Best investment opportunities in rising interest rate environment

[Shane Clark]

Hello,

I have been investing in real estate since 2012. I have been purchasing value add apartments for the purpose of capital (or asset) growth. My company buys apartments with management deficiencies and also in need of physical updates. The plan has been to make capital improvements to increase the net operating income over the course of 5-7 years. At the end of this period, we will exchange into a larger commercial property with a similar value add component. Over the course of the next 20 to 30 years we will build up our portfolio until we reach the point of exchanging into more passive triple net lease class A properties requiring less intensive management. 

In light of increasing interest rates and the expectation for interest rates to continue to rise over the next several years, I am hesitant to continue the above strategy. If rising interest rates cause local cap rates to increase by 1.5-2.5% over the next 5 years, my projected internal rates of return for my apartments will be decimated. I am looking for capital growth opportunities at this stage of my investing career. For some of the veteran investors in the BP community who have lived through multiple RE cycles, what types of growth investments do you recommend in this rising interest rate environment? 

Very Respectfully,

Shane 

[David Thompson]

Shane,

Good value add players will create massive value in the first couple years then refinance and pull a lot of equity back to investors so that will limit your risk somewhat.  Then they'll put the property up for sale so goal is not to be in 5 years or more.  Example, my partners have a property in their portfolio where they just did a cash out refinance on a property they had only owned for 16mos, investors have received $46K on a $100K investment including distributions along the way. Syndicates say 5 year hold is target in the Private Placement Memorandum (PPM) but makes little sense to hold an investment after that massive value is created in year two...otherwise from year 3 - 5 you are essentially just growing at market rent growth rates 3-5%.  So, they want to make money, get out and go find another play.  

Keep in mind cap rates are anyone's guess.  A strong market (demand for apts exceeding supply of B/C) will contract cap rates all things being equal. There are many components to cap rates -  interest rates and supply / demand factors are probably the most prevalent.  So, it won't be lock step.  Also, good syndicates should be conservative in their underwriting and should at least be putting exit cap rates up 500 basis points above where they purchased.  Regards to direct interest rates on your the plans mortgage, you could review to see if its fixed or sponsor has a way of capping rates w/the lender.  We actually like to continue to play variable rates but w/opportunities to lock annually and in our last deal we actually purchased a hedge giving us the option to lock anytime over the holding period.  

So, I would not panic. Review your deals, talk to the syndicates and ask them directly what plans they have in place. We do sensitivity analysis for instance and show investors changes in occupancy, rents prices, interest rates and cap rates and impacts to CoC and IRR for each project. Syndicates should be open, honest and educate you on how they will handle changing market conditions. No guarantees but use logic and I'm sure by doing this you will feel better about your investments.