Interest Rates and Real Estate Investing

Interest Rates and Real Estate Investing

Interest rates come up a lot, I get asked
this question quite a bit about how higher interest rates are going to
affect real estate. Just to review, two things have happened over the last 18
months. One, LIBOR, which you know is measured as the risk-free rate
and all of our loans are measured above LIBOR as a spread, so if you hear in
real estate borrowing “I’m borrowing at 250 over LIBOR” that’s 250 over the
interbank lending rate. The interbank lending rate is directly correlated to
the federal funds and the discount rate, that’s what the Fed is moving. As you
hear the words “they’re tightening” that’s what they’re moving. LIBOR correlates
with that almost all the time, until it doesn’t, and I’ll give you an example. In
a financial crisis like 08, 09, the Fed can be cutting rates which they were, but
if banks are afraid to lend to each other because they don’t trust each
other’s ability to repay, which happens and in the situation like 08 and 09, LIBOR
won’t go down with Fed Funds. The joke in the financial crisis was: LIBOR is the
rate at which banks won’t lend to each other. And basically they
wouldn’t lend to each other at any rate so LIBOR is whatever you want to claim
it is in a given day, but 99.9 percent of the time,
LIBOR correlates wholly with Fed Funds and the discount rate and so over the
last 18 months as the Fed has been tightening, LIBOR also has been going up…
so what does that mean? Well what it means is unless those spreads move in
then your total borrowing rate is going up. So for example, if I was
borrowing at 250 over LIBOR 18 months ago and LIBOR is 0, then my total borrowing
rate is 250. 2.5%. So that’s a very low borrowing
rate. Now if the spreads are the same and I’m
borrowing at 250 over LIBOR, well LIBOR is also 250 so now my total borrowing
rate is 500 or 5%. So it’s doubled. What’s happened
as LIBOR has gone up with Fed Funds because the Fed has been tightening the
spreads have come in and basically the banks and other lenders have said we’re
willing to eat some of that by just making less money on our loans so
they’re not charging 250 over they’re charging 200 over, but
still I used to borrow 250, now I’m borrowing at 450 that’s quite a bit
higher so what does that mean for real estate? There’s two things because
there’s no question that borrowing costs have gone up. The first
is it’s going to have an effect on my income statement, and what I mean by that
is if everything else is held constant in a real estate deal, if my borrowing
cost went up from 250 at a zero LIBOR, so 2.5% so now it’s 5%, obviously there’s a lot less free cash after debt service, so when I’m
looking at my income statement it’s top-line revenue, expenses, yields net
operating income. Net operating income then I have to subtract out cost of debt.
The cost of debt’s much higher, so my free cash – that’s what’s available to
investment partners, equity partners in the deal – is lower. That’s the first
effect of higher debt. The second effect of higher debt is actually your balance
sheet which is what the asset is actually worth. So what’s happening
to the asset when I sell the asset for our investment partners. Everything else
held constant, if you have a higher cost of debt, that’s increasing what’s called
your weighted average cost of capital which essentially is the denominator in the
the terminal asset evaluation, and so if I hold everything else constant what I’m
telling you is: your asset value on the balance sheet – the actual value of your
asset – should be going down. And that’s why when you hear anyone talk about the
stock market it’s not just real estate, it’s any asset, any capital asset. If you
hold everything else constant, assets should be worth less in a higher
interest rate environment. One of the ways to think about this, it’s very
simple is: if I said to you, you can make a return of 5% and take no risk or you
can make a return of 2% and make no risk, which of those two things would incent
you more to move to a risk-free investment? Well obviously you would want
to make 5%. Well that’s essentially what’s happened in the market is the
risk-free interest rate has gone way up and so people are more likely to invest
in risk free assets versus assets you take risk in. Real estate: if you invest
in private real estate there’s risk in it. Same in the stock market. Same in the
private equity market. Same in the venture market. Same in any capital asset.
So just from an investor psychology standpoint it should make sense that as
the risk-free rate goes up, capital flows will tend to move into that risk-free
asset because it’s incenting them to do more of that. We were in a zero
risk environment for literally years and years and years, and it incented capital
to move to risked investment it incentied you to take risk. Now the
Federal Reserve is saying well actually the economy is growing at a rate that
we’re happy with and, you know, look unemployment is at such a low level
that we’re actually starting to get concerned that there’s going to be
inflation in the labor market because that’s really when inflation starts to
get out of hand is when it hits the labor market in the commodity market. So
they’re now saying well, we actually want to shrink our balance sheet. So
when the Fed is shrinking their balance sheet they’re actually unloading their
assets to banks and the banks are now tying up money they could be lending in
their securities. So there’s less money floating around the economy, but
then they’re also raising rates. Both things are creating a higher interest
rate potential environment and quite frankly, that’s what the Fed wants right
now because they believe the economy might be a little bit overheated.

One thought on “Interest Rates and Real Estate Investing

  1. Where do you think interest rates will be 5-10 years from now?

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