All Forum Posts by: Chester Transo

 Thanks Mark.

Any other thoughts, anyone?

Ok so the reality is that nobody really knows what is going to happen to interest rates over the next 5 to 10 year window because there is no crystal ball. And in many ways, this is not the central point of the original post. The question really is not what specific level interests rates will be 5 or 10 years out, but whether or not there is the potential of a new rate environment that will have to be accounted for somewhere down the line and if so, how to protect ourselves.

Other than for short term flippers, it seems to be a relevant question because I don't know what the average hold is for a multi family (say 10+ units) investment but it would be fair to say that many operate in 5 and 10 year windows unless you are looking at a long term hold. Given that, it is a useful discussion to reflect on what steps could be taken to avoid a potential financing problem in 5 years. While I'm not sure that we are looking at the commercial loan explosion that @Mark Whittlesey referenced above, we could at the very least be looking at higher debt servicing costs that will eat up a bigger portion of the available cash flow.

Again, the goal of this post is not to fear monger, but simply to look at rational strategies going forward for new multifamily purchases in a potential new rate environment. While many who bought 5 years ago may have benefitted from the cap rate compression that accompanied these record low interest rates, it seems that it could be a two edged sword as the pendulum swings back the other way. Higher potential interest rates and higher potential cap rates down the road could make some exit strategies (sale/refinance) far more complicated.

@Victor Menasce presented one potential strategy for dealing with this; one of getting all of your investment cash out of the building by adding value and refinancing early, so that you would have little or none of your investment capital at risk down the road. I would like to get more details from you on the actual mechanics of this Victor, as I guess the only question that I have is how to avoid over leveraging, because unless you can get a non recourse loan you will still have some interest rate risk on refinancing.

It seems to me that it really comes down to that old question of how much leverage is good. Obviously, if you pay cash for the building you have zero leverage but are completely protected from the vagrancies of the debt market. You would have the ability to hold on forever, even if the economy and vacancy rates took a hit.

But we all want to use other people's money (OPM) to improve our return on cash invested, especially in the current low rate environment. So where is the balance? Is it possible to have our cake and eat it too?

One potential strategy that I would like to put forward is the idea of banking the net cash flow from the property over the term of the mortgage (say 5 years) to build a cushion that could be used at the time of refinancing to pay down debt, should the interest rate environment turn unfriendly.

So in the example that I used in the spreadsheet in my first post, the net cash after debt servicing over 5 years would total $150,000. This added to the almost $300,000 in principal reduction over the 5 year term of the mortgage would allow me to pay down the existing debt by close to half a million dollars. That would offer some safety from a rise in rates. Obviously if I put more cash down on the original purchase, I would have more net cash flow available to build my war chest, but this would reduce my leverage and return on cash.

So it would seem that it comes down to the old risk/reward thing. As I see it, it's a higher leverage/higher returns versus lower leverage/higher safety scenario.

Does anyone have any other thoughts on strategies to balance risk/return in an uncertain future?

 Thanks Mark.

Ok...I've got another dog in the fight...awesome! 

So let's hear from all the rest of you on this. Do you really believe that there is zero interest rate risk on the horizon or is it just head-in-the-sand hopeful thinking. After all, being an investor is not about having no risk, but about identifying all potential risks and then taking steps to manage it. Obviously you can't manage a risk until hasn't been identified so how about it? What is the future for interest rates in the upcoming 5 year and 10 year windows?

 Hi Ben, Thanks for that.

Can you elaborate on what metric/metrics you use to arrive at a buy decision?

Thanks. 

 Hi Bob. Thanks for your comments.

I recognize that the cap rate is only one matrix to be looked at and that it changes from investor to investor (what you are willing to accept) and property to property (condition, location, upside potential) and market to market (San Fran vs Juno Alaska). I also understand that the real test for a potential property is what internal rate of return and cash on cash return it offers after you have brought it to it's highest and best use.

But I 'm not sure that I can totally throw cap rates out the widow at least as an initial lens through which to filter potential properties. But maybe I've got it wrong. And I'm certainly willing to drop any errant thinking.

So I'd appreciate it if you could give me some example of how you would approach a potential investment. What do you look for in a property? How do you select one property over another? How do you gauge return on investment? What is your strategy for improving a property? What exit strategy do you imply?

Thanks Bob

 Two excellent points Nick. Thank You.

Anyone else have any thoughts on this?

 Thanks Ben, 

So is the consensus then that there is zero interest rate risk on the horizon that we would need to plan for in our exit strategy in say, 5 years or is there a small but manageable risk, or a larger but manageable risk, etc.

In other words, what do you think is the most likely interest rate and market cap rate scenario 5 years out and what steps can we take to manage any associated risk?

 Hi Troy

You are correct that if year 5 NOI was $231,854 capitalized at 5% then the building value in year 5 would indeed be 4.64MM with $640,000 in appreciation profit. The scenario that I was painting however, is one where market cap rates have moved up along with interest rates, so that the cap rate on the sale of the building would be 8%, not 5%. $231,854 capitalized at 8% puts the building value at 2.90MM, so instead of a $640,000 profit you are looking at a loss in value of over 1MM.

Thanks

 Hi Victor.

Thanks for your comments. I find them really intriguing. 

What I think I hear you saying is that the best way to protect your capital investment against a potentially unfavorable interest rate move in the future is to buy at enough of discount to market now, and then add enough value to the property, so you can refinance it and pull essentially all of your capital out of the property. I like that a lot.

So then you have few, if any funds at risk and the property is still cash flowing. Then you really don't care what happens in the future because it's all gravy. I love it!

You said that it's easy to create deals like that. I'd appreciate it if you could give some me more insight into how you create these deals, cause all the deals I've been looking at lately suck. There is just too much money out there chasing deals.

Thanks much

Right, I see how you came to that conclusion now. I was simply saying that if I wait until cap rates rise I could buy the same NOI for less money. In other words, if the NOI is $200,000 and the cap rate was 5% I would pay $4 mill for the building but if the cap rate was 8%, I would only pay $2.5 million for the same building with the same $200,000 NOI. Therefore, if I was convinced that cap rates were going to rise, I would be better off waiting for cap rates to rise before buying because I would pay $1.5 Mil less for the same building and same NOI.

Hope that clarifies things.

Best wishes