings ratio (P/E ratio), which are inverse calculations of the other. A cap rate is the measure of the annual pretax income produced by an investment assuming no debt on the investment stated as a percentage. The P/E ratio is the price of an asset over the annual net income produced by that investment. A cap rate of 10% equates to a P/E ratio of 10 and a cap rate of 5% equates to a P/E ratio of 20. In real estate, because most investment properties are owned with debt, the cap rate is used more as a relative measure of market value than as a calculation of returns. However, the cap rate, taken in conjunction with interest rates, does determine the returns an investment property will produce. Looking at it purely from a cash flow perspective (ignoring amortization) is the easiest way to review it:

1. A $5 M purchase, at a 7% cap rate, purchased without debt, produces $350,000 a year in cash, and a 7% return
2. A $5 M purchase, at a 7% cap rate, purchased with 70% debt, at a 4.5% interest rate, produces  $192,500 in income on a $1,500,000 investment, for a 12.8% return

What this shows is that the spread between the cap rate and the interest rate pays, and right now it pays well. However, if interest rates were to rise to 5.5% that same $1,500,000 investment would not only produce a 10.5% return, a reduction in the rate of return of roughly 20%. This is substantial. To compensate, an investor is likely going to want to obtain a better cap rate so that the return on his money can stay constant. To do this, based on identical performance from the investment, the purchase price would have to drop to $4.55 Mil, a decrease in market value of 9%. Certain markets along the coasts, especially in California, have far lower cap rates which exacerbates the problem. Using the same example above except using a 5% cap rate instead of a 7% cap rate (a higher value given for each dollar of income), the return leveraged at 4.5% interest is 6.2%, however with the 5.5% interest rate the return drops all the way down to 3.8%. For an investor to obtain the original 6.2% return the price of the property would have to drop to $4.38 M, a 12.5% decline in market value. If the 9% and 12.5% declines in market value don’t seem like a big deal, remember this. Those declines equate to a 30% and a 58% loss on investment respectively.  That, my friend, is a big deal.

Now, after all the doom and gloom there is a ray of light. I do not believe the effect on cap rates by interest rate increases will be as linear as detailed above. In the 2000’s cap rates were at or below where there are now in many of the major markets. This despite interest rates being considerably higher than they are now. That means investors were willing to take a lower spread on their debt than what is currently available in the marketplace. In fact, there are many examples of negative debt spreads, meaning that instead of the investor making a higher rate of return by borrowing money they were losing money on the money they borrowed. This may make sense in a repositioning situation but hardly makes sense (to me) for ownership of a stabilized asset.

There is still a lot of cash sitting on the sidelines and the velocity of money is still extremely low. An increase in interest rates could get that money back into play and flowing again, which would mean there would be even more cash available than there is currently to chase the same limited number of opportunities. All this would point to a compression of the cap rate/interest rate spread. As a caveat, this is my opinion, and my opinion only. Time will tell if it is accurate or not.

3. Assumability Loans

This is especially relevant to some of the projects we are working on right now. Current interest rates are great, but people also thought they were great a couple years ago and took out assumable loans with hefty prepayment penalties. As a result there are lots of properties with high prepayment penalty, high interest rate (by today’s standards) loans in place, severely restricting the options of the sellers. In a lot of ways it looks like the valuation discussion above in reverse:

1. $350,000 of NOI, 70% leverage, 5.5% interest equates to return of 10.5%/year
2. $350,000 of NOI, 70% leverage, 4.5% interest equates to a return of 12.8%/year

Over an 8 year life of the loan that difference is substantial in terms of real dollars of lost income; $280,000.  How do we balance out the difference caused by the interest rate? In the most straightforward calculation the price would have to be adjusted downward using the same math as we used above to show the effect of an increase on interest rates on cap rates. However, there is one more thing to consider. When that loan expires there will no longer be the same interest rate drag on returns and the property will return to its relative market value. How exactly to value that future increase in market price is going to be largely dependent on the discount rate used to calculate the cash flow and the future value of the property in each interest rate scenario so that the present value sum can easily be compared.

In summary, caution needs to be taken when assuming existing debt to ensure the buyer isn’t overpaying for the property even if/when the NOI on the property justifies a higher price based on the current market cap rates. Additionally, consideration needs to be given to the expected length of time ownership of the property. A property with a bad loan can be difficult to move without offering the same discount to a buyer that you would expect to obtain in buying that property. However, there also is some opportunity here. If the logic above can be used to justify an offer lower than market value based on the NOI and the market cap rate, upside relative to the market will be obtained upon expiration of the existing financing.

When people ask me what keeps me awake at night, I say nothing. By the time I go to bed I am far too tired to stay awake for long. But if something did keep me awake at night it might be contemplating issues like the above. Trying to predict the future is a fool’s errand and yet future (and largely unpredictable) changes to market inputs can have a large impact on the returns we can produce for our investors. I can research demographics and make an educated guess on directions of growth. Property conditions I can have inspected and come up with a plan for repair. Interest rates…I have no control over the actions of the Federal Reserve so it is really all just a guess.

Don’t want to have to think/worry about all these things yourself? We would be happy to do it for you if we don’t already. Contact our office and we can discuss upcoming opportunities that might fit your investment goals.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.