The Impact of Rising Interest Rates on Commercial Real Estate
It's the elephant in the room in many conversations now.
The question about interest rate increases comes from new investor prospects, seasoned Wellings Capital investors, and colleagues at masterminds and cocktail parties.
We've experienced a long boom in growing income and value in our commercial real estate investments. More recently, as real estate owners we’ve "enjoyed" the byproducts of almost two years of historically high inflation: a significant growth in rental revenue and asset value. Check out this surprising graphic from the Federal Reserve Bank of St. Louis showing the median sales price of homes sold in the US…
But now, many feel like the doomsday clock has advanced ever closer to the end, and they fear how this recent and near-future rise in interest rates will affect their current and prospective investments.
Though this topic is not as straightforward as others, I decided to get my thoughts on paper to promote a healthy conversation. Please note that I am not attempting to prognosticate in this post. My goal, as always, is to help our firm and readers make the best decisions possible in light of where we are in the cycle.
Lag Time
I'm writing this in early July 2022. We've witnessed a doubling of retail mortgage rates, from about 3% to about 6%, since January. And commercial interest rates have risen from the mid-3% range to over 5%. Yet we are witnessing little to no cap rate expansion in most commercial sectors. Why?
I am in my third decade as a real estate investor. I have witnessed a noticeable lag time like this in every cycle. It is a time when most buyers are tightening their underwriting and decreasing their offers or not making offers at all, while most sellers are frozen in disbelief about not getting the top price they had been holding out for. It happens every time.
The conversation between owner/seller and broker could go like this…
Broker: "I think I can get a buyer at $11.5 million for your property."
Seller: "I'm still holding out for $13 million. You told me I could get $12 million last year, and I told you I'd wait a year to get my price. Are we there yet?"
Broker: "To the contrary. Interest rates have caused a pullback in buyers, and I don't think you can get your number."
Some time passes…
Seller: "Well, ok, I will consider $11.5 million. Send that offer over.
Broker: "The market has continued to soften. It's likely I can only get you $10.5 million now…if that. And it will probably get worse."
You can see how this disparity between seller and buyer expectations could cause a time lag. I think we are in this time right now. The Wall Street Journal reported last month that there was already a decrease in transaction activity in the past quarter.
Cap Rate Mystery
But that doesn't explain why many deals are still transacting at about the same compressed cap rate as before. In other words, many deals are trading at about the same selling price per dollar of net income (as measured by the cap rate) as last year. Why?
I can't prove this, but I have a hunch. It's related to the "greater fool theory."
Brokers are telling me that the number of buyers has markedly decreased. The frenzy to buy real estate assets is cooling.
But as I've often written, there has been a flood of new investors in the commercial real estate space since the Great Recession. A veritable tidal wave of new syndicators has emerged, and many are billing themselves as gurus. (I playfully call them Newrus. New Gurus.)
Many of them haven't experienced the pain of a downturn. And some even believe the lie that "It's different this time." Others make money on fees whether the deal goes north or south, so they continue to buy using their investors' capital.
For years, we've seen dozens of parties bidding up the price of every broker-marketed deal. Some deals have 50 or more bidders and transact at 20% or more above an inflated initial broker estimate.
While most of these prospective buyers have pulled back, there are still at least a handful of investor-funded buyers ready and willing to overpay. And lenders, who often head for the hills when times get bad, are still giving out loans like candy. (Note I did not refer to all of these buyers as fools. I'll tell you why later.)
So, the result is that we've seen very little cap rate expansion. So far. But it doesn't make sense for this to go on for long. If the so-called risk-free rate (quantified by treasury bonds) continues to rise, investors will begin to prefer other options. The cap rate will expand (CRE prices will drop), and the risk premium for investing in CRE will normalize again.
Rant Alert
Here's a quick example of how weird things are right now. One of my friends is among the nation's top CRE syndicators and fund managers. But everyone gets a lemon sometimes, and he had one. It was a multifamily asset that barely cash-flowed above the debt service. His experienced team worked on it for three years to no avail.
He recently accepted an offer for 50% more than he paid for the asset! Furthermore, my friend's interest rate was around 2% (he's a big player), and the buyer had bridge debt at about 5%.
Can someone tell me how on God's green earth this deal is going to work out for this buyer…and his investors?
But I digress. We were talking about interest rates, not fools. Two final comments on this digressive sub-topic, however…
When the tide keeps rising, as it has for CRE for over a decade, it's hard to distinguish between lucky amateurs and professionals. Amateurs take more risks, so they often look better in boom economies. But the tide is likely going out, and soon we'll see who's skinny dipping (thanks for the analogy, Mr. Buffett). Then professionals will be valued again.
One article reported that many CRE buyers are responding to rising rates by…taking on more leverage. You heard that right. Why would they do this? To hit their equity return targets. Think about that for a moment.
Rant over.
There are at least three strategies to maintain returns and asset values in a time of rising interest rates. We'll cover all three briefly.
Combat Rising Inflation and Interest Rates by Asset Class Selection
Not every operator/syndicator has the luxury of choosing their asset class. Some have decades of experience, a seasoned team, and deep relationships in a particular asset class, so they need to stay in their lane.
But as fund managers, we have that luxury. And as an investor, so do you.
Some commercial real estate asset classes have fixed leases with long durations. We know what we'll be paying for our office space through 2027. Amazon has locked in its warehouse leases into the 2040s, and some land leases go even longer.
