This is about as good as it gets for commercial.
If you’re new to this blog, you’re probably expecting some sort of cheerleading saying why commercial is the best asset class to own now, similar to like that of the National Association of Realtors®.
But I’m here to tell you otherwise. Yes, we’re cynical at best, and paranoid at worst.
Before I get too ahead of myself, the drivers for commercial are materially different than that of commercial. Residential real estate is more politically-driven as owning a single-family home is, for most American families, their largest store of wealth, second to their 401(k)s and IRAs.
And that wealth effect drives sentiment and hence votes.
Commercial real estate values are driven principally on income, and specifically how that income is compared to other investment classes using the 10-year treasury as the benchmarks.
And when your debt service increases, that will affect how much cash flow a commercial asset will throw off.
If interest rates are low, people can afford to pay more for a building. This is why people paid 5% caps on multifamily assets that should have traded much higher. The 5% was seen as being really attractive as compared to the risk-free rate that the 10-Year Treasury Note was giving them.
To make it even more appealing, low interest debt was used. When you mix low interest debt with overvalued assets, any increase in mortgage rates will light a fuse.
Love him or hate him., the Trump Administration has set the economy on fire. More people are employed. Wages have increased. And there is wage inflation now for skilled labor.
And when things get too hot too fast, you need to tap on the brakes a bit.
This is when the Federal Reserve will raise interest rates. And when interest rates rise, that affects how much you can pay for a commercial asset. Say a multifamily building.
But what happens when interest rates rise? All those who over paid retail because the debt was easy to get will soon be laying in a pool of their own sweat.
Rents have peaked in most cities. You can’t arbitrarily increase the rents as that’s become a disproportionate – in most cases 50% – amount of their after tax income that a wage earner pays. This is especially true in lower income Class B or C multifamily assets.
Concomitantly, soaring rental costs have rapidly eroded overall disposable income for the US middle class.
The Lit Match
And if you can’t raise the rents, or rents fall or you need to give incentives to new tenants, that could affect the DSCR, triggering an issue with the first trust deed lender, who may want additional equity to secure against their collateral. Rents don’t grow to the sky.
There’s only so much after-tax income a family or individual can pay on rent.
Of course, if there is a sale, these equity investors will probably not be made whole because if interest rates rise, cap rates have to rise to, and that means the building will be sold for a lower price than what it was purchased for. No one is going to pay a 5% cap for a building where all others are for sale or are trading at a 6 or 7 handles. In this scenario, the capital structure resembles a lit match, with the equity being burned first, then the mezz, then the debt as the flame approaches your fingers.
Anyone who acquired assets over the past year or two and counted on a continuation of ultra-low rates and cap rates was just foolish.
It’s true, it’s the debt that floats all boats, and as Warren Buffett has famously stated before “you never know who’s been swimming naked until the tide goes out.”
So right now, we’re going to call the top.
There’s a lot of chatter on our deal desk from other institutions putting their pens down for now as they’re waiting for assets to re-trade. Things aren’t selling as fast as higher interest rates equates into more expensive debt service and, hence, no more reach loans as equity investors don’t want to get pinched on the exit.
If a deal hinges on rates staying close to where they had been, then the deal makes no sense. You need to at least project that interest rates could be as much as 7% in a few years when you go to exit.
If the deal does not make sense under that scenario, then maybe you need to reconsider the project, or find ways to cut costs. Rate alone should never be the determinant factor in a deal as they are unable to be forecast with any level of accuracy over five years, and there is nothing you can really do about it.
For those raising capital, your timing couldn’t be any better.
The Fed could hike three times more this year. Just because interest rates that are linked to borrowing money are going up, doesn’t mean that the banks are obligated to pay you anything more on your savings accounts. People are still desperate for yield, the same as its been for the past 10 years or so.
In the smaller balance space (loosely defined as 15mm or less in value), you’re going to see a lot of weak, inexperienced operators get pressured from their lenders as loans get called due because the rents have dropped, or prices have gone down. Of course, another reason why using private capital is so crucial to use when buying assets.
But I digress.
Be on the lookout for the next blog on how to play this. Ask the hard questions to any sellers as to why they’re selling:
- How long has this building been on the market for?
- Who’s managing it?
Those questions will tell you everything you need to know about why the seller is really selling.
(NOTE: Want access to my business vault? Right now I’m offering access to my systems, strategies, templates, trainings, and recordings. It’s all included in The Investor’s Syndicate, and is available to you here.)