Will interest rate increase eliminate preferred returns?

Question

New LP syndication investor here dipping my toes in and looking to do my first deal this spring. With compression between CAP rates and debt service due to interest rates rising to a much more normalized historical level, will that eat up most of the cash flow on syndication deals?

I was planning on using a balanced approach from an investment perspective between cash flow and EM to generate passive income for FIRE.

Now I’m worried the cash flow component will be virtually gone (1-2%?), and that also means lower total IRRs and EMs.

Are GPS broadly adjusting for increase financing costs? How is this going to affect the mix in the capital stack? Are the high historical returns now just pipe dreams?

Would I be better of just sticking with my brokerage account if the returns or more on parity with the stock market but much less liquidity?

Thank you

Brian Burke · Answer

@Chad Childress, I agree with @Kyle Kovats…investors won’t place Capital if there isn’t a return, so the only option for new deals to get done is lower acquisition prices. I just discussed this at length on the BiggerPockets “On The Market” podcast. If you are thinking about making an investment in syndications, you might want to give that a listen.

Joel Owens · Answer

Depends on the type of investor you are talking about. I do NNN syndications and not multifamily. There are still some multifamily deals being done with assumable debt loans but take a ton down for equity raises. The normal down and debt deals for new loans in multifamily is almost non-existent. Some used floating rates to do deals and make pencil but are getting hammered now.

Basically 2 different type of accredited investors.

1. Those that need that preferred return TODAY. These tend to be barely qualifying for accredited status and want that money coming back to them right away for as much cash today as possible. These type of investors do not fit my type of investor on my deals.

2. Those that do not need the money today and already have lots of wealth and more focus on total equity growth return over time.

Most multifamily deals have longer horizons to hopefully double the money invested ( usually 7 to 10 years time ). There was of course shorter exits on the fast upcycle of 2 to 4 years but that is NOT typical for multifamily. You have to watch out for any syndicator in any asset class PUMPING deals to make fees. Some of them build such a large infrastructure that they keep having to feed the beast and pay for staff with fees and HOPE some of the deals become winners over time.

I do value add NNN single tenant where I buy dark buildings with cash and reposition with a new tenant. When new lease is in typically max value achieved. In other asset classes there are a lot more steps and longer times to get to a new improved value and might not turn out as expected. My equity multiples tend to be achieved quicker than other asset classes. These are smaller properties being bought for cash mostly 1 million and under.

With government and business bonds giving returns around mid 4's I have clients floating millions to tens of millions of dollars to get some kind of return while waiting for 1031 volume money to flush out of the market. 1031 exchange money thinks different. Many tend to think they will pay a low cap rate with a loan today to avoid millions in tax penalties and then they will hopefully have a no to little pre-pay penalty loan and refi in 1 to 2 years when they believe interest rates will fall to preserve their spreads.

Buyers not 1031 putting money down with a loan or paying cash want a return more than the bonds they are getting unless the real estate is A quality or better that rarely comes up every decade or so then they want to lock that in as part of the long term portfolio.

I make millions doing commercial brokerage so only want to syndicate deals with high equity multiple potential.

Brian did a lot of multifamily and then exited so he can sit back and only do deals when he wants to which is important for a quality syndicator. So really pay attention to syndicators that LIKE to do deals but do not HAVE to do deals to live off of the fees. The ones living off of the fees are the ones you really have to watch out far because they can have a potential conflict of interest.

J Scott · Answer

Agreed with the guys above, but I will say that you are likely to see lower actual pref returns in the near future.

Many of the deals I'm seeing these days and many of the deals we are underwriting ourselves are showing very little cash flow in years 1 and 2, and while those deals still might be offering a 6% pref or a 7% pref, if you dig into the actual cash flow projections what you see are early years not actually hitting the pref target (but catching up in later years).

If you're looking for consistent returns from day one and are willing to give up a little bit on the back end, I would take a look at preferred equity funds or debt funds. You can typically hit 6% or 7% consistent cash flow in these vehicles, but you'll find that you're total return is capped somewhere at around 12%.

In my mind, it's a reasonable trade-off for those who are looking for consistent returns and lower risk.

Chris Seveney · Answer

@J Scott

Great points and I agree, people like to compare debt funds with MF but they are two completely different animals.

One thing as a GP I am seeing is some LP’s wanting higher returns or thinking returns should be higher because the feds “risk-free” rate of return has increased.