These long leases can come back to bite their investors in at least two ways. First, when the leases were set with yesteryear's inflation in mind, they will likely not keep pace with today's inflation rates and devalued currency. Rent escalators of 2-3% mean the "real" income and returns from these assets decrease every year.
Secondly, if the debt on the commercial property matures during a time of inflated rates, the deal can go south quickly. Imagine owning an office building in 1980 that was due for refinancing when the prime rate hit 21%.
This is even more painful for assets with long-term leases that don't catch the benefit of inflation to create higher revenue. I'm thinking of office, retail, large industrial, and others.
So, what's a potential solution? Invest in assets that capture the benefit of inflation. These assets are generally considered recession-resistant; this is where Wellings Capital has chosen to focus our investments.
These could include multifamily and mobile home parks, where about 1/12th of the rents can be escalated monthly. Self-storage is much better since they operate with month-to-month leases. Many of our self-storage assets saw increases north of 20% last year. Many RV park rates can be reset even more frequently, and we are excited to see the results of our recent investments in that asset class this year.
Combat Rising Interest Rates by Using Conservative Debt
This is quite simple. In the extreme case, if you don't use any leverage, you'll be unconcerned about interest rates. Of course, that's not optimal for most, but investors with lower leverage, fixed rates, and longer terms will generally benefit during times of rising interest rates.
For example, imagine your debt has a floating rate, a two-year term, and an 80% loan-to-cost ratio. You could quickly find your debt service coverage ratio (the ratio of periodic net income to debt payments) in trouble.
Syndicators who elect hold times and debt with longer terms, say 10 or 12 years, can ride out the rise and subsequent fall of interest rates with less concern about imminent refinancing. Those with fixed-rate loans have a long window of predetermined debt payments. And those who use less leverage see a lower impact from higher rates if they must refinance when rates are elevated.
This is a key reason Wellings Capital has a 10-year hold time, though we realize many prospective investors prefer a shorter hold. The longer hold gives us the flexibility to ride down through a recession and out on the other side. Through a rising interest rate cycle and on to a lower rate period on the other side, likely before it's time to sell. And we capture all the continuing rent inflation along the way, which translates to income that rarely recedes after interest rate hikes subside.
I spoke to our largest operating partner last week. Wellings Capital and our investors have invested almost $50 million with his firm over the past three years.
He reported their average debt term is 7.1 years, and their average interest rate is 4.1%. His average loan-to-cost at acquisition is a modest 65%, but here's the stat I love most: his average loan-to-value across their portfolio is only 35%. Their debt service coverage ratio is an amazingly conservative 2.8x, meaning there is a 180% margin of safety between their net income and debt payments.
Wait, you may wonder. How could he have such a wide variance between loan-to-cost and loan-to-value ratios? And how does he achieve such a healthy margin of safety in the debt service coverage ratio? Great questions. I'll answer through my third and favorite strategy to combat rising inflation and interest rates…
Combat Rising Inflation and Interest Rates by Harvesting Intrinsic Value
I believe this is the best strategy to create principal safety, outstanding returns, and significant wealth in any market, cycle, or asset class. I've written and spoken on this repeatedly, so I will summarize it briefly here.
This is the strategy – value investing – the world's greatest investors use to beat the herd for decades. Warren Buffett, Howard Marks, and others are among its adherents. It applies to real estate just like it does to stocks and companies. Honestly, even more.
“Price is what you pay. Value is what you get.”
In the commercial real estate space, this strategy is based on locating and acquiring assets that can be optimized or repositioned to create significantly higher income and value. These assets are often, though not always, acquired from mom-and-pop operators. These operators typically don't have the knowledge, the desire, or the resources to optimize operations, increase cash flow, and maximize value. They don't need to since the market has done the heavy lifting for them in the past decade.
Commercial real estate assets are a perfect fit for this strategy because of certain fragmented markets and because of math. Let me explain…
The stock market has hundreds of millions of eyes on it. Investors and analysts from around the world study companies and managers and news to make calls on value. This is why the Efficient Market Hypothesis has been taught as fact in business schools for 50 years. The theory says it is impossible to get a good deal, so investing in a broad market index is better. (Buffett is thrilled that this is taught and claims to make billions at the expense of its adherents.)
This theory is certainly not true for real estate. And extremely untrue in certain asset classes. Lack of public information, disparate geographies, inefficient management, and other factors create a potential gold mine for those seeking intrinsic value.
There are about 53,000 U.S. self-storage assets in the United States. Independent operators own about 75% of them, and two of every three of those are considered mom-and-pop owners.
The U.S. mobile home park count is estimated at 44,000, and 80% to 90% are mom-and-pop owned and operated.
Aside from a few large operators, most of America's 8,000+ RV Parks are owned by small-time operators.
Conclusion
Acquiring assets like these is perhaps the best way to protect your capital and grow your wealth in any market or cycle. And when you acquire long-term, fixed-rate, conservative LTV debt, it's even better. Add into the mix the fact that these types of assets allow operators to capture annual or even monthly inflation, and you've got a winning combination to prosper in times of inflation and rising interest rates.
This is what we do at Wellings Capital. We add diversification and extreme operator due diligence into the mix to round out our investment thesis.
But we haven't fully proven ourselves yet. The rising tide has made almost all the real estate world look great.
But the tide is going out. And we believe we are ready. Are you?
If you have any questions, please email us at invest@wellingscapital.com or use this link to set up a call.
This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. All investments involve the risk of loss, including the loss of principal. Past performance, and any performance results reflected in this article, is not an indication of future results.