Real estate investors now know about the risks posed by interest rates. But what is the threat they’ll be facing in a year or two? G. Brian Davis breaks it all down.

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For the past 18 months, it feels like real estate pundits have talked about nothing but interest rates

And yes, rising interest rates have squeezed homebuyers, compressed cash flow for investors and put downward pressure on home prices. In commercial real estate investing, rising rates have caused some distressed sales among owners with floating rate loans and driven up cap rates. 

So investors have (understandably) focused on mitigating the risk of interest rates rising further. They’ve tried to assume low-interest loans from sellers or, failing that, buy interest rate caps. Real estate syndicators tout how “conservatively” they’re approaching their investments by talking about interest rate risk. 

All of which is fair, as far as it goes. But the time to worry about rising interest rates was two years ago — before anyone was talking about it. By now, interest rates have already done most of the rising that they’re likely to do. And some investors found themselves woefully unprepared for it. 

That raises another question: What risks aren’t we talking about today that we should be as real estate investors? In a year or two, what will we wish that we’d protected ourselves against?  

It’s a question I’ve started asking professional real estate investors across sectors from multifamily to self-storage to retail to industrial. Here’s what I’ve heard so far.

Risk 1: Prolonged high interest rates

I joined Josh Cantwell on his Accelerated Real Estate Investor podcast a few weeks ago and asked him about real estate risks that not enough people are talking about. “Everyone has been assuming that interest rates will drop back down in 2024. But what if they don’t? What if they stay high for the next three to five years?” he asked.

That risk has profound implications for real estate syndications in particular. Syndication sponsors often use short-term financing such as three-year terms, and the longer rates stay high, the more syndications will end up with negative cash flow when they go to refinance. 

We’ve already seen distressed syndication sales from sponsors who bought properties with floating interest rate loans and no rate caps. They got crushed when interest rates doubled, finding themselves losing money each month rather than earning it. It hasn’t happened en masse yet, but if rates stay high for more than a year or two, it could cause enormous losses and a wave of distressed sales. 

Risk 2: Rising cap rates

Higher interest rates historically lead to higher cap rates on real estate investments. And it makes sense: Higher borrowing costs mean higher expenses and lower cash flow, so investors pay less to purchase the same rents.

Sure enough, cap rates did rise from extreme lows in the first quarter of 2022 through early 2023. After reaching a nadir of 4.13 in Q1 2022, exit cap rates rose to 4.99 by the end of Q1 2023. They stabilized around that level in Q2, closing the quarter at 4.94. 

That’s still low by historical standards. The mathematically inclined among you might also note that while the Fed funds rate leapt from roughly 0 percent to around 5.25 percent, cap rates rising from 4.13 to 4.94 is small change by comparison. 

Some investors, such as Nichole and Mike Stohler of The Richer Geek, are starting to wonder if the rise in cap rates has only just begun. “Higher cap rates mean better opportunities for buyers, but losses or leaner profits for sellers,” they said. 

If the market does get flooded with distressed properties from sellers struggling with negative cash flow, expect cap rates to skyrocket. Many would-be sellers would then have to choose between selling at a far lower price than projected or holding far longer than expected. That in turn may require a refinance — which would be expensive if interest rates stay high. 

Risk 3: Soaring insurance premiums

Anecdotally, I’ve heard investors and homeowners alike complain about property insurance costs rising 40 percent to 150 percent over the last year. 

No one budgets for a 100 percent jump in insurance premiums when they write up pro forma projections for cash flow. It’s crazy — until it starts happening, like it’s doing now. 

Insurance companies claim that they’ve paid out billions of dollars in higher claims on natural disasters over the last year or two, and that they’re simply passing on those costs. Some point the finger at climate change, others at El Niño or irregular droughts, but everyone from commercial investors to rental investors to homeowners are seeing huge premium hikes. 

Most investors that I’ve talked to haven’t started adjusting their cost projections enough to cover these kinds of hikes. Bear that in mind before you invest with one of them. 

Risk 4: Spillover effects from bank troubles

In early 2023, several local and regional US banks failed. After an initial flurry of fear over contagion, most people have stopped worrying about the banking system. 

Meanwhile, everyone acknowledges that commercial office space is experiencing “some pain.” But between high interest rates squeezing commercial property owners and the surge in office vacancies following the work-from-home trend, smaller banks might find themselves with a wave of commercial loan defaults. 

At best, that would lead to banks tightening their lending standards. Lower loan-to-value ratios, much higher cash reserves, and of course higher interest rates would ensue — and all drop a cold blanket over real estate investors. 

At worst, a chain of bank failures would seize up credit markets entirely. That would be catastrophic for real estate investors, especially those with short-term loans set to expire. 

Any of those scenarios would, again, drive up cap rates, making it hard for investors to sell at a profit. If they can’t sell and they can’t refinance, that leaves them with few options when loans expire. 

Mitigating these risks

When you evaluate a real estate investment, first and foremost look at the underwriting assumptions. How conservative are they? Do they rely on rent growth of 3 percent to 5 percent, or would the deal still make money at 0 percent to 2 percent rent growth over the next few years? 

Would the deal still make money if insurance premiums jumped 50 percent to 100 percent next year? What about the year after that? 

What’s the projected exit cap rate? If it’s under five, it’s delusionally optimistic as an assumption. If it’s five to six, that might happen — or it might not. Above six, it’s probably conservative enough. Probably.  

Look for deals where you (or the sponsor) can add a lot of value, rather than relying on rising rents or low cap rates carrying your returns. For example, our SparkRental Co-Investing Club just invested passively in a deal where the combined acquisition and renovation costs per door totaled around $110,000, but the replacement cost in that area was over $200,000 per door.

Plus, the area had been completely developed, so little or no new construction is even possible. The sponsor had bought the worst property in a great area, and plans to completely overhaul every component of every unit. Even if rent growth stalls completely at 0% over the next five years, the deal will still cash flow well because rents will shoot up so much when renovations are finished. 

Do some soul-searching about active versus passive investing in real estate. Do you want to renovate properties, manage contractors, oversee tenants and property managers? Or would you rather just write a check to diversify into real estate? 

If you’re an active investor, you can reduce risk by buying in cash, or by assuming an existing low-interest loan. If you invest in passive real estate syndications like I do, you can invest in deals with assumed low-interest long-term loans, or in deals with other long-term financing in place. 

Final thoughts

Sure, investors need to consider hidden risks for real estate over the next few years. But do you know what I’m not worried about? A recession. 

Don’t get me wrong, a recession might come along and raise rent defaults and vacancy rates. But historically recessions don’t cause rent declines, removing that particular risk. Also, what’s the Fed’s first move in a recession? Slashing interest rates — which ameliorates many of the risks outlined above. 

Recessions make for bad times to sell real estate, but with freshly low interest rates, investors won’t have to sell. They can simply refinance and hold for cash flow until cap rates drop again. 

And in the meantime, they’ll have plenty of opportunities to buy properties at bargain prices. 

G. Brian Davis is a real estate geek and co-founder of SparkRental.

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