Interest Rates, inflation and Their impact on Cap Rates

[Ryan Howell]

Not sure the best place for this discussion, but I'd love to get forum feedback on this topic. We invest in small to mid size apartments, class C typically, in B class areas and with value add with the intent to hold long term. We buy for strong cash flow and generally build a lot of equity in the first year. We are debating our long term debt strategy in this inflationary environment. Our purchases are 10-30 units in size, so we are in the commercial space. We typically buy with small local banks and refinance in 12 months after boosting the NOI. The question I have is how everyone is balancing their portfolio in terms of interest rates and term length. Here is how I see our options:

Small banks:  5-10y fixed, 20-25y amortization, little to no prepayment penalties, low interest rates

No-doc/DSCR loans: can fix up to 30 years, but with significant prepayment penalties, higher rates and points

Agency debt (we've yet to use this):  long seasoning required, low interest, 30y fixed is possible

All this considered, we want to go after agency debt eventually, but don't have enough seasoning, so we typically refi with small local banks.

Ultimately, the question comes down to what will the interest rates be when our balloon comes due and how will the property be valued then, if we have significant rate hikes?  Some of my reading indicates cap rates track with the Fed rate (with an offset) assuming stable jobs, population, etc.  If this is true, we could see significant cap rate expansion in the next 5-7 years potentially and even in 2-3 years when we are looking for agency debt, this could have a big impact.  

To protect against this risk, should we pay extra for DSCR loans for 30y fixed to hedge against this risk?

What are everyone's thoughts on how cap rates are impacted by inflation and how would you balance low interest rates vs longer term loans?  What sort of cap rate expansions are you underwriting right now?