Cap Rates and Interest Rates/ What the *%%€*+??

Question

Can some with long term experience explain how interests and cap rates can be inverted, stay inverted and investors keep making money?

Here is another way to ask this:

If it cost me 6.5% to borrow money but the cap rate is only 5%, —— how does it make any sense to buy under those conditions?

CDs are at 4.5% —- Why is would I ever take on all the risks and headaches to make a mere 5% over 4.5% with zero headaches and zero risks?

Can this stay with way for very long? What do experts and experienced investors see up ahead with this situation?

Can anyone help me grasp what is happening and where this market is headed?

Thanks I’m advance.

Ben Firstenberg · Answer

When your interest rate is higher than your cap rate, they call it "negative leverage" in the commercial lending space. There are ways to make money, but it's hard.

When this happens, commercial players aim to deleverage their assets. So when they'd normally borrow at 75% LTV, they're now borrowing at 60% or even 55%. This is the only way to make commercial loans work at these interest rates. Commercial lenders will be looking for at least a 1.25x DSCR and when you're negatively leveraged you're not going to hit that unless your leverage is low. People are doing cash-IN refinances just to lower their leverage and hold on to their properties.

You can think about it like this: The cap rate applies to the entire value of the property, but the interest rate only applies to the debt. So if your value is $1M, cap rate is 5% and interest rate is 6.5%, you're making 50k in NOI and your interest payment at 60% leverage would be 39k ($600k*6.5%).

To answer your other question, no it's not sustainable. Cap rates will HAVE to move up OR interest rates will have to come down. Experienced institutional investors right now are doing everything they can to just ride out the storm. They're looking for maximum flexibility.

The commercial space is very frozen right now. Nobody really wants to buy or sell. Once the volatility with interest rates stops, people are expecting the market to open back up.

Henry Clark · Answer

Another approach to look at this and other angles.

Pick one.  Let’s use $100,000 and your 5.5% a year ago or 6.5% today.   There will be less competition today.   Would you rather pay 6.5% on $100,000 or 5.5% on $110,000?  Do the math.

You can’t ever reduce the extra $10,000.   The interest rate if it goes down from the 6.5% in the next 13 years you’re ahead. You refi.  Can’t do that with the $10,000. If the market interest rate goes up, your ahead.

Plus you have other investments.   Hopefully you stuck with the same finance group and didn’t shop all over for rates.  Now this one bank can look across your portfolio which should have increased equity and this will help leverage the new investment.   If you used several finance companies, then your collateral is tied up and you don’t have easy access to it.

Immanuel Sibero · Answer

Interest rates and asset valuations are generally inversely related, this is in the Fed's playbook, no?

Cheers... Immanuel

Henry Clark · Answer

The prior post was suggested ways to look at your investing.

What did we do?  First we are in Self storage, subdivision lot development, and getting into flex buildings.       1.    We sold our largest debt position and took profit off the table.  Paid down debt, bought some land and held some cash back.    2.  Bought some land at the right price.   Waiting to build once costs and outlook are favorable.  Sitting tight.     3.  Developing 75 acres into 25 country lots.   This is a really bad time to start a subdivision.  But we are going after higher wealth home builders.   Still a housing shortage here.

Henry Clark · Answer

Here are some ways to look at it.   But it depends on your risk/reward weighting and outlook.

1.  Interest rates go up your asset value goes up.

2.   Interest rate goes down, you refinance.

3.  Interest stays the same you raise rents.  You can tell the degree that is possible before you buy.

4.  Interest stays the same you review and challenge the underlying NOI costs in the cap rate.

5.  Any of the above, buy for value add and appreciation.

6.  Pick investment areas that drop hard and comeback roaring.   Example Phoenix and Las Vegas.  You’re in Arkansas look at resort type property areas.  Wait and be prepared for the moment in about 6 months.

7.  Don’t buy.   Either prune your existing investments or value add them.

Cap Rates and Interest Rates/ What the %%€+??

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