Delve into the intricate dance between cap rates and interest rates and their profound influence on the commercial real estate landscape! Join us in a thought-provoking conversation about strategies for investors to pivot and prosper regardless of economic fluctuations. So, if you want to navigate the complexities of commercial real estate in any market condition, tune in to this episode!

Key takeaways to listen for

• [00:57] How shifts in interest rates directly impact property values and what this means for investors
• [05:47] The challenges and opportunities presented by the historic rise in interest rates
• [07:42] Strategies for staying resilient and successful amidst changing market conditions
• [10:39] Lessons learned from an investor about the risks of not diversifying debt structures
• [13:17] Predictions on the future and impact of interest rates for the rest of 2024

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When you're investing in a real estate property, you're marrying the property, you're dating the interest rate.

So even if they would rather be ahead of the curve and lock in debt, that's a little bit more expensive than to wait until rates come down, have more buyers in the market, and the price is going to go up and likely have multiple offers.

Welcome to Truly Passive Income. I'm Neil Henderson.

And I am Clint Harris.

I wanted to jump on today and talk about cap rates and interest rates.

It's very important for someone who is investing in commercial real estate to have an understanding of how interest rates affect cap rates, because cap rates affect the price of real estate, has a huge amount of effect on commercial real estate values, cash flow, and therefore your investment. So it's very important for you to understand that. So I'm going to just fire away at Clint and start this discussion.

So, Clint, can you explain why it's important for someone investing in commercial real estate to understand the connection between interest rates and cap rates?

Yeah, absolutely. So, number one, there's a relationship, it's basically an inverse relationship between the interest rate and the value of the property.

The higher the interest rate is going to go, a lot of times it's going to compress the value of the property because it costs more for someone else to be able to afford the debt to buy that.

But basically, we're in an interest rate environment right now where with commercial real estate, we're anywhere from seven and a half to eight and a half percent interest, sometimes as high as 9% right now, which in the grand scheme of things, traditionally, looking back to when my parents were buying houses and it was 13 to 15%, it's still not that much. However, we all have a little bit of recency bias coming off of the last few years when interest rates were rock bottom.

In fact, I would argue they were rock bottom for too long and money was too cheap and it really heated up the market. But basically, people are looking at interest rates now and they feel really high compared to where they were recently.

And when you look at a commercial property in particular, people typically are a lot of times are buying with some kind of bridge debt or variable rate debt that might adjust up or down with that interest rate. Hopefully you're getting fixed rate debt.

But essentially what happens is there's something when you look at a commercial property, one of the ways that you give value to that property is through something called the capitalization rate or the cap rate. And basically the cap rate is the net operating Income divided by the cap rate gives the value on what the property is going to be.

So right now people are buying, for instance, we're in the self storage business. People are buying self storage at a 7 cap or an 8 cap, depending on if it's in bad condition.

And with the cap rate, it's the opposite of what you think. The lower the number, the higher the value on the property is. That means the more desirable it is.

So a 4 cap, the same property valued as a class A facility valued at a 4 cap, is wildly more expensive than the same property valued as 6 cap.

And basically what happens is when the debt is really good and meaning that companies are able to borrow money for really, really cheap, they might pay a four or a four and a half cap because they don't really have to have high interest reserves. They can get into the property, it's cash flowing, they can lock in fixed long term debt and it's going to be a great deal.

And so because of that, when money's cheap, there's froth in the market and people are hungry and everybody's pouring in and it becomes seller's market.

It's great for the sellers because you have so many buyers competing to try to get something and lock in that cheap long term debt, that cap rate just marches down. It goes from a six to a five and a half to a five to a four and a half, sometimes a four. And it gets crazy as the interest rates go up and they rise.

First of all, the people that have variable rate debt are exposed and have to scramble to reposition.

And when we have something like just happened, the fastest rate increase in history, a lot of people got caught with their pants down and didn't have the interest reserves that they needed. And a lot of projects have really, really struggled and some have gone down.

But basically what happens is as that interest rate goes up, the cost of the project goes up, the cost of the debt goes up, the cost of the interest reserves goes up.

Maybe before you had to have, if it's a development type project, you might have had 2 to $300,000 set aside during the period of which you're doing construction on a project and then you're going to lease the project up.

So to the point of it being cash flow positive, well now if the interest rate has just shot up, that same project, you might have to put 800,000 to $1 million into your interest reserves just to pay for the debt during that same construction period.

And that lease up period, that makes that project much less desirable, which means you're willing to pay less for it because that debt is so expensive. So as that interest rate goes up, you'll find that the cap rates go up as well.

