What the New Normal in Commercial Real Estate Might Mean and How to Financially Manage It

The big “I” source of tumult in commercial real estate at the moment—interest rates—aren’t really the problem. The real issue is that many investors either don’t have the experience with higher interest rates or have forgotten what such an environment is like. That makes multifamily investing more of a challenge than it has been in years.

As a reminder, here’s a graph from the Federal Reserve Bank of St. Louis showing bank prime loan rate—the one listed by a majority of top 25 larges in domestic assets insured U.S.-chartered commercial banks. We’re using it as a proxy for the least expensive end of short-term commercial lending.

st louis fed prime rate graph

When the Fed slashed interest rates to encourage recovery from the Great Recession, prime dropped to 3.25%. The last time before 2009 that the rate was so low was in 1955. Extremely low rates are an historical anomaly.

But many people in real estate now have never experienced this before. Even for those who have, the interest rate jump was rapid and left little time to adjust. In February 2022, prime was still 3.25%. By August, it reached 5.5%.

Not only have interest rates shot up, but they’ve put pressure on cap rates, and that makes for an increasingly difficult math problem for investors to solve. They’ve generally been trying to reach an internal rate of return of between 15% to 18%, or a cash-on-cash return (pre-tax cash flow as a percentage of the total amount of cash invest at the start) between 4% and 8%. You could offer an owner less, but many of them still have high prices from the very recent past on their minds and assume they should be able to achieve those numbers.

Making the numbers work for a given new project or refinancing means stepping away from assumptions you may have been using and reconsidering how everything interacts and then looking at what you could change to get the results you need, whether it’s assumptions, strategic plans, expectations, or the debt and equity stack.

For example, there are some companies that will take a greater risk in projecting the future. Instead of, say, planning on a 5% rent increase in the second year and 3% annually after that, they might push to say that either units aren’t near market rent or that rent growth in that particular market is likely to be stronger, and then set the second year at an 8% growth and 5% in year three. But risk management make it prudent to consider whether people paying less might balk and leave, creating additional turnover costs. So, you probably want to create several scenarios in your spreadsheet model.

Lenders have been getting stricter on terms over the last year. Many are holding things at 65% loan-to-value ratio. You might have counted on a 90% LTV, but that won’t be happening, at least not through one lender. Could you get an interest-only loan for a period of time and then refinance—assuming interest rates will improve in the next few years (and they may not? Might you swing a supplemental loan to get you partway, like 75% LTV? Perhaps, but how does that boost debt service in the short term?

Looking for a deal with an assumable loan could get you an existing lower interest rate, but now you’ll have to add an assumption fee, probably 1%, into the mix, which could push things into the unworkable zone again.

There may be other choices. Working a value-add deal on a B- or C-Class building? If there’s organic rent growth in that market, perhaps you can ride it out as is or do half the dollar amount of renovation. Or phase it in with turnaround costs as apartments vacate.

Once we helped save a deal by realizing that holding for only three years rather than five, as the market was hot, meant that the metrics were a lot more favorable, and the IRR still worked. One company we know decided to focus on a single geographic market. Because everything was in the one area, properties shared administration and maintenance costs and give them room to offer a bit more when necessary.

You can’t pull off miracles. Models have to incorporate market-based assumptions. You can take risks but only with your eyes wide open. We can help you get a fresh perspective on the analysis and your options. Get in touch today.

 

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