If rates rise and economy slows

[Mike Migliaccio]

What is the downside to purchasing a multi unit (28 units) building (currently approx 90+% rented),  if rates rise, and the economy slows? I heard on podcast 3 that the guest lost millions in the 2008 downturn. I am guessing that can only be due to be over-leveraged ..or having tenants move out leaving the investor to pay the mortgages. Can anyone comment on this type of a scenario as we are currently looking to invest approx $2.2MM in our second multi-unit apartment building and don't want to make a mistake with the likely hood of a rate rise etc. Thanks 

Mike

[Brian Burke]

Being overleveraged in the face of economic weakening is a sure way to incur losses, but as the guest of podcast #3 I can tell you how it happened to me in 2008.  I had a hospitality property that I really wanted out of just before the collapse and the only buyer I could find could only do the deal if I took land in lieu of a down payment.  So I took the land, and in the wake of the housing collapse land values became less than zero.  That was painful, but it could have been worse, the buyer of my property ultimately lost it in foreclosure.  I'd rather have worthless land than a foreclosure.  Moral: stay out of land and you'll probably be OK. 

My biggest pain on the multifamily front was a property that had high vacancy due to all of the job losses, resulting in the gross income only covering the operating expenses.  I ended up servicing the loan out of my own pocket for a couple of years--another $400K down the drain but ultimately the rebounding prices will allow me to recover that when I sell someday.

Moving on to your questions, which are two distinct questions with different answers.  What if rates rise?  If you have fixed-rate financing your biggest exposure is the prevailing rate at the time of maturity.  You might have to refinance into a higher cost loan if you don't sell.

Some people have said that if rates rise, cap rates will rise and that will cause the property's value to decline. Not necessarily true for two reasons. First, the spread between cap rates and the 10 year UST is presently historically wide. While interest rates and cap rates tend to trend in the same direction, they don't necessarily track in parallel. A slight rise in interest rates could result in level cap rates and simply a compression of the UST-CAP spread. Thus, no change in property value. Or, rates could rise say 3/4 of a percent and cap rates only 1/4 of a percent for example. Or not, there's just no way to know for sure. The second reason is that higher NOI due to rent growth could negate the loss of value resulting from a higher cap rate. In this case it's a headwind to appreciation, not a knock-out blow. Presumably, interest rates increase because the economy is strong, and strong economies tend to favor rent growth.

As to your second question about a weak economy, this can hurt you much more than interest rate risk (still assuming you have fixed-rate financing).  Job losses can and will result in increased physical vacancy, higher credit losses and skips, and more concessions.  Rising economic vacancy will impact your income and your cash flow.  It's even possible to have declining rents (gasp!).  How bad it gets will determine how hard you get hit.  You could end up like I did on that one property where the income drops so low that it only covers payroll, maintenance, property taxes, etc or you might get lucky and only experience less cash coming into your pocket than you are used to.

Rising rates AND a bad economy would be an anomaly and likely wouldn't last, as monetary policy would likely reverse rates in an effort to stimulate the economy. 

Self defense: Buy with conservative assumptions for economic vacancy. Forecast annual income for each year during your expected hold period and have a growth factor in your cap rate. For example, if similar properties are trading at a 6% cap rate right now, you might forecast your sale at a 7% cap rate in 10 years or some other number depending on your cap rate philosophy. Calculate your exit price and see if that's a scenario you can live with, and if you are so inclined, run a sensitivity analysis to calculate your IRR with a variety of income growth factors and exit cap rates.