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.
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%.
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.
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 that, 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.
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. That’s what they have. That’s the main piece of the liability side that a lender wants to be able to get rid of their risks that they’re not going to be paid.
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. Now the benefit to you is that there’s less scrutinizing of the terms, you have to find the investors that are willing to do it. And most of the time, in order to do that, you have to pay them at a higher rate. So in order to pay them at that higher rate, the benefit to you is you don’t have that risk of foreclosure, the benefit to them is they get a higher rate. So that spread, that difference, it’s always a balancing act. You’re trying to figure out which is better for your deal.
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 where everything takes place at the shareholder equity side. The benefit here is that suddenly now we can refinance the property, we can take on bank debt, because bank debt doesn’t care at all about the shareholder equity. Not only does it come before shareholder equity, but it also has that ability to foreclose. If you had given the shareholders a possibility of being able to foreclose, you’re not going to get a bank that’s willing to lend on it. It’s not gonna happen. Even if they’ve got priority, they’re not going to do it. Now they’ve got an increased risk that somebody who’s in a secondary position can take them out.
So that’s kind of a long explanation of the capital stack of things we think about as it relates to them. The interest rate risk is understanding how that plays in. So we’ve got those two competing forces: we’ve got the possibility of high interest rates, and we’ve also got the shareholder expectation of what their return should be. Now, we’ve also got the risk mitigation thoughts that need to take place.
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, and I’ve got these other shareholders here, they’re not a part of this necessarily. But I need to get a 50% loan to value. And the bank comes back and says, “Okay, no problem, we’re going to give you a loan for that amount, and we’re going to do it at 10% because we’ve considered it a somewhat risky deal, and it’s going to be temporary. But guess what, because we don’t know exactly where interest rates are going, we’re going to peg it to something like LIBOR. And we’re going to make it a variable interest rate loan. And so although it’s 10 years, it adjusts every quarter. And we’re going to do it over the next five to seven to ten years, whatever that determines. And it’s going to be variable.”
Now, you may say, as the asset manager, “Oh, okay, that’s great. Because when rates go down, I’m going to do better, right? So now my payment goes less, my IRR goes up, everything’s winning.” But what if those rates go up? What if you’ve decided, “No, I’m not exactly sure where it goes.” I mean, where I sit today, we’ve already seen, oh, inflation might be still pressing. And finally, the perceived inflation from the Fed might be saying, let’s keep interest rates higher, maybe they’ll decide to bump it up a little bit more. What if inflation jumped to 4% or 5% next quarter? Suddenly, there’s going to be this increased pressure from the Fed to raise rates, and that’s going to drive our interest rate for that loan that’s pegged to LIBOR, it’s going to make those payments higher. Now, suddenly, everything we’ve promised the investors is in trouble.
So how do you mitigate this risk? Well, what you can do is you can buy what’s called an interest rate swap. What that does is you go to somebody and you basically say, “Look, I’ve got this variable rate loan, I want to buy a fixed rate loan, I want to basically trade it in. Let’s trade our payments, you take on the variable interest rate, you take on the fixed rate interest, or the variable interest rates that I’ve been paying. And I’ll take on the fixed rates that you’re willing to give me, and you’re gonna make money through that spread. And I’m willing to pay for that.”
So what that does is it gives you that fixed rate. Well, I’m stuck at 10%, but at least it’s not going to go to 12%. So at least your numbers aren’t going to be thrown off. There’s risk on the other side of okay, I’ve done that. But what happens now, when interest rates fall? What if interest rates fell to five? What if they fell as low as we’ve seen, like 3%, or just under 3%? Oh, my gosh, you just made a big deal, but you made a very bad decision.
So you can actually do the opposite. Say the bank had given you a fixed rate loan, you can actually sell that fixed payment, you can trade that cash flow that you’re paying on the fixed rate, and turn it into a variable rate and peg it to something like LIBOR or something like that. So you can actually buy a swap that goes the other way. Now, of course, the risk is that interest rates go up, and now you’re back up at that 12% interest rate. So that’s sort of the thoughts that go into the risk mitigation piece.
The last topic that I want to talk about is the impact on valuation. If I’m buying a single asset, or I’m buying a multiple pool of assets, valuation of the individual assets is going to change based on interest rates. And why is this? Because cap rates are somewhat correlated to the value of the asset. So cap rates generally go up after some period of time after the interest rates go up. Now, why is this? Because people want to make money from their assets. So if interest rates go up and the borrowing power makes it so I’m getting less cash flow from it, they still want to enjoy that cash flow. The only way to make up that spread between the cap rate and the interest rate is to increase the cap rate. So the only way the buyer of a potential property will be able to do that is to buy at a higher cap rate. This can change that valuation period. So what this means is that you may be at risk if interest rates go up of having your values of your properties actually go down. Because remember, if cap rates go up, that price goes down.
But it also introduces another kind of issue, perhaps there’s an arbitrage opportunity. If you feel very confident in the next three years that interest rates are going to fall, and you’re able to buy as if that interest rate is at this level, and so the cap rate is up here. And suddenly the interest rate is here. Well, now suddenly, you can sell with a cap rate here, which means a lower cap rate means higher price. So that means you’ve just made a massive amount of money for your investors just on the natural changes in the interest rate itself.
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. Now 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.