When in actuality as of today with cap rates lower then interest rates the opposite is happening in many fund types.

So back to original post you can get prefs but will have much lower upside or lower pref with potential more upside

One is not better than the other, it’s a personal preference.

Brian Burke · Answer

I hope you enjoy the book, @Chad Childress!

In theory, returns should be agnostic to single asset vs. funds.  After all, the fund is buying single assets, just more of them.  Funds have the advantage of diversification, which is important in the real estate space where the success of assets can be hit and miss.  Funds smooth that out.

Debt lenders don’t care if the owner is a fund or a single-asset syndication because they require all assets to be owned by a single-purpose entity anyway, so the availability of capital, or lack thereof, shouldn’t sway your decision on fund vs single, either.

What should drive that decision is sponsor track record and their approach to today’s market conditions.  Sponsors with little to no track record shouldn’t be doing a fund, and if they are, you probably shouldn’t invest in it.  Sponsors with a good track to record that are doing a fund now, and are aggressively buying right now, might be doing so just to feed the beast (meaning, buying to earn fees so they can pay their office rent and payroll).  I’d avoid those, too.  Watch for fund sponsors that are not buying right now (there’s no rush to get in, don’t let FOMO drain your bank account) or who have a very disciplined or unique strategy.

Kyle Kovats · Answer

@Chad Childress good question. The adjustment won’t necessarily be to pref but rather acquisition price. There is definitely a little price discovery going on right now and a delta between seller/buyer expectations. It’ll be interesting to see how fast that gap closes when deals that are forced to sell due to maturity or rate cap expiration without sufficient reserves come to market.

7pref 70LP/30GP is fairly standard and could that change to 6 pref 70LP/30GP? Sure. But as a GP we underwrite to our investor expectations and if that is a 7% pref, it will be reflected in our offer to the seller.

Joel Owens · Answer

My NNN value add deals typical 1 year to stabilize but cap rate in double digits for break even.

My goal is to hit 2 to 3 equity multiple over 3 year hold.

Nothing is guaranteed like any investment but I am heavily invested with time to see equity upside on the back end as the sponsor otherwise I keep making even more millions doing the commercial brokerage thing.

Accredited investors invest for different reasons. Talking to thousands of them over the decades they all have different viewpoints on living life and where they want to go and when they want to take the foot off of the gas pedal and coast.

There comes a time when max yield might not be at the top of their list. It's more passive equity growth over time as their jobs bring in mid six or seven figures a year already.

Mike Dymski · Answer

Opportunities are few and far between but they are out there.  I just committed to an offering with a very experienced sponsor that projects CoC of 7.64% in year 1 with no rent increase needed.  Property will have a fixed rate loan at ~5.25% and an annual tax abatement of $3+ million that is helping with cash flow and is creating built in value add that is equal to the equity raise.

Chad Childress · Answer

Thanks. I'll take a look. I have about a 15 year horizon to retirement so I'm trying to take a balanced approach to driving growth now but also stacking deals to build up a strong cash flow position in the future.

Christine Bellish · Answer

Many multifamily deals I've seen out there right now are offering lower COC returns during the hold right now because of higher purchase prices, higher interest rates, higher overall costs (construction, labor, etc). I've personally diversified into other types of investments right now for that reason:

1. net lease - turnkey cash flowing properties occupied by essential business tenants with long term leases and built in rent increases - COC return isn't as high as the value-add multifamily deals of the past, but if I'm going to get lower COC returns I'd rather it be in this space versus multifamily because there's more consistent monthly income, versus the volatility you experience in the first few quarters or years of stabilizing multifamily.

2. development - ground up and office-to-multifamily conversion. With the cost of existing B/C class multifamily properties so high, and immediate cash flow pretty hard to come by these days, it's becoming more attractive to just make something brand new, wait a few years for construction and lease up, then refi to get a major return of capital and stay in the deal to cash flow with a new property, less maintenance/capex issues, higher quality tenants, etc.

If your goal is immediate consistent cash flow you may want to consider investing in other asset classes, like net lease, storage, etc. If you are patient and willing to wait for a bigger payoff, multifamily and development would make sense, or a combination of both - diversification is important.

Also for cash flow - perhaps you should look into participating in deals that are debt structure versus equity - many of these deals are still offering 10%+ guaranteed COC annually - catch is that you don't get the tax benefits or benefit from the upside, you're just a lender.

Will interest rate increase eliminate preferred returns?

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