December, 2022

Finding opportunities in a high interest rate world
Did you buy all the deals you wanted before rates started climbing? I sure didn’t but I may have been lucky. I bought a deal earlier this year whose loan rate was locked in pretty low. It was in a strong market where vacancies and unemployment are still low, and no one is hesitating about paying up for premium renovated units. That’s not the case in a growing number of markets, though.

This year both interest rates and cap rates have risen. Interest rates a lot more than cap rates. In fact, cap rates in a lot of markets have hardly risen at all. Good luck finding a property in a market where cap rates have not increased, because it probably won’t pencil. Loan proceeds will be low, possibly 60% LTV or lower, your cash flow will be low and maybe 0, and you may have to accept a huge prepay penalty for paying off your loan sooner than its term. Defeasance or yield maintenance prepay penalties say if I’m paying off the loan early, I need to also compensate the lender for all the interest they’re not going to get. When interest rates are high today, there will be an extremely high fee to sell or refinance your property early.

So what to do? You found a value-add property, you can invest in unit renovations and increase rents. Not only do you have to know how much you can increase them, but also how sure are you that you can increase them. Is the economy tanking? Then certainly unemployment is around the corner and with that comes vacancies. What happens when you can’t increase rents. (- – > disappointed investors)

When faced with the realities of a high interest rate loan and low loan proceeds, a stabilized property has to be priced to allow an investor to make money, and unfortunately most are not today. Investors buying these properties are making a bet that they can refi into a more favorable loan very soon, because rent upside and therefore income will be limited.

But here is another suggestion. Unstable properties are generally defined to mean occupancy is low. How low depends on the lender but let’s say it’s 90% occupancy. When you the seller are selling an unstable property, your expectations are lower. You didn’t succeed in getting it to a stabilized position in the market and now you need to sell it. You know you’re going to take a hit. That’s a buyer’s opportunity.

The buyers for these properties know there are units to lease up. This is their value-add opportunity. They also know they’ll need a bridge loan, which is a loan designed for unstable properties. Those loans unfortunately come with higher interest rates, roughly 8-9% today depending on the property, the sponsor’s experience, the market, and other factors. You’re not going to cash flow a low occupancy property with rates like these, but you have a clear path to profitability.

With a bridge loan you are also likely to be able to borrow more. Possibly 75% of the purchase price or more, plus most will include your renovation expenses and most don’t have any prepay fees.

Are you betting rates will go down? Yes, most definitely, but when you execute your business plan, do your renovations, and lease up to 95% occupancy, you’ll see your income rise and provide you cash flow. If your bridge loan term is long enough, say 3 years or more, and your interest rate is locked for that period, your likelihood of seeing lower interest rates in the next 3 years is high. That’s the way interest rates have historically worked. The Fed spikes the Prime rate, the economy cools, then the Fed drops rates. There’s no predicting when the cycle will complete, but if you think that rates at least won’t be any higher in 3 years, you are in good shape.

Finding investors for an unstable property in today’s market? That’s a big challenge but certainly not insurmountable for the right property and the right story.