So today I'm going to talk about what do interest rates do to real estate values.
And at the end, I'm going to give you four risks
that real estate investors still will face as we head into this recession.
So first, let's start off with what's happening with interest rates.
As you know, the federal Reserve just made one of the biggest,
largest moves with interest rates since 1994.
This is the federal funds rate set, 1998.
So as you can see, it's been all over the board.
But rates have been so low.
This, for sure will affect real estate values
and how many people are actually going to buy real estate.
So in this video,
not only am I going to talk to you about my own personal experience on deals
that we have in escrow and units we have under construction.
But also, I'm going to talk to you about the risks
that we all still believe we still face.
As you can see, there's all kinds of predictions that the Fed is going
to continue to raise interest rates as they try to combat inflation.
I would also encourage you to go look on the Internet for the Goldman
Sachs report that says the Fed is going to hike
their rates seven times in 2022 instead of five.
That's a bold statement from a very, very big company.
So now let's take a look at what these recent increases in the interest rate
and the potential increases in interest rates might do to real estate values.
Real estate buyers and real estate sellers.
So this is your typical real estate deal that anyone can come across,
and it might be any broker package in any city.
It doesn't really matter if it's a commercial office building,
a self-storage or multifamily, but it's a $2.5 million value add.
Value add means that you're going to get some net operating income growth.
In this particular case, it's 100 K to 120 K.
We're not going to get into the details today about
why it's a value add or due diligence or any of the things that are necessary.
Obviously, if you do buy this, but this is a typical deal
you might find today where it's a value add and you can create value
not only for yourself but for your investor, of course.
And why is just net operating income, which is income minus expenses?
That's all it is.
And all the banks out there, look at your at a Y
when they're looking at one kind of loan to give you, because the a y
is actually going to be the income that pays the debt or the debt payment.
In this scenario, it's your very typical scenario
where you got a 75% debt and 25% equity.
Now, this equity can come from anywhere can come from you,
it can come from investors, it can come from all kinds of places.
This is your typical scenario.
And both of these, of course, equal to 2.5 million.
So this property produces 100,000 net Y
or net operating income, income minus expenses.
If you stop here and take your and Y and divide it into the purchase price,
it gives you a 4% cap rate or capitalization rate.
And we're going to talk about that a little bit more later.
But in this scenario, you're buying this property at a 4% cap rate.
When you take $100,000 and divided into
2.5 million, the next thing is the interest rate.
So let's say this property was in escrow for 60 or 90 days.
A 4% interest rate would have been something
that might have been underwritten at the time.
We, of course, know that rates have gone up set.
So if this buyer had nonrefundable money in escrow,
then they're a bit in trouble and they have to close.
If you've had refundable money in escrow, then of course you could walk away
from this deal because interest rates have gone up while you have been in escrow.
Assuming as a buyer you've negotiated that in your agreement,
what you should be doing if you're not, you take your 4% into the 1.875 million
and you come up with a payment of around $75,000.
Then you subtract that from your at all y and you get about a $25,000 cash flow,
which is great, and that calculates to about a 4% cash on cash.
So you take your 25,000 divided in your 625,000,
and that's how you get your 4% cash on cash.
Not a bad return because now we haven't even calculated the value add.
So this is a pretty common deal that every investor looks for
because your cash flowing on day one and you have the ability
to increase the cash flow.
So in most of these scenarios, we're looking for at least
the 20% growth in the net operating income or at all Y.
So let's just assume for the moment that there's about
a $20,000 increase in the NOI that might take a year or two.
But regardless, you've got a little bit of a value add here
because the bank, again is going to give you the value on the real estate.
Based on that and a Y that 20,000 increase in the no
y drops to the bottom line increases your cash flow to $45,000.
All of a sudden you've now got about a 7% cash on cash return.
This, as is, is a great deal because you're going from a 4% to 7% cash on cash.
It's a value add.
