Conflicts of Interest: Let’s Talk About Underwriting and Interest Rates…

This week we are covering another core element to our underwriting process, interest rates.  Why do interest rates matter to real estate investors?  How do we use the interest rate element in our investment process?  What are the implications of current interest rates during the pandemic and moving forward?  The goal of this post is to address these questions and many related questions.

First, let’s begin by defining interest rates.  As it relates to multifamily investing, an interest rate is the amount charged by a lender to a borrower for the use of their fund.

If interest rates are low, a bank will earn less on an issued loan and a borrower will pay less to obtain a loan.  When rates are high, a bank earns more and a borrower pays more.

For real estate investors this concept matters because it is obvious that when you want to borrow money to invest in a property, you want the least possible amount of money coming out of your “pocket.”  Higher interest payments eat away at your net cash flow and investment returns.  This is known as the cost of financing.

Interest rates also matter because any knowledge of past and current interest rates can serve as a tool in investment analysis.    

At CF Capital, we look at various times throughout history when interest rates have fluctuated in a market cycle and observing the relationship to the economy, we strengthen our ability to approach an investment. 

Our research can tell us where we might be in a market cycle.  Because we can make an educated estimation on current times, we can further understand the potential outcomes of a certain scenario driven by market forces.  

In terms of financing, we generally believe that low interest rates are good for us when we are only thinking about the negative effects on net cash flow by having to pay interest on a loan.

Holding everything equal, the yield on a property investment goes up when interest rates go down.  A yield also becomes more attractive if it is higher than the treasury equivalent and provides cash flow that is more like a stock dividend.  Let us provide a brief example. 

Yield is defined as the difference between the cap rate and the cost of financing.  If the cap rate is 5.0% and the cost of financing for a 10-year loan is 3.0%, the yield would be 2.0%.  At this point in time, a yield of 2.0% exceeds the 10-year treasury yield of roughly 0.7%.

With that said, interest rates shouldn’t be considered in isolation.  Rates are tied to other market forces that may lower or cancel out the positive impacts of falling interest rates.

In the current pandemic environment, the fed funds rate (i.e. the interest rate set by the US Federal Bank) has been lowered to historically low levels, 0.25%.  One would initially anticipate that this would attract more capital to property markets, leading to some compression of cap rates.  Compressed cap rates should increase property values  given the NOI stays the same. 

 We are certainly aware that the pandemic creates additional uncertainty in our industry. We also understand that there are certain types of properties that are more sensitive to interest rate changes.  Because of this, we remind ourselves to carefully consider properties and implement a business plan that reduces risk of interest rate (and economic) changes. 

However, as we stated above, interest rates shouldn’t be considered in isolation.  Also, it is important to remember that we do not like to speculate.  We take into account what we know at the fundamental level, and apply it to a conservative, well-informed approach when underwriting.  

 Tying everything together, it should come as no surprise that we are actively seeking out investments with greater yield during this pandemic.  Factoring in interest rates and other market forces, we continue to pursue the right balance of risk and return.

"Buy a stock the way you would buy a house. Understand and like it such that you'd be content to own it in the absence of any market."  Although we are not investing in stocks, this same concept in the quote by Warren Buffett can be applied to what we do in multifamily real estate. While we have specific business plans that we intend to execute during our hold period, our thought process entering into every acquisition is that we would be comfortable owning it forever.  

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