The Reality Of High Interest Rates And What They Mean For You As A Passive Investor

Who out there is waiting to hear what the Fed does with interest rates next?

Hopefully you aren’t spending your days thinking (or worrying) about what the Federal Reserve (fondly known as the Fed) will do next. Hopefully you leave that to the experts on your team – like us.

We’re thinking about what the Fed is doing all the time here at Goodegg Investments. That’s because the Fed impacts everything we do – from putting together real estate deals to managing our budgets to ordering our lunch.

In this article we’re diving into the realm of rising interest rates and today’s debt market. We’re also going to keep coming back to what this all means for you – the investor.

It can be really tricky to interpret how the Fed’s actions actually impact our daily lives. We’ll help you to connect the dots between a Fed rate hike and your next trip to to the grocery store.

What Does A Fed Interest Rate Hike Mean For Multifamily Investors?

Let’s start with a recent 0.25% increase the Fed announced. This means the Fed is raising the interest rate (also called the federal funds rate) by 25 basis points, or 0.25%. Currently, this brings the target range up to 4.5% – 4.75%, which is high. As high as October 2007 rates, in fact.

The Fed continues to raise the federal funds rate in an effort to curb inflation. When the Fed raises rates, the goal is to increase the cost of credit throughout the economy. A rising interest rate makes loans more expensive for both businesses and consumers (mortgage rates included), so everyone ends up having to shell out more for interest payments.

Those who can’t or don’t want to pay the higher interest payments may choose to postpone or walk away from projects that involve financing. At the same time, this encourages people to save money to earn higher interest payments. Housing prices may even slow because fewer people are buying with mortgage rates rising.

This, in turn, reduces the supply of money in circulation, which tends to lower inflation and moderate economic activity, which helps to cool things down.

So, the Fed raises interest rates in hopes that your grocery bill will stop increasing so much every month. We love the sound of that!

However, raising interest rates also means that getting the same financing or debt is going to cost us more in each monthly mortgage payment. This impact to the housing market will, in turn, impact our real estate investments. This can happen as our expenses increase with more money going to the bank to pay for the loans on our properties.

Higher Federal Reserve Rates Bring The Cream To The Top

We constantly analyze potential deals here at Goodegg Investments. When interest rate hikes occur, we have to scrutinize each deal more since we have limited ability to change the rates being offered to us.

As such, we underwrite each deal around the rates we can find, making sure to account for fluctuating cap rates in the area, any additional fees that may be required, and the overall market forecast.

In a high interest rate environment, only the best operators can make real estate deals truly work. Many, unfortunately, will move other numbers around to make the deal seem feasible. Perhaps they cut costs in management line items, or budget less for value-add opportunities. Either way, these can become extra risks and lead to smaller returns for the investors.

When the federal funds rate is on the rise, it is more crucial than ever to find a good operator. With the appreciation cycle after the 2020 pandemic, investment groups could get away with buying something that was a little too expensive. There was incredible market velocity – a term for incredible appreciation.

Today, you can’t get away with that.

Today, no one can (or should) hope for appreciation. Operators must show that the deal works (offers returns for their partners) without the potential of appreciation. Those assumptions don’t work.

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What Can A Multifamily Operator Do In This Housing Market?

It can be hard to make any deal look incredibly appealing in a high interest rate real estate market. However, there are a few ways to reduce the uncertainty behind changing interest rates when obtaining debt for a real estate deal.

The most important thing for any operator should always be preserving their investor’s capital and not rushing into any deal just to offer something. Deals must be scrutinized more carefully in a higher interest rate environment. You, the investor, certainly don’t want to work with a team that tweaks the numbers just to get a deal to look good.

Patience is key, as is conservative underwriting.

It can be easy to see a lot of deals today, but it is harder to make them work. A deal has to work today, not in a future scenario with a ton of appreciation.

So are there any types of debt that are more appealing in a high rate environment? Glad you asked.

Find Fixed Interest Rates – The Set-In-Stone Interest Rate

Fixed rate debt means that the interest rate quoted will remain the same for a specified duration of time. That means that, no matter how much the Fed decides to raise rates in the coming months, this investment will be protected against all those ups and downs.

In this market, it is possible to find fixed rate debt over longer periods of time, such as a 7-year term. Banks or lenders mitigate their risk (the risk of interest rates rising and missing out on higher interest payments) by offering fixed rate debt at a little higher numbers. For instance, these rates are sometimes at 6-7%, which is double what they were just a year ago before the fed began rising the base rate.

The downside to this is that disincentives are included to encourage borrowers (an Operator) from selling early and paying off the loan balance. For instance, if an Operator signs on for a longer term (say 7-10 years) and decides to sell in a shorter term (say 5-years), there is typically a fee. Banks have to hedge their risk too when dishing out new mortgage rates.

