Interest rates are one of the key financial factors that we as investors have to consider when looking at the viability of a potential deal. The frustrating part is that it’s an element that is hard to forecast, and is definitely out of our control. Higher interest rates mean higher borrowing costs, lower cash flow, and increased risk of default. Interest rates can be directly correlated to the value of a property. So we have to be incredibly thoughtful in how we approach the risk, and now the reality, of rising interest rates.
Here are six concepts and strategies we consider as tools in our strategy planning toolbelt.
1. Choose less risky investment strategies
We primarily target class B and C properties with a value-add opportunity. We don’t want “deep value add” turnaround projects where the going-in occupancy level is horrible and the buildings are ready to fall over. We buy properties that are already performing reasonably well but aren’t at maximizing their potential. By avoiding the total turnaround projects, we build in a cash flow cushion with the existing rental revenue. If borrowing costs are higher, we ensure this cushion can accommodate the impact. When there’s a lot of interest rate risk in the air, new construction and war zone projects might just be too risky.
2. Borrow less
Leverage can be a incredibly powerful way to maximize returns with less equity at risk. But over leverage is likely the number one undoing of investment projects. In times of uncertainty or higher borrowing costs, it may be wise to decrease the amount of funds borrowed from the bank, and increase the equity position from General and Limited Partners.
3. Appropriate Use of Variable and Fixed Rates
Variable, or floating interest rate loans tend to be less expensive in the early years of a project compared to a fixed rate. While it can feel comfortable to have a fixed rate, we have to use them judiciously since they can severely impact the performance of the property. Most of our properties are sold in under five years, with the business plan of improving the property being complete within the first two. With the short time horizon in mind, interest only type loans, or variable rates with a rate cap in place can be very appropriate.
As you’re evaluating investment opportunities, more important to consider than the potential of minor rate increases is over leveraging a property and the inability to refinance when needed.
4. Create a detailed sensitivity analysis
A sensitivity analysis is shown in every investment summary we create. The goal of this analysis is to show the impact of variables like occupancy, rent rates, cap rates, and of course interest rates. It’s shown in a grid or matrix style and allows for an easy grasp of projected returns as a result of various scenarios. This exercise is an effort to ensure that we’re satisfied with the returns as well as the sustainability of the project in worst case scenarios. We want to know where the breakeven points are to know what the property can tolerate before it begins to incur losses.
5. Reserves, Reserves, Reserves
We went into one of our most recent projects with enough cash reserves to operate the property at break even for five years with a 50% occupancy rate. In Phoenix. Phoenix occupancy rates have never been that low. That’s doomsday scenario. But it makes us and our investors feel really great that we know we can cover surprises as they come and not be in a position of a forced sale, a default, or requesting more cash from the investors.
Fortunes are made in downturns, and it’s often by the people with cash reserves buying assets from people who were desperate to sell. We never want to be forced to sell in a bad market. Reserves are what provide the ability to ride out the storms.
Yes, this is a viable risk reduction strategy in times of uncertainty. Rates and markets can change quickly, and our operators must be willing to adapt their business plan and timelines in response. It’s common for our operators to seek a refinance option once a turnaround plan has been executed and the value has been increased, and then enjoy operational cash flows for a few years. However, as market conditions shift it may make more sense to sell the building and reduce the investors’ exposure to rising rates or market decline. That might even mean selling the property before the business plan is fully executed.
Interest rates rise and fall. Markets expand and contract. The only constant is change. Uncertain times don’t need to mean retreat and stuff cash under your mattress. With cautious forethought and specific planning, risks can be managed and money can be made.