You're going to increase the value of the building with the increase
in the net operating income.
So now let's take a look at the interest rate increase from 4% to 5%.
So you take the 5% times the 1.875 million
and that increases your mortgage payment
to a little over $93,000 from $75,000, just that 1% increase.
Now, all things being equal, you take the 93,000 from the 100,000, so
now you only have a little over a $6,000 cash flow
against a $625,000 investment.
So that drops your return down to 1%.
So you can see without going any further, how just 1% increase in the interest rate
can negatively impact a cash flow from an investor standpoint.
So now as an investor, you're going to say,
I can't buy this property, I can't pay as much.
So as a buyer,
you're actually not going to want
to pay this price because you're not going to
put $625,000 down for only a little over $6,000,
even with a $20,000 value add, because all you're really doing
is getting back to about the 4% cash on cash rate.
So the only solution at this point is to go back to the seller
and say we can't afford to pay 2.5 million.
So in this scenario so far, you can see that we're not going to be able
to pay $2.5 million with these increases in interest rates.
And we have to negotiate something less because, of course,
the buyer or the investors are going to want a better return.
So now let's take a look at this at $2 million as opposed to 2.5.
As a buyer, you're always solving to your cash flow.
So you figure out how much you I put down and how much return am I going to get.
So by running this at $2 million as an offer,
you can see that using the exact same scenario, 75%
down as a $1.5 million loan, $500,000 out of equity.
So your equity goes down a little bit from six and a quarter to 500.
Your NOI is the same. It's the same property.
The only thing that happened
where your interest rates went up, you've got a 5% interest rate
and now you have, again, a $75,000 payment.
So as you can see, the payment was $75,000
at a 4% rate and it's $75,000 at a 5% rate.
The only difference, of course, is how much you borrow and how much you pay.
This, of course, produces a $25,000 cash
flow and about a 5% return.
So now, again, we're back to a pretty good deal and this is why
what you pay for properties as interest rates go up matter.
So I did a video a little while ago that talks about interest rates and cap rates.
Are these two things here, the capitalization rate and the interest rate
and how they're not exactly correlated, but as you can see here,
as buyers offer less and sellers
accept less for the exact same analyze,
then you're going to see cap rates go up a little bit.
This is what we call the exit cap rate.
This potential increase in cap rates or exit cap rates, I believe is
one of the biggest issues that real estate investors are facing today.
So in this scenario, as you can see, the exit
cap rate is actually 5%.
So the cap rate started at four with the same amount of why
and now it's at five because we're now solving to cash flow.
The sellers are going to have to be more realistic on what they're selling,
their properties for.
Today, the buyers are getting less cash flow
because the interest rates are now going up.
So the four risks as promised for you guys are cap rates going up.
We just explained that higher cap rates mean lower values.
So that means if you bought it at a four and you got a lot of value add and you're
selling at a five, you've actually lost 20% of your value debt service coverage.
What this is this is how lenders decide what to lend.
So in that last scenario, $100,000 and a Y is
what they're looking at to be able to loan you money, keep your eye on these debt
service coverages, because what they're doing
is they're actually driving the loan to value down
and creating more and more equity to buy these properties.
Number three is what I call value add harvest.
The entire reason that you want to buy a property for a value add potential
is to harvest it later through cash out refinances
and as rates go up and cap rates go up, the value
add, all that work that you do and all that stuff that you talk about
in your business plan to raise capital might get evaporated
with these higher cap rate.
And four, of course, as I said in the beginning of the video,
these higher interest rates could further drive down cash flow
as your mortgage payments go up even more.
Given the scenario that I just talked about with $100,000
and a Y, can you imagine what would happen if those interest rates went to six?
Then you would, of course, just pass on the deal.
So these are the four risks that I see in 2022.
So whether you're raising capital or you're investing with someone else,
make sure that they have or you have these things
well thought through because these are real risks to returns
moving forward as we head into this recession.
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