By: Laus Abdo, CEO & Founder, AGP Capital
Understanding the impact of higher rates on real estate and private debt funds
Inflation and interest rates will influence the investment environment for the next several years. The 10-year Treasury rate is a useful representation of how interest rates have moved throughout the years and is an important benchmark for determining lending rates and expected returns for real estate investors. During inflationary times, Treasury rates rise, which pushes up the cost of borrowing, cap rates, and expected returns. In periods of low inflation, Treasury yields remain low and the cost of borrowing, cap rates, and real estate expected returns fall.
Based on the long-term 10-year Treasury rate chart below, we have been in a period of declining interest rates since the 1980s. The 2010s to early 2020s were an abnormally low interest rate environment associated with two major events: the Great Financial Crisis of 2007-2009 and the Covid-19 Pandemic. Both events caused the Fed to stimulate growth and fight off a potential economic crisis by aggressively reducing interest rates and increasing the money supply through quantitative easing.
The Fed’s trillion-dollar cash infusion in response to Covid-19 set the foundation for inflation to increase rapidly, reaching over 8% by early 2022. To tame inflation, the Fed intervened by aggressively raising interest rates beginning in March 2022. Treasury rates rose from a prolonged period of near zero and as of this writing, are currently at 4.27%. The Treasury rate of 3.25% to 4.30% over the past six months is more in line with historical norms than it was during the previous decade. We believe that a normalized 10-year Treasury rate is in the 2-4% range.
As rates go up values decline
A sharp rise in interest rates will cause property values to decline. Commercial real estate is valued by assessing a property’s future cash flows and for stabilized property, the net operating income (“NOI”) is divided by a capitalization rate (“cap rate”). The cap rate consists of the risk-free rate plus a risk premium less a growth rate. The 10-year Treasury rate is a regularly used proxy for the risk-free rate. The risk premium is based on several factors including location, tenant, and development risks. The growth rate reflects the property’s projected NOI growth, which in a healthy market is typically in the 2% to 3% range.
As an example, an apartment building generates $100,000 in NOI. Prior to the Fed raising interest rates, assume that investors valued this building using a 5.0% cap rate or $2,000,000 ($100,000/5.0%). Since the Fed raised rates, the resulting interest rate environment requires a higher expected return, which pushes up cap rates. Recall the cap rate is a function of the risk-free rate and the property’s risk premium. That same apartment building is now valued using a 6.25% cap rate, which means it is now worth ±$1,600,000, a ±20% decline. When cap rates rise and property values fall, as shown here, many would-be sellers instead hold onto their properties hoping that the market will recover.
Higher rates means lower LTV’s
Higher interest rates also result in increased debt payments and consequently, lower loan amounts. With lower debt, real estate investors are required to contribute additional equity to finance a project. Using the apartment example from above, imagine that an investor wants to purchase the property for $1,600,000. Assume that the investor wants to put a 25% down payment ($400,000 in equity) and finance the rest of the purchase with a $1,200,000 loan. A lender offers an acquisition loan at a 1.2 debt service coverage ratio (“DSCR”), meaning that the property’s NOI must be at least 1.2 times the amount of the debt service, resulting in a loan of 75% LTV.
At a 5.5% interest rate, the property would qualify for the $1,200,000 loan. When cap rates were at 5%, the investor might have been able to get a loan at a 5.5% interest rate. Given the Fed’s recent interest rate increases, however, the lender’s interest rates have also increased. The best rate the lender can now offer is 8%, which lowers the loan amount to $946,000 or approximately 60% of the purchase price, down from 75% when the interest rates were lower. Accordingly, an investor would have to put up an additional $254,000 of equity to purchase the property. This example of lower debt and higher equity also holds true when an investor has to re-finance a property.
Outlook: How investors use debt funds to capitalize on higher interest rates.
The current investment environment is vastly different from what it was over the last ten plus years. We expect interest rates to be sticky near-term and then normalize, close to where they are now in the 2-4% range but nowhere near the recent past zero to two-percent range. The higher rates combined with higher construction costs will require more equity and less debt in real estate investments and developments. Well-capitalized developers are better positioned to weather the current environment, contribute additional equity to their projects, and still make an acceptable return on investment.
Developers who cannot paydown their debt to right-size their loans may end up selling their properties at a discount from peak values or simply hand the keys to the lender. As property values decline, opportunistic investors will step in to capitalize on these buying opportunities. Once the market is at equilibrium between buyers and sellers, property values will begin to stabilize and recover along with increased transaction activity.
Equity type returns from debt funds
AGP Capital is encouraged by the current real estate lending environment and the growing importance of private debt funds. As a private lender, we are favorably positioned to originate lower LTV loans at a higher yield, as we illustrated in the above examples. Since inception, AGP Funding REIT has provided attractive risk adjusted returns to our investors. These returns are consistent with the 20-year returns on private real estate investments which have averaged a little over 8%, as shown on the chart below. By investing in debt funds, investors can achieve overall return targets without having to rely as heavily on riskier investments such as equities.