Remember, as the cap rate goes higher, the value of the property is less.

So basically, whatever that cap rate is going to be, let's say you take the net operating income of a property divided by a cap rate, you divide that number by four, it's going to be a much bigger number than if you divide that number by eight. Right. So as the interest rates are going up, the property becomes less desirable, and the cap rate is going to go up as well.

The cap rate determines at what price you're going to be able to sell the property. So that's where we are right now. We've had interest rates that are. They're not sky high, but they feel sky high. Because we all have the recency.

Buyers have a lower interest rate, but because of that, the cap rates have gone up with it. Neil, I'll fire a question back at you. The more important thing is what's going to happen with interest rates.

We all know at some point they're going to come down. So I'm interested to hear prediction on that. We can talk about that later if you want.

But more importantly, when the interest rate comes down, what happens to the cap rates, what happens to the price of properties, and what happens in terms of the amount of buyers in the market that are interested?

As you start to lower the interest rate, the cap rate is going to tend to come down and there's also going to be more buyers in the market, which is going to intend to cause the value of the real estate to go up. It's a tough position that a lot of residential buyers in right now are not in the market.

And we're mainly talking about commercial, but this applies to commercial as well.

There's a lot of people that are kind of sitting on the sidelines waiting for interest rates to drop because they don't want to pay the same mortgage. They don't want to pay that high mortgage to buy a property that a year ago cost $1,000 less a month to buy.

The problem is the moment those interest rates start to drop, more buyers are going to enter the market, which is going to drive up prices, and they may be stuck in the same position. There's an inverse correlation between high cap rates and the value.

That's something I really want people to take away from this discussion is the inverse correlation between high cap rates and the value of Real estate, the higher.

The interest rates go, typically the banks look at it as the more risky the investment as well. And so a lot of times with the interest rate change, you'll see things like the LTV will change.

Like a few years ago we could do a self storage conversion project at 3.5% interest, at 80% loan to value, and now we're underwriting for eight and a half, but it's typically more like 6.75 to 7.5% interest and it's 65% loan to value.

So we have to bring 35% of the project to the front just to pad the stats to make it a more secure investment because the bank looks at it as it's starting to be a little bit shaky with the high amount of interest reserves that are there.

So the banks are always going to protect themselves and put themselves in a position where they think that you're still going to be able to pull it off. As the interest rates go higher and the cap rates go up, a lot of times the LTV will shift with it.

Typically what you see is you see a lot of buyers backing out of the market.

So besides what we just talked about, as there's going to be a lot more buyers coming into the market when things change, I would also say that there are a lot of people that do have properties that they were probably going to move last year or this year or maybe next year.

They're waiting for that interest rate to come down a little bit because they know when the interest rate comes down, the cap rate comes down and that affects their ability to juice the price on the property significantly. Here's a lesson that I think is really important for anybody.

We have a lot of people that we talk to that listen that invest in residential or smaller properties. Right. I started out with a lot of duplexes, triplexes, quadplexes in airbnbs and anything 4 units or less is considered residential.

And it typically it's valued based upon the bricks and the sticks, sometimes the short term rental projections on the property. Anything over that typically is going to have a value that's based upon the net operating income of a property. So that's why it's really important.

If you've got a property and you're over the four unit limit, or especially I've got a quadplex that I'm selling right now and the buyer is using a commercial loan because it's right there on the limit, right? It's right on the cut off. It's four units. It could be Residential, it could be commercial. He's using a commercial loan on that.

So leading up to that, the smartest thing you can do with a property like that is if you know you're going to liquidate that project in a year or two, whether it's 4 units or 40 units or 140 units. Leading up to that, you want to maximize the net operating income, which obviously means you want to increase the rents as best you can.

But it also means you want to reduce your expenses and you want to cut advertising dollars back if you don't really need to cut the maintenance back. And get yourself in a position where you're stabilized because that net operating income divided by that cap rate is going to determine the value.

One of the things that has impacted commercial real estate over the last year is the rapid rise in interest rates. And as Clint alluded to earlier, interest rates are not historically high.

It was historic rise in interest rates that happened incredibly quickly and it caught a lot of borrowers flat footed, which has created some instability in the commercial real estate market.

You've got some operators are challenged by their new interest rate and they're having to stopping payments, they're having to renegotiate their loans and things like that, which has really impacted a lot of that. Plus Covid, especially with the office market, has impacted a lot of community lenders.

And so community lenders have really tightened up what their lending standards, which.

