The current interest rate environment is causing investors to scrutinize each deal more than they have in the past. This change in scrutiny is due to the fact that interest rates are higher than we’ve seen in the recent past, and investors are uncertain how long this will last. As a result, deal flow has slowed down across the entire real estate market.
Today, real estate investors and operators can’t simply go out and buy a property and hope that it’s going to appreciate as it has in recent years. Operators need to purchase properties based on current interest rates and have realistic expectations about all other expenses while underwriting deals. This fact is especially true when refinancing the property is part of the business plan.
Higher interest rates mean operators need to use additional scrutiny when underwriting all aspects of the deal. There simply isn’t as much room for error as there was over the last several years that had such great market velocity (or incredible appreciation).
Commercial real estate owners need to execute on all levels of their operations, including:
- Asset management
- Property management
- Tracking the financial statements
- Leasing rates
Commercial property owners who are not able to operate their properties efficiently and are impacted by rising interest rates will be at a greater risk.
This change in the current market is why it’s so important for investors to do their homework when selecting an operator to invest alongside in this environment. By taking the time to understand the debt market and the deal they’re looking to invest in, they can make a well-informed decision that’s more likely to result in a positive return on investment (ROI).
How to Hedge Your Risk
Commercial real estate hedging strategies are important for a few reasons. First, the debt market for commercial real estate is often cyclical, meaning rates tend to go up and down. Additionally, the cost of commercial real estate can be high, so investors want to make sure they protect their investments.
There are a few different ways to hedge your risk when investing in commercial real estate that we’ll cover below.
Invest in Fixed-Rate Mortgages
Many investors consider a fixed-rate mortgage to be the key to a successful real estate investment during periods of higher interest rates. A fixed-rate mortgage offers stability and predictability. You know exactly what your monthly payments will be for the duration of the loan, which completely eliminates interest rate risk and makes budgeting and planning annual cash flows much easier.
Even if interest rates rise in the future, you’ll be protected against increases with a fixed-rate mortgage. This protection can be especially important if you’re planning to hold your property for a long-term investment.
When it comes to hedging interest rate risk and predicting cash flow, a fixed-rate loan is the ultimate hedge. However, investors must understand the trade-off is that it comes with higher prepayment penalties, which could reduce the profits at sale. And if interest rates fall in the future, they’ll be paying a higher rate than they could get on a new loan.
Buy a Rate Cap on Floating-Rate Mortgages
The other option for hedging your risk is investing in a deal with floating-rate debt where you buy what’s called a rate cap. With a floating-rate loan, you’re accepting more interest rate risk (risk to your cash flow) to have a very small or possibly no prepayment penalty (reducing the risk to profits at sale). A rate cap is sort of like an insurance policy. It means that the floating rate can only go up to a certain amount.
However, buying the rate cap requires the investment group to pay a fee up front, which is generally a percentage of the total investment. The cap then acts as insurance against interest rate hikes within the debt market.
The reason this can be a smart move is that when you’re investing in a property, you’re not just betting on the current interest rate environment; you’re also betting on where interest rates will be in the future. And if you think interest rates are going to go up in the future, it makes sense to buy a cap.
Of course, there’s never a guarantee that interest rates will go up or down. But if you think there’s a good chance they’ll go up, buying a cap can be a way to protect yourself against that risk.
However, rate caps usually last for a shorter period of time, genereally 1 to 3 years. So if your loan term is longer and you plan to hold the property longer than that, you’ll probably need to buy a replacement rate cap in a few years. Some lenders will require that you put funds into an escrow each month with your mortgage payment so you have enough built up to be able to purchase a replacement cap when it’s time.
The difficult thing to predict is what the price of rate caps will be several years in the future. When the economy is humming along and running well, their prices are typically low. But when there’s volatility in the market and interest rates are rising, the cost of rate caps can rise dramatically.
This could mean that when it’s time to buy a replacement rate cap, the price is much higher than the operator was planning to spend. It could also mean, if the operator is escrowing monthly for a replacement cap, that their lender could raise their escrow amount dramatically, constricting their cash flow.
Since you never know what the price of rate caps will be in the future and you’re more exposed to interest rate risk without one, it makes sense to have higher reserves on a property with a floating-rate loan. A floating-rate loan may make sense if you think interest rates are going to stay stable or go down…but you have to take rate caps into consideration. Talk to your operator to learn more about rate caps and floating-rate loans, and how they may impact any deal you’re evaluating.
