CONSERVATIVE planning for the future of your apartment deals

[Marc C.]

We've been blessed with low interest rates, even for commercial properties, for several years now. Right now, http://www.crefcoa.com/apartment-rates-main.html shows apartment rates under 5% for almost all types of loans. Short-term loans are under 4%.

It is NOT a coincidence that cap rates have compressed over the same time. Low interest rates allow for lower monthly payments and therefore higher cash flow (cash-on-cash returns). Brokers and sellers know this, and they have TONS of demand for multifamily, so they therefore charge more for their properties and investors will still be able to earn higher cash returns than they could in most other investments. It's even possible to make a property cash-flow at a 5% cap rate if the LTV isn't too high and the interest rate is low enough.

I read lots of apartment deal sponsor pro-formas. Most of them say "hold time of 5 years." They therefore get financing which has a term of 5 years, meaning they will have to refi or sell at that point. They also typically assume they will be able to sell (or refi) at a lower cap rate than they are buying it at (at least for value-add/turnaround deals). For example, they buy at 8%, turn the property around, and assume it will be worth a 7% cap rate as a result. That calculation almost guarantees appreciation, which results in a high IRR (total property return) over the 5-year hold time.

But what if you have to sell/refi at a HIGHER cap rate in 5 years? Does the deal still make sense on an IRR basis? At the same time, what if interest rates rise to 6.5% in 5 years (not exactly a huge stretch from where they are now)? Will the deal still offer a 10%+ cash-on-cash return? Will there be any appreciation if cap rates rise 1-2 percentage points between now and then?

Higher interest rates and higher cap rates are inevitable, at some poinit...they can't go much lower than they are now. The coastal markets have now topped out on multifamily rents and values. It is likely that condition will spread inland over 2017 and 2018. So the market is softening even BEFORE interest rates rise. What will happen if rates rise 1 percentage point over the next 5 years? 2 points And, God forbid, 3 points? What if 5 years comes and we're in the bottom of the market, due to overbuilding, poor wage growth, etc.?

To be conservative and prepared, I'd like to see investors calculate their selling/refi cap rate 1-1.5 percentage points higher than they bought it at. I'd also like to see folks get 10 year financing rather than 5 year, allowing the investor to wait until times are better if they aren't so great in 5 years. (Yes, the interest rate on the loan will be higher, but if the deal doesn't make sense with 10-year financing rates, it's probably too skinny of a deal to begin with.)

What are YOU projecting for your deals? Are you taking a conservative approach and expecting times to get worse? Or do you think these good times will more or less continue forever?