And anytime you have that, you have like all these commuter banks are now suddenly not lending, or they're requiring a larger interest reserve or they're requiring a larger down payment, whatever, again, that further restricts the pool of available buyers, which depresses the price of commercial real estate and it slows down development.

No, I think it makes a lot of sense.

One thing I will say, and I know that we're going to head in a different direction about the way that we buy properties and the way that we value properties. I think this is a really good time to talk about.

Something that came up in discussion when you and I talked to an investor a couple weeks ago is that there was an investor that had invested in eight syndication deals. Not with us, with various operators, most multifamily, but a few different categories.

In talking to this guy, he was strategic about the way that he invested. And I think there's a really important lesson here for anyone that's thinking about a limited partner position in syndication.

He invested into eight different deals, different geography, different operators, and a couple different asset classes. So he thought he was extremely well diversified. When I talked to him.

These were his first eight LP investments and he had six of them that had stopped distributions, one of them that had stopped distributions and then done a capital call. And one of them is that stop distributions, did a capital call and looks like it's going to be a total loss and it's going down all the way.

Because even though he thought he was diversified across asset geography and operator, he never really took a really close look at the debt structure. They all had some level of the same form of variable rate debt.

And when you had that historic rise in interest rates, they all got affected in different ways by having recourse variable rate debt that was not fixed.

And because of that, even though he had what he thought was diversification, the bedrock that he had built his portfolio portfolio on eroded out from under him. And everything across his portfolio had the same exposure because he didn't dig in on that.

So I think there's a really important lesson here that you want to look at the operator, the deal, the track record and everything else.

But you better take a look at everything that you've got and figure out what's the depth structure, is it variable rate, is there bridge debt and is it recourse or non recourse and find out exactly what that looks like.

Because you literally can have a multifamily project in Miami, a vineyard in Texas and an RV park in Ohio that all have the same risk exposure if they're using similar types of variable rate debt. So I think there's something important there.

Now we've talked about that a lot over the last year and we've talked about the diversifying cross asset class geography and operator, but also being very mindful of the kind of debt all those projects are all taking on and diversify across debt as well. So what us to get our crystal balls. I know you've got yours hidden there below the off screen there.

And we want to talk about what we think interest rates are going to do over the next let's call three quarters. Like our interest rates are going to drop before the end of the year. And when I think that they are.

Obviously we still have some work to do in terms of inflation and the unemployment numbers. There's a meeting today. So this is Wednesday. We're recording this on Wednesday, March 20th. If they drop interest rates today, I will eat my shoe.

It's not going to happen. It's absolutely not. However, this is an election year.

So my prediction, something that miraculously seems to happen when we're in an election year and Especially if things aren't looking great for the incumbent candidate.

This amazing, miraculous phenomenon happens where gas prices start to come down, interest rates seem to level off, and all of a sudden everything gets really rosy. So my anticipation would be, yes, I know that he can't make that call, that shot, whatever you want to say.

I do believe that interest rates are going to come down towards the end of this year. I think that more people thought they were going to happen in Q1 and then it was Q2 and now it's Q3.

Could be, but I think Q3, Q4, it's either going to happen before November or leading up to that. There's going to be a lot of really good news and a lot of people are getting excited.

The stock market is going to go up because everybody knows that interest rates are going to start coming down relatively soon. So people are going to start moving, and especially in real estate, it's going to have a pickup.

Because everybody knows that even if you know they're going to come down in the future, when rates come down, prices are going to go up. And when you're investing in a real estate property, you're marrying the property, you're dating the interest rate, Right?

So even if they would rather be ahead of the curve and lock in debt, that's a little bit more expensive and know that they're going to be able to refinance in the future than to wait until rates come down, have more buyers in the market and the price is going to go up and likely have multiple offers.

So my prediction is that they do come down, they come down later in the year, but before they come down or right as they start coming down, there's going to be a little bit of a bump in the economy because people are going to start moving and they want to get in before the properties do start to switch from a buyer to a seller market. So Q3 or Q4, I'm saying end of Q3.

End of Q3. All right. I predict summertime's coming up. Gas prices have already kind of stick up a little bit.

Biden has announced that he's trying to refill the strategic oil reserve. There's also some continued disruption with Russia and Ukraine. I think gas prices are going to put pressure back on the economy this summer.

I think it's going to make it really hard for the Fed to justify lowering interest rates. Gas prices have a huge effect on the numbers that the Fed looks at to determine whether or not they want to lower interest rates.

