How Rising Interest Rates May Reduce Seller's Profits!
So, you're a real estate investor. If you are like many, you've likely never really seen a rising interest rate environment before. Like most things, if you've never experienced something you: a) think it's scary b) think it's not a big deal.
Let's address why rising interest rates can be a big deal for real estate investors especially if you are deciding to sell.
First, this is not going to be a lecture about why selling during a rising rate environment is a horrible decision. We all have (I hope) personalized exit strategies. Not too mention life happens and circumstances change.
What this hopes to provide is a better understanding of the how's and why's of rising rate's effects on investment real estate. Make no mistake, it applies to apartment buildings, medical offices, NNN, industrial.....
February 2022
As of today's writing, the Federal Reserve plans to end their bond buying program that began in spring 2020. Additionally, they intend to begin raising the Fed Funds Rate as well as reducing their $9 Trillion balance sheet. That may sound complicated and no doubt the mechanisms involved are very sophisticated. Here's what that really means: The Federal Reserve will spend less on buying treasuries; in fact they intend to begin selling their accumulated treasuries. They've essentially been a treasury market of one since spring 2020. Driving down the yields and with them lower interest rates.
Question, what do you think happens when the only participant in a market stops buying and begins selling? In this case, yields on U.S. Treasuries will increase. That's critical for real estate investors because those are the mechanisms with great influence over borrowing rates. Don't worry, I'm not going to nerd out on you and describe the in's and out's of how. Although I really have to fight that urge.
Right now, the U.S. 10 Year Treasury sits just below 2.000%. To put that into perspective, the market low was July 2020 when it closed at 0.5330%. That's a 1.467% increase! The December 2021 low was 1.356%. Massive moves for the time frames involved!
Now the question you may be asking is, "How does this affect my investment property if I decide to sell?"
Let's focus on two reasons. First, generally speaking as interest rates rise economic demand slows. Second, rising interest rates will affect the net operating income post debt servicing--that's after financing payments.
Rising interest rates will generally occur, through various actions, in order to slow a rapidly expanding economy. As demand declines, business sectors will begin evaluating all supply cost inputs (that's cost to produce a given product). One of the first cuts made will usually be employee costs and wages. In other words, people lose jobs. As the unemployment rate climbs, people may not be able to afford their current rent/mortgage or for that matter even separate housing. This leads to a consolidation in housing--family members may begin living together when they once lived apart. This can create, in renting terms, increased vacancy for multifamily properties. A higher vacancy rate will generally lead to lower property prices.
Even if housing consolidaiton does not occur, rising interest rates will undoubtably cause borrowing costs to increase. This will inevitably lead to slower investment demand until such time as prices decrease sufficiently to once again spur investor demand. This will occur across all real estate investment sectors. The Following case study shows how the base scenario (first column) changes with higher interest rates. The second column requires significantly more downpayment funds while the third column lowers the asking price. See the table below for an example.
Multifamily Property Case Study
Asking Price: $2,150,000 | Asking Price: $2,150,000 | Asking Price: $2,000,000 |
Gross Rents: $237,000 | Gross Rents: $237,000 | Gross Rents: $237,000 |
Operating Expenses: $88,000 | Operating Expenses: $88,000 | Operating Expenses: $88,000 |
NOI: $149,000 | NOI: $149,000 | NOI: $149,000 |
Capitalization Rate: 6.93% | Capitalization Rate: 6.93% | Capitzalization Rate: 7.45% |
Downpayment (20%): $430,000 | Downpayment (26%): $550,000 | Downpayment (20%) $400,000 |
DSCR: 1.3x at 4.50% for 25 year amortization | DSCR: 1.25x at 5.50% for 25 year amortization | DSCR: 1.25x at 5.50% for 25 year amortization |
Annual Debt: $114,700 | Annual Debt: $117,900 | Annual Debt: $117,900 |
I know this can get a little confusing. Here's what it boils down to for those wanting or needing to sell investment commercial real estate during a rising rate environment: Buyers have greater leverage in negotiations. It's that simple. Whether or not you as a seller agree is a different story altogether. But most experienced real estate investors are going to see it a similar way as I've illustrated above. I know I could make a compelling case that the above property is overvalued by $150,000.
While rising interest rates should not be the only overriding factor in whether or not you sell your investment property, they must be factored into the equation. What goals are you trying to accomplish by selling? Are you performing a 1031 exchange? Will you re-invest in another business venture? Are you out of real estate investing altogether to sit poolside on a Caribbean island sipping drinks with little umbrellas in them? These are the primary questions you need to consider even if interest rates are falling. Don't let interest rates completely dictate your decision to sell.
Wes Purvis
Director & Founder
Purvis Commercial Group
Coldwell Banker Schmidt Realty
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