Key Takeaways
- Higher borrowing costs compress cash flow and IRR, especially for leverage-heavy deals, making returns less attractive relative to safer alternatives like CDs or treasuries.
- Investor expectations shift upward in high-rate environments, forcing sponsors to offer higher preferred returns or adjust structures to stay competitive.
- The capital stack becomes more challenging to balance, as debt becomes expensive and equity requires higher compensation to justify additional risk.
- Variable-rate loans introduce significant risk, which can be mitigated through interest rate swaps—but swaps carry their own potential downsides.
- Higher interest rates push cap rates upward, lowering property valuations—but also creating potential arbitrage opportunities if rates later fall.
Transcript
The Broad Impact of High Interest Rates
In a high interest rate environment, what are the effects on a real estate syndication or real estate fund? They must surely have effects. In this video, we’re going to go through exactly that topic.
My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group. One question that is always in the back of all my syndicators’ and fund managers’ heads is: what is going on with interest rates? I often get asked what I think is going to happen with interest rates. Let’s go through exactly what that effect is, where I think it’s generally going, and hopefully, that’ll give you some guidance.
Cash Flow Pressure and IRR Compression
The interest rate risk is obviously in a very high borrowing environment. When interest rates are very high, it is going to have a problem with the cash flow and probably the appreciation of your property. So that IRR is going to get compressed when interest rates are up if you have debt on the property.
Now, there are two things kind of going on at the same time. We’ve got that pressure that takes place if you have debt on the property. But one thing I don’t want to leave out is that second area, and that second area is if we’ve got high interest rates, we probably also have a lot of products on the market that are paying investors a return in order to save money. For example, in CDs, something like that, we have a return that’s getting paid right now that can be around four or 5%.
Investor Behavior: Competing With Safe Yields
So an investor automatically can make very safe money, not perfectly safe, but very safe. They can put money into a bank, make four or 5%. Now if your risky real estate deal is paying four or 5%, why on earth would they take it? So that’s obviously a negative factor that goes on to it as well.
Understanding the Capital Stack Under High Rates
Now that other piece of it is the borrowing rate. We call this whole entity of how the money comes in the capital stack. Normally, there are two components in the capital stack: we’ve got debt, so we’ve got money from a lender from a bank, something like that. And then on the other hand, we have money that is the shareholder equity piece.
That shareholder equity piece may look a lot like debt, or it might just be pure equity, that beneficial ownership. The benefits to the investor might be getting a fixed rate payment, or they might be getting the benefit of actual ownership and that appreciation. It depends how you set up your syndication or fund as to which they’re going to get.
Debt vs. Equity Risk and Return Dynamics
So we’ve got these two things as part of the capital stack: we’ve got the equity side, and we’ve got the liability side.
Now lenders are always on the debt side. It gives them a lot more power, it gives them a lot more control, they have the ability to foreclose on the property, the ability to take that property back to sell it, and to be able to recoup their losses.
Now, the reality is on the syndication side, we have the shareholder equity piece. That shareholder equity is not subject to foreclosure. So your investors actually do have an increased risk over the bank.
To attract them, you typically must pay higher returns—creating a balancing act between what your deal can support and what investors demand.
All-Cash Strategies and Refi Flexibility
Some deals, you’re going to do all shareholder equity, you’re just going to load up on that. It’s going to be an all-cash deal…
The benefit: you can refinance later when interest rates fall, and banks don’t care about your equity structure—they care about collateral and priority.
Variable-Rate Loans: Hidden Danger
One strategy that you can do, because if I’m going out and I go to a bank, and I say, I need to finance this property at 50% loan to value…
The bank might offer:
- A variable-rate loan pegged to LIBOR (or SOFR)
- Adjustable every quarter
- At a high initial rate (e.g., 10%)
This can be attractive if rates fall—but devastating if rates rise.
Using Interest Rate Swaps as a Risk Mitigation Tool
So how do you mitigate this risk? Well, what you can do is you can buy what’s called an interest rate swap:
- You trade your variable rate for a fixed rate.
- You pay a premium via the spread.
- You lock your rate at, say, 10%, preventing it from rising to 12%.
But there’s a flip side:
- If rates fall to 5% or 3%, you’re stuck overpaying.
You can also do the reverse—swapping a fixed rate for a variable rate—introducing its own risks if rates rise.
How High Rates Impact Valuation
The last topic that I want to talk about is the impact on valuation.
When interest rates rise:
- Cap rates generally rise.
- Property values fall.
This is because buyers demand a higher return to compensate for the higher borrowing costs.
But this also presents a potential arbitrage opportunity:
- Buy when rates are high and cap rates are high.
- Sell when rates fall and cap rates compress.
- A lower cap rate = a higher valuation, creating windfall gains.
Final Thoughts
Now, I hope this video helped kind of put some perspectives on things that go through my head when I do my own deals as it relates to interest rates. I also work with clients as a real estate syndication attorney and help guide them through the legal aspects, but also because I have so much experience in doing real estate syndications, I openly share that information with my clients.
If I can help you, we’d welcome a call. Let’s talk about your project, what you’re working on and see if we have a good fit and maybe we can work together.