5 year loan on apartment building, then rates skyrocket?

Question

Say I buy an apartment building today with a 5 year note that amortizes over 30 years. I'm cash flow positive -- lets just say interest rate of 4% and a 7% cap on the building.

My real question is this - What if rates are up at 9% when it's time for me to negotiate a new note on that apartment building in 5 years. How is that not risky? We know rates are almost certainly going to be a lot higher in 5 years than they are today... Sounds like I have no choice but to sell the building?

thanks,
J

Joel Owens · Answer

Hi John,

When I work with clients on larger apartment buildings the local banks tend to give  only 5 year terms. On large loans these do not make sense unless you are repositioning the property and have bought at a low price. Also some apartment buildings are condo conversions where you can sell them off one by one from where they were apartment units to lower the note balance.

In addition to selling you could refi or bring on a partner to retire the debt.

Usually we will look to a regional bank as they will give 7 to 10 year loan terms instead of the five. The five year loan term is crap and unless you know you have a sure exit I don't recommend it. You want at least 7 to 10 years to be able to pay down the loan balance and  throw some more cash flow at the property to pay it down. These people loading up on short term debt without an exit plan because it's easy to find will probably be in a world of hurt in the coming years.

Michael D. · Answer

Tevis Verrett, what makes you think there will be any appreciation at all, especially considering the higher 9% prevailing rate that we're assuming? If anything, higher rates push prices down. And why would an investor pay 14% just to acquire a cash-flow negative building? If the building wasn't cash-flow negative, then John's problem wouldn't be a problem.

John R., I think you're right to be concerned about this exact problem. I have one of these today myself, and my belief is that higher rates will be driven by inflation, and that same inflation will be pushing my rents northward faster than my costs. I hope. And if not, maybe I can get a new loan with a longer term than what's left on the existing, thus keeping my payment down. Otherwise, yes, it's going to be a problem. Worst case, I always have it in the back of my mind that I need a way to come up with the payoff somehow.

Michael

Ben Leybovich · Answer

John R.  Understand the game a bit.  Who controls all RE - the banks.  How?  They lend at low % to entice us to jump in, but then the FED cycles the rates up and exactly what you described happens - people foreclose and banks are only too happy to lower the rates and entice other newbies to get in.  This has been the game forever - understand this :)

Talk to your bank about a "cap".  You will pay points up-front, but this will allow you to cap the interest rate increases to say 2% per and no more than 6% for the life.  Once you know this "worst case scenario" you can use the CF to positively amortize the loan to engineer your principal balance be at a level whereby your payment will not increase at the worst scenario interest rate.  Caps are not cheap, but the safety is worth it.  If your bank won't do it, find a different bank.

Michael D. · Answer

Tevis Verrett,

All else being equal, higher rents produce more income, which increases the value of the property. But all else is NOT equal. We're talking about a world with much higher interest rates, most likely forced by inflation. That means costs will be rising as well. You might see higher income, but then again maybe not.

Even if income goes up, there's still another important factor in determining property value: cap rate. In general, cap rates follow interest rates. An 8% cap rate looks great with treasuries at 1-2%, but horrible when treasuries are at 6-8%. It is very possible that even with higher income, the value of the property could remain stagnant or worse. I'm not saying that it's a certainty, just a real possibility that OP should consider.

I'd be interested in hearing from others active in RE way, way, way, WAY ;-) back when interest rates were over 10%. Were the cap rates then much higher as well?

Joel Owens · Answer

I forgot to mention that national banks have some great loan programs but are much more picky on the areas they will do a loan, demographics, per door selling price, etc.

They only want the best of the best where smaller banks will look at other properties.

Eric Claxton · Answer

Couldn't agree more Andy- Multifamily will remain one of the safer sectors of active commercial investments for the near future in my opinion (hence the reason we continue to invest. ha)

Kyle Hipp · Answer

I think the key here is to get a 5 year baloon commer isl mortgage as you described bjt ammortize it over 15 years instead of 30. This way come 5 years out you have a good chunk of equity between the down payment ( or great purchase price and prin  cipal paydown. These shorter terms pdovide you with many more optionz az time moclved on.

Mike H. · Answer

I agree with some of the comments on here that say they don't think interest rates are going to rise that much that fast.

Do you think unemployment will be dropping down to 3% any time soon? With the global economy, I think its going to take some time for us to be booming to the point that rates will be at that 9% mark.

And the fact is, you are investing in real estate. The returns are better than cd's or bonds because you have some risk.

You mentioned you were afraid that rates might go to 9%. Well what if the prices drop down to where the building is only worth half its value? You won't be able to requalify then either - not with that LTV.

You have to be a bit of a risk taker but I always believe they should be calculated risks. And I don't see rates hitting 9% or 8% any time soon.  Could they hit 7% in 5 years? Sure.

But, by then, your rents should be higher. And your principal should be less. So you may lose some cash flow relative to where you are at in year 5. But you'll still be fine.

Jeremy Cyrier · Answer

You would probably want to sell the building, but would need to figure selling it at an 11 cap or higher if that were the case.  While I don't expect interest rates to rise that dramatically in that short a time period, it is important to plan for a higher interest rate environment in 5 years.  Make sure your rents are set, operating expenses are lean, and be ready to pay more money in interest for your loan that you do today.

Andy O. · Answer

Late to the discussion here - but this is my biggest concern with a apartment purchase in this environment.

This eases my mind, at least a little bit: http://www.freddiemac.com/multifamily/pdf/mf_property_valuations.pdf

Conclusion
It is an unusual time for multifamily fundamentals and capital markets. With interest rates low and the stability of cash flows from rental properties attractive, the asset class is getting more attention than usual. On the surface, it is easy to raise red flags when looking narrowly at some factors, such as cap rate, impacting the market. Yet, with a more broad view, it becomes evident that current valuations in the multifamily market are not at the edge of a cliff. Interest rates will almost certainly rise in the medium and long term, which will have a downward affect on asset valuation. However, there are offsetting factors (e.g., rent growth and new multifamily supply)that will push values up. With the understanding that today’s valuations are justified and forecasts of fundamentals are strong, market participants can be confident that the positive attention that the multifamily sector has drawn in recent years is not doomed to a rapid shift downward and that multifamily markets remain healthy.

5 year loan on apartment building, then rates skyrocket?

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