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 Read more