Secure A Loan Assumption – The Inherited Mortgage Rates

An assumable loan is one that can be taken over by the buyer when the owner of a property sells. For instance, if Moses owns an apartment building using an assumable loan with a rate of 4.0%, he could possibly pass that loan on to a new buyer, say Shelly. In this case, Shelly would not have to find a new loan with a new interest rate.

A great win in this housing market for Shelly!

This can be a great find for Shelly if interest rates have increased since Moses’ loan was originated (or started).

Not every loan can be assumed and every lender has their own stipulations. There are some loans that state whether it is impossible to assume, or there are certain criteria (like credit worthiness or higher fees) required that make a loan assumable.

Assuming a loan could also take longer to close, sometimes 90-100+ days.

Finding a loan assumption is a strategy for finding new real estate investments in a high interest rate environment. If a loan is at a lower rate than today’s rapidly rising interest rates and is assumable, it could make a deal work that otherwise wouldn’t with a new, higher interest rate loan. Operators must incorporate associated fees, longer close time, and other criteria into the underwriting for these types of loans.

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Is It Possible To Find The Best Of Both Interest Rates In Real Estate?

Like the amalgamation of caramel and chocolate ice cream, with chocolate cookie swirls, chocolate chip cookie dough, and peanut butter cookie dough that is Ben & Jerry’s The Tonight Dough flavor, we too can combine these high interest rate hedges into a delicious fixed-rate assumable loan.

Ok, maybe not as delicious as that ice cream flavor, but we still get pretty excited.

The fixed-rate assumable loan can help secure a low interest rate loan (originated by the seller) and prevent that rate from further increasing since it is fixed. The best of both worlds in this type of real estate market.

Can Floating Interest Rates Still Work?

While the biggest hedge on debt is getting a fixed rate, perhaps in the form of an assumable loan, it is still possible to use floating rate debt in today’s high interest rate environment. There are a few ways these loans may work for a deal.

First, it may be possible to secure a period of interest-only payments, such as the first 2 years. If a deal will be flipped in that period of time, the numbers could be really appealing. However, if the business plan does not account for the higher interest payments after that initial interest-only period, it may be helpful to dig deeper. Ask what the plan will be if those higher payments will need to be made and where those funds will come from.

Purchasing Caps to Combat A Floating Interest Rate

Caps are one option to make the floating rate debt structure work in this housing market. Putting a cap on a loan is like only bringing a set amount of cash to go shopping for that new smart-watch you want. The price you’ll pay can only go up to a certain amount. A loan cap is simply a defined amount that the interest rate will not exceed.

Caps must be bought when a loan is originated. Buying a cap also requires up-front fees depending on the size of the cap. These fees can be massive and will require a hit to cashflow.

These options can hedge risk, but higher fees can hit a deal much harder. When fees hit, distributions may not get paid out and returns could drop. Any type of hedge in a high interest rate market should include the impact of these additional fees.

What Real Estate Investors Need To Know About Rising Interest Rates And Passive Real Estate Investing

Real estate investors can still find great opportunities when interest rates rise. However, there are a few considerations that will help make your decision to deploy capital easier.

Rising Interest Rates Means A Slowing Of Deal Flow

When interest rates begin to rise, there may be a slow down of deals. Investors may not have as many options to get their money deployed immediately.

Remember, the federal reserve increases the federal funds rate to reduce the supply of money in circulation and cool inflation rates. Borrowing money easily would put more money back into circulation.

The slow down of deal flow occurs mainly because selling groups may not yet modify their prices (lower them) as interest rates increase. They, naturally, want to ask for prices that made sense in the past, when interest rates were much lower. Yet buyers have higher costs associated with the debt, which means that the price they can pay for the same asset is lower.

This creates a lag in purchasing real estate assets.

It may take time for multifamily property owners to realize that buyers can’t pay the same prices with higher interest rates. This lag in expectation will likely cause a gap in deal flow where sellers aren’t willing to reduce their asking price and buyers can’t make deals work due to higher interest rates.

High Interest Rates Impact The Entire Housing Market

Multifamily syndications aren’t the only real estate market impacted here. You’re likely also seeing rising mortgage rates if you’re searching for a new home to live in or a small rental property to invest in.

Housing prices may respond similarly despite property values remaining the same. Home prices may continue to be high initially and then soften as sellers realize buyers are also contending with rising mortgage rates.

Why This May Be The Best Time To Invest?

Finally, it can be relatively easy to manage a deal well and hit pro forma and projected investor returns when interest rates are at rock bottom.

However, as interest rates climb and as the housing market shifts, it’s increasingly important to invest with teams who underwrite carefully and conservatively, stress test the investment from every angle, build in ample reserves, and make wise, strategic decisions on your behalf.

That being said, if real estate investors put forth the effort to find and vet those great opportunities, this type of high interest rate environment could be arguably the BEST time to invest – when others are fearful and holding back.

Great fortunes have been made during times such as these, and this may just be your opportunity to change the trajectory of your financial future.

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