How Do Rising Interest Rates Effect Underwriting?
Last week, I spoke about the effect of rising interest rates on multifamily investing in general and concluding that even with rising rates there are still great opportunities to be found. This week we will pivot into one aspect of piecing those good deals together which is how underwriting changes with the rising rates.
How do rising rates impact deals?
When we underwrite (analyze) a multifamily property there a numerous considerations to be made. That said, at a high level we are projecting our income and then subtracting our expenses to arrive at the net operating income (NOI). The NOI is a metric of financial performance used on commercial real estate that is independent of the debt placed on that property. If the debt is then subtracted from the NOI we are left with the cash flow on the property which can be distributed to all the investors. The cash flow is therefore impacted by the cost of the debt service on the property. In other words, a higher interest rate will cause the cash flow to be lower which can therefore create pricing adjustments on the deal due to these lower cash returns.
How is Apogee modifying our underwriting?
One might think that the purchase price would be low enough to result in the same cash flow that we were seeing when interest rates are lower. However, this is not the case. Most all investors believe that in the next 1-2 years we will see the Fed begin to once again lower rates which will offer owners the opportunity to sell at a high price point or refinance with a much better rate. For this reason, while there has been some downward pressure on pricing, the overall cash flow today of properties is lower than a year ago. This has caused us to really focus on the going in price of a property and look for those properties that offer a meaningful discount from what they would have been a year ago and from what they likely will be in another 1-2 years. Additionally, we have been looking at a number of properties with loan assumptions that have attractive rates. A loan is assumption is simply where you take over the debt from the seller instead of placing new debt on the property. Some of the deals we have seen with loan assumptions recently have higher cash returns on going and still very strong overall returns.
In summary, we at Apogee are continuing to look aggressively for new deals that will offer our investors opportunity to invest in properties that are currently discounted. We are though taking the time to cautiously consider the many potential challenges in the market including rates that continue to rise, expenses rising from inflation and CAP rates which have expanded during this year. We believe investors who take this approach of balancing thoughtful caution with future optimism will be the most successful coming out this economic recession.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please check out our free ebook "Achieving Financial Freedom Through Multifamily Investing."