So I predict they'll go down, but I think it's going to be Q4 at the earliest. I tend to agree with you that they certainly would like to see them come down in election year, especially for the incumbent.

But I think the last CPI numbers that came out were slightly higher than they expected. And I think as long as those numbers are not coming down to the level that they want, they're just not going to risk juicing the economy again.

That's my prediction.

I love it. This is a bait and hook. This is how we make sure that people tune back in in six months to hear how you're wrong and I was right.

So it's exciting stuff.

Listen, I wanted to finish off because this is something that is important I think for people to understand about us is we don't buy on a cap rate. We're buying vacant buildings. There's no cap rate. We're buying on a price per square foot.

We do care about the exit cap, obviously, and that's what we're usually underwriting for a higher cap rate than sort of the industry average right now we're usually at least probably 100 basis points higher. So we obviously got investors interest in seeing interest rates come down because that's going to increase the value of our property.

But we're typically creating so much value out of the gate that it's not a killer. I mean, unless interest rates just continue to just go up and up and up, which I don't think they will do, we're still in pretty good shape.

I'm happy where we are.

Yeah, absolutely. I think that's the value of an asset class conversion or any type of really heavy value add is that we're not buying on a cap rate.

We're buying buildings that they're basically worth what we are willing to pay for them. Because there's very little appetite for big box retail space. We are converting them to a different asset class.

We do sell and refi on a cap rate but because we have that massive value swing and typically it's stabilization, we're sitting at 30 to 35% LT. The thing that's going to change is like yeah, the terms and maybe instead of refining a property to 60% LTV, we refinance it to 50.

We never go over 60 anyway. But it's going to be 50, 55 or 60% LTV because we don't want to stress the asset.

We want to refinance, give ourselves and all of our investors a nice payday, but allow the asset to continue to cash flow.

So because we're not buying on a cap rate and we have such a value swing, we can move our number around where it needs to be to fit within the confines of what the market is giving us. We do sell them. We refi at a cap rate.

But if we want to just wait a few, an extra year, extra two years, and let it continue to cash flow until the market is in a more favorable spot to refi, we can do that. And I would say this like one thing we talk about at the office aside, like politics aside for everybody.

If you're a real estate investor and that's what you're doing for your living and to provide for your family, in a lot of ways, it doesn't really matter what the interest rate is and it doesn't really matter who's in office. Like, there's going to be different tax breaks.

There's going to be more people that are higher taxes, lower taxes, more loopholes for businesses, less. There's going to be compression. It's changing. But you know what? It's always changing. Each local market is changing.

The state market is changing, the macroeconomics are changing, the microeconomics are changing. It's all changing. Our job is to listen to the market and be adaptable. So we don't want to get hung up on.

Like, you can have your personal preference or your beliefs, and you should vote the way that you want to. But at the end of the day, it doesn't really matter who's in office. It doesn't really matter what the interest rates are.

Maybe it changes your timeline or it changes your strategy a little bit. Your job is to listen to that and adapt. But you don't sit on the sidelines and you wait for the president that you want.

You don't sit on the sidelines and wait for the interest rate that you want. Even in this time, right now we're underwriting at eight and a half percent interest. A lot of people are dried up.

But when you are in a situation where you can have the ability to raise capital, the ability to do construction at cost if it's in house, you have the ability to adapt and be nimble in the marketplace. And you can buy in any market. And what that means is the projects you're taking on right now might be a little bit tighter than they used to be.

But when there's a swing and that interest rate shifts down and that cap rate drops, you just have more inventory, and that creates that massive swing upward. And you have that upward ability that comes with having built a portfolio through good times and bad times. It's going to average out in the long run.

So at the end of the day, like, yeah, we're talking about having a crystal ball. It doesn't really matter. We're going to be nimble and we're going to adapt as most good operators do.

And at the end of the day, we'll be rewarded for action because imperfect action is better than perfect inaction. Our job is to get better at our strategy all the time, and we're not going to let the market or who's in office slow that down.

I like my politics like I like my weather. Mild and predictable. I just need to know in general, is it going to be rainy tomorrow or is it going to be cloudy? Is it going to be hot?

As long as I kind of know that and can have some sort of understanding of where it's going, then we'll figure out some way to make money doing it. And that's the way that I think most professional real estate investors look at it. It doesn't matter. The weather's the weather.

Totally agree.

All right, man, listen. This. That was a nerdy discussion, but I think a valuable one for anybody who's investing in commercial real estate.

We're doing this all again next week. Please tune in and thanks for listening. Thank you so much for listening and watching the Truly Passive Income podcast.

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