New Fixed-Rate vs. Assumable Loans
When you’re investing in a commercial real estate deal, one of the most impactful assumptions is how a property will be financed. Currently, most commercial real estate investors look at two primary financing options: a new fixed-rate mortgage or a loan assumption. The prices of rate caps, which are extremely high right now, are keeping most investors from considering floating-rate loans to be a good option.
Both new fixed-rate loans and loan assumptions have their pros and cons, so it can be difficult to decide which financing option is best for a specific property. Let’s take a look below at the differences between new fixed-rate loans and loan assumptions so that you can understand how financing can impact your investment as a passive investor.
New Fixed-Rate Loans
New fixed-rate loans are exactly what they sound like. They’re brand new loans where your interest rate will be locked in for the term of the loan, so you’ll never have to worry about the rate increasing. This type of mortgage can be a great option if you’re worried about interest rates going up in the future. You may be able to get several years of interest-only payments at the start of a new loan, too, which keeps payments lower (because you aren’t paying the principal down) and increases cash flow while executing a value-add business plan to force appreciation. It also gives you peace of mind knowing that your monthly payments will stay the same for the life of the loan (except any changes in property tax and insurance escrows and any interest-only period at the beginning of the loan).
A new fixed-rate loan isn’t always the best option, though. They often come with longer terms (7- to 10-year loans, for example). This can be good protection from being forced to sell or refinance when the market is doing poorly. But if the property is sold earlier than the full term or refinanced for a lower rate, a hefty fee (prepayment penalty) may be required. If these fees are not integrated into underwriting from the beginning, they could be a significant blow to investors’ returns at a sale or refinance.
Loan assumptions, on the other hand, are loans that pass from the seller to the buyer. A buyer “assumes” the loan terms from their seller in this case. The buyer becomes fully responsible for the seller’s loan from that point on, and the original borrower (seller) is no longer liable.
It’s crucial to note that a loan assumption is not the same as a refinance when it comes to the debt market—the new borrower is not getting a new loan. They’re simply assuming the payments on an existing loan. This may make sense, especially if the loan being assumed is fixed rate and has a lower interest rate than can be obtained on a new loan.
However, they may have a short or no interest-only period left on the loan. And the term that’s left on the loan will be shorter than with a new loan. This could be a negative since it could force the buyer to sell or refinance sooner, but it could also be a positive since any prepayment penalty is likely to be lower.
Assumable loans can also be hard to find, can come with big fees, and can take extra time to close. Operators must incorporate associated fees, a longer close time, and other criteria into the underwriting for these types of loans.
Which Choice Is Right for You?
So, how does this impact you as a passive investor? It depends on your investing preferences. If you’re worried about a loan with a shorter term-life remaining and believe the highest amount of interest-only period outweighs a higher prepayment penalty, then investing in a deal with a new fixed-rate mortgage may be a great option. Be sure to ask the operators about the prepayment penalty structure for a new fixed-rate mortgage. You will want to see that they are integrating those numbers into the underwriting of the deal.
If you want to invest in a deal with a lower fixed interest rate, then a loan assumption may be a better choice. For example, with current rates being in the 5 to 6 percent range, you could potentially assume a loan with a 4 percent interest rate. Again, look for any additional fees or penalties for this type of debt when you review the investment offering.
For many commercial property investors, loan assumptions have become a popular strategy with a lot of new deals. Operators may find that paying the extra fees and waiting the additional closing time to assume a loan from the seller is worth it. They are looking for projects where they can assume debt that’s potentially at a better rate. What this means for a passive investor is that there may be better cash flow in a syndication with an assumed loan than one that has a higher interest rate. However, that isn’t always the case, and an investor should always ask about the consequences of any different loan structure.
Investing in Commercial Real Estate
As you can see, interest rates have a significant impact on the current syndication deals operators can offer. The current deal flow has slowed down, and many operators are looking into fixed-rate mortgages and loan assumptions for the best rates. Furthermore, seeking a fixed rate or buying a cap on floating-rate mortgages are some of the ways these operators are looking to hedge this risk. So, consider the current market conditions we’ve covered, and always ask your operator to explain any assumptions with current debt structures.
Further reading: Analyzing a Real Estate Syndication Like a Professional Underwriter