Impact of Rising Interest Rates on Your Apartment Building
May 09, 2018
Impact of Rising Interest Rates on Your Apartment Building
Thinking of selling your apartment building in the next few years? Thinking that rising interest rates won’t effect the value of your commercial real estate? Holding out for the market to go even higher? Or are you just holding on forever and will let your kids deal with it. Maybe your apartment building is already on the market and your holding out for the unicorn, you know, the foreign buyer from another continent that has some how come across your 10 unit building in a suburb of San Diego?
The topic I’m writing about today is on rising interest rates and how they will impact the price of your apartment building or any other commercial real estate you own (not to mention your home, click here for chart). Simply put – when interest rates increase for commercial apartment building loans, payments increase, net income decreases and ultimately the total return of your asset decreases. When total return decreases, the value decreases. A standard measure of value for apartment buildings and other commercial real estate is the Cap Rate. When Cap Rates go up (this means the return on your investment increases) the dollar amount paid for the real estate decreases. As the dollar amount paid (the asking price or the value) increases, then the Cap Rate will go down. Cap Rates increase, value decreases. Cap Rate decreases, value increases. For further reference check out breakdown of the latest PwC report here.
Here’s an example. Let’s say that your building is 16 units, in an “A” neighborhood of San Diego, average rent per unit is $2,000 for each of your two bed one bath units, this equates to $384,000 in gross income annually. (Yes, this is a really nice building, tenants and toilets are perfect too.)
Now, let’s say your broker has quoted that the value of your building is approximately $6,000,000. With a gross income of $384,000 and approximate net income of $218,876 (we’re assuming about 40% expenses or $153k, remember we need to account for the new property taxes the new buyer will pay and is included in the total expenses). These numbers give us a 15.63 GRM and 3.65% Cap Rate. If you are lost on Cap and GRM, feel free to email me by clicking this link or visit the glossary here.
Now, like I touched on above, most people are not going to drop $6M cash out of their brokerage accounts to take on a 3.65% rate of return. They would rather put down $3,000,000 cash and get a loan with a 3.85% interest rate and let the left over $3M stay in their brokerage account where it’s liquid and their stock broker is getting them 5-8%. At least in most cases.
Even if the buyer gives you a cash offer, they will probably end up financing the deal while in escrow or refinance shortly after.
Back to the scenario of how rising interest rates will impact the value of your apartment building…
3.85%, 5 year fixed, 30 year amort. loan.
$218,876 net operating income
$168,771 annual loan payment
With these numbers and an annual loan payment of $168,771, we’re looking at a 1.67% return for a new buyer to invest in your building. Now of course, this doesn’t account for taxes, principal reduction or depreciation or any other tricks you can do to increase the income this building puts in your pocket.
Now, despite the slim 1.67% return, there are plenty of people that will probably want to buy this building; such as high income earners looking for depreciation deductions, high net worth individuals that needs to diversify, real estate collector/accumulator etc.
The point is this, 1.67% is really not that great, is it? But that’s ok, because there is still probably a buyer out there for it.
Now, what if interest rates increase from the 3.85% used in our example above to 4.00%? That 1.67% return decreases to 1.57%. Or in dollars, $50,000 to $47,000. $47,000 is not a lot of money is it? Considering you have a $6M asset you are dealing with and you are only earning $47k.
Here are the rest of the tiers:
4.25% interest rate = 1.39% return or $41k
4.50% interest rate = 1.22% or $36k
4.75% interest rate = 1.04% or $31k
5.00% interest rate = 0.85% or $25k
These are slim margins. One remodel, one major repair, puts the buyer at negative cash flow and perhaps even risk of defaulting on your loan.
Now, as you would probably do when buying a new piece of real estate, fix it up, add some value, right?
Let’s say it’s not even a true value add item where you really don’t see this additional investment increase the value of the building, such as roof, plumbing, electricity etc. For this example, let’s assume that you have owned this property for 40 years, you haven’t really touched this property since the rents have kept on increasing and you are loving life, retired, hanging out with grandkids and before you know it, 20 years went buy, your roof needs to be replaced, your steel pipes and electric are near end of life. That’s about $100k approximately in repairs and replacement, and that’s only $100k if you’re lucky. Not to mention any loss to lease income for having to remove anyone if you need to repair their unit temporarily.
However, right now, you are in luck, the market is high, brokers call you every day with an “offer”, buyers are scrambling over apartment buildings and willing to take on the expense of the $100,000. Now what happens to the numbers that we went through above for the new buyer when they need to spend $100k day one of their new investment?
4.00% interest rate = negative 1.77% return
4.25% = negative 1.94%
4.50% = negative 2.12%
4.75% = negative 2.30%
Just one, $100k expense, on a $6M asset and a 50% loan put a buyer in the red, getting 1.77% negative cashflow if the interest rates increase just 0.15%. Now even worse, we get to rates that we are seeing right now, like 4.25%, and your property isn’t worth what is was in 2014 or 2015 when interest rates were as low as ever.
If interest rates go up and a buyer’s return diminishes from an already low 1.39% down to a negative cash flow of -1.77% or worse – well, they are going to need to pay less for your apartment building to get some return on the investments.
From the examples above, we can see what the prospective buyer is looking at when analyzing whether or not to invest in your apartment building and at what price actually makes sense.
Now let’s look at how this impacts the value of your building.
Let’s take Same $6M building, same income, same 3.85% interest rate on the loan, same everything.
Your broker tells you the building is a 3.65% Cap Rate, which sounds great, though that rate is only if the buyer pays cash, which they probably won’t as we discussed above. And let’s assume that your buyer is conservative or they have a fiduciary duty to the real estate investment fund they manage and they need to get at minimum 2% return on their $3,000,000 down payment to help pay for expenses, allow for a buffer and deliver what they promised to their investor group.
To arrive at 2% return, they would need to offer you $5,800,000 which is probably where most of the other offers will land too unless your building has enormous upside to unlock, which in this example, it doesn’t.
Let’s say you got that $5.8M offer in the first week of the property being on the market and you were like, $200k under asking?! Go pound sand. Then two weeks went by, no more offers higher than $5.8M and at the same time interest rates increased by 0.15% from 3.85% to 4.00%. Now, the rate of return a new buyer would have received dropped from 2.00% to 1.90% which means this buyer needs to now offer you $5,740,000, $60,000 less than two weeks ago. Your broker calls up the rest of the buyers and they all say the same thing. You decide to hold out for another 30 days to see what happens, maybe some international money comes in to town. In the next 30 days, interest rates go up to 4.25% and now that same buyer can only offer $5.64M to stay at their 2% return. Now, with just 0.40% increase in interest rates, your property once valued at $6M has now lost $360,000 in value.
In the illustration on this page, you can see that with each 0.25% increase in interest rates, there is approximately $100k lost in the value of the building for the buyer to be able to maintain a decent return on their investment. This article doesn’t touch on debt coverage ratios which limits the relationship between the debt payments and the net operating income and the amount a bank is able to lend on a commercial apartment building. Normally the ratio of 1.20, anything below the bank won’t lend on or lend a lower amount than you are asking for.
Why roll the dice and hold out for a higher price? Take some chips off the table now. Make your life easier. If you are deciding to sell, trade or just curious on what your current scenario looks like on paper and what your building would like to potential investors, call/text me 310-900-9505, email at email@example.com or click here to send an email through the website.