Interest rates and the small investor, is there really an effect? Beyond the obvious cost of borrowing, I have wondered if the small investor really notices a change in the Fed Funds rate. While I am not going to make the same mistake of asking you all to humor me, I am going to try to show that the small investor is less sensitive to smaller changes in rates. I am also starting with the assumption that smaller investors tend to invest in markets with higher cap rates.
First, let’s get some things clear so we are starting from the same page. If we consider the value of commercial real estate, we can approximate it with a simple formula, Net Operating Income (NOI) divided by the cap rate. Additionally, let’s assume that the cap rate acts as a proxy for investor demand. This makes sense because NOI is simply based the rents collected, while cap rate is the return investors will accept for those rents. In markets with very low cap rates, investors are willing to pay more for rents now because they expect a higher rate of future rent growth than lower cap rate properties and/or they expect lower volatility in those rents or they expect even lower cap rates in the future (appreciation).
Next, let’s think about investing. Most investors try to leverage their properties as much as possible. Banks understand this, so they enforce strict standards. Typically investors can get 80% Loan to Value terms, as long as Debt Service Coverage Ratios (DSCR) comes in at 1.2. The DSCR is simply NOI/Debt Payments. In markets with lower cap rates, this becomes more important because the higher value creates higher debt payments. This situation creates a cap rate floor for smaller investors, who have less financing options. Investors who focus on $1 Million and under properties do not have the same access to financing because their loans are not as profitable and harder to move in the securitization market.
Then, we have to analyze the effect of a 1% change in interest rates on loan terms. Looking at a $500,000 loan with standard terms (30 year amortization, 6% to 7%), there is only an increase of $336 a month. This increase will not have a significant effect on a purchasing decision in areas with higher cap rates, though it will decrease returns. However, this increase could be devastating for a market with lower cap rates. Reflecting back on the DSCR formula above, if the Debt Payments increase small buyers will essentially have less buying power.
Finally, you may have noticed a disconnect in this formula. There will be markets with low cap rates even when interest rates are high. One of two things happens in these markets. Typically banks will be looser with funds in lower cap rate markets, but they will still have reasonable standards. The second option is exotic mortgages. Enter mortgage brokers, private equity firms, no money down lenders, etc. Again, investors in smaller properties have a harder time getting this financing and it tends to be very expensive. The price of this financing offsets some of the returns smaller investors receive and make them less likely to bid cap rates down too low. There are always exceptions to these rational rules, but again, more often than not this rationality persists.
So, given all of the above, how can a small investor use this information? First, small investors should not worry about as much about interest rates. Second, they should think very hard before taking exotic financing. If financial modeling is not your thing, then ask yourself how much more you are paying for additional financing and is it really worth it? Can you get a better return investing in a slightly cooler market vs. swinging for the home run?
Inversely, smaller investors should beware of owning investments in low cap rate markets. While there will be opportunity for appreciation, there will be some point where investors can simply no longer afford to buy those properties because banks will no longer lend on them. At this point, values will decline, leaving you high and dry. Hopefully, today’s post will provide small investors some insight into the structure of real estate investing. I am a huge fan of investment experience, but some times a little investment theory can help the small investor avoid large pitfalls.
