April 2018

In the April Issue

  • Investing in the Age of Rising Interest Rates
  • How Your Real Estate Investments Could Be Affected
  • 5 Strategies for Investing in Real Estate While Minimizing Your Risk

If you read our March newsletter, you’re aware of the current, volatile stock market conditions and alternative investment strategies you may use to diversify your portfolio.

This month, we’re going to dig deeper into how to invest in an age of rising interest rates, which is timely since the Federal Reserve recently announced their plan to raise interest rates 2-4 times this year. Immediate tremors were felt in the stock market after this announcement, but how will these increases affect the real estate market?

How Rising Interest Rates Can Affect Your Cash Flow

Every type of real estate investing, from residential to commercial, multi-family to self storage, or industrial to retail, are dependant on interest rates, so the cost of financing is a significant variable to consider.

Let’s look at a hypothetical but simple metric: a 30 year fixed mortgage. Right now, you could finance at an interest rate of 4¼% for 30 years on a $100,000 loan. Your payment at this rate, fully amortized, is around $492 per month.

If interest rates rise by 1% (or 100 basis points), then you’re borrowing at 5¼% for 30 years, increasing your monthly payment by about $60.

This is significant for two reasons:

  1. It puts downward pressure on affordability for a retail (individual) borrower.
  2. For investment properties, it reduces net operating income (NOI) and possibly the financing available for commercial loans.

The consequences that follow thus include a risk of price correction and general downward pressure on prices of all real estate asset types.

It’s safe to say, then, that interest rates heavily affect real estate, but the good news is there are strategies to help you manage the risk associated with rising interest rates.

In this newsletter, we’ll discuss 5 strategies to help you protect your real estate investments.

Strategy #1: Refinance Your Real Estate Assets

The first, most common strategy when rising interest rates are on the horizon is to refinance your properties while rates are still low. This is true for anyone who owns real estate investment assets, including primary residences and investment properties.

As an investor, you need to look at your portfolios, mortgages, loan maturities, and current rates on loans to determine if you should refinance now, knowing interest rates could increase in the near future.

Example: Refinance Now or Not?

My co-op in New York City has a mortgage on a condominium building that will mature in 1.5 years. It was originally a 10-year term loan and maintains a prepayment penalty of 2%.

If we refinance now and pay the prepayment penalty versus waiting to see what the interest rates do a year and a half from now, we could generate huge savings especially if the rates jump 100 basis points. We pay 2% to save 10% over the next 10 years.

*Bottom-line: Consider refinancing your existing portfolio and locking it in long-term. Your first, go-to option should be a 30-year fixed rate, but the next best thing is a 10/1 ARM (10 year fixed, floating rate every year after).

Strategy #2: Lower Your Leverage, Increase Your Equity

If you’re acquiring a new property or your property is going through refinancing with rising interest rates, your best option is to decrease your leverage and put more equity in the deal.

When interest rates are low, you can put down 25% and take a 75% loan to value mortgage. But when interest rates are high, reducing leverage by borrowing less money will reduce your payments.

By doing so, you’re counteracting the impact of high interest rates by putting in a little more money while creating a margin of safety and reducing your risk. It’s a valuable technique in a market climate when interest rates are on the rise.

*Note: Investors can use this strategy to negotiate with banks. Investors willing to borrow 5-10% less by upping their equity are much more likely to secure better rates, counteracting the raised interest rates that are on the horizon.

Strategy #3: Find an Alternative Way To Fund Your Investment

What if you find an excellent investment opportunity for your portfolio, but because of higher interest rates, you’re paying more upfront so your equity capital is more limited? What’s your best strategy in this scenario?

One approach is to look for partners. Partners can provide the extra capital, financing or even experience you need for your investment opportunity, but be sure to use caution and choose someone with a good track record. Consider these questions: Will they have voting control? Or simply provide extra capital with no other responsibility? Before looking for partners, it’s important to decide how active of a role they will have in the partnership.

3 Benefits of Finding a Partner to Help Fund Your Next Investment:

  1. Equity Capital
  2. If you need to put 30% down on a property but you only have 25%, you can bring on a minority partner to provide the other 5%. In this scenario, they will be a “passive partner” with no voting control. They simply provide the extra cash while you maintain control of the deal.

  3. Credit Partners
  4. Taking on a credit partner with a good banking relationship and track record could very well enhance your deal. Banks are more willing to underwrite a loan and give better rates if your partner has strong credit.

  5. Experience
  6. Finding a trustworthy partner who’s already navigated a similar market climate is worth more than any monetary value.

Investors should find active partners who they know, like and trust, or take on passive partners that bring in capital and will happily participate with them in the deal.

Strategy #4: Choose a Defensive Asset Type

In real estate, there are both aggressive and defensive asset types. Aggressive asset types typically have limited cash flow and high dependence on market conditions (not a good investment when interest rates are rising).

Defensive assets types, on the other hand, have strong cash flow from day one, low vacancy, lower renovation costs, and good predictability. Multi-family properties and self-storage facilities are prime examples of defensive assets with predictable returns.

How to Calculate Strong Cash Flow

When determining if your real estate asset will protect you in a downturn, it’s important to look at debt service coverage ratio (DSCR).

In essence, DSCR is a number banks compute to ensure there is enough income on the property to service the debt. (DSCR= Net Operating Income / Total Debt Service)

If you’re starting a project with a DSCR higher than 1.5, you could survive a downturn. Most banks require a minimum DSCR of 1.2, but a defensive asset will have a higher ratio because that means you have enough cash flow coming in to service the debt even if vacancy increases or you lose tenants.

Where to Find Defensive Assets

In real estate, location is an important variable to consider because each market is different. In cyclical markets that tend to rise and fall like a yo-yo, as interest rates increase, these markets tend to spin downward. A few examples include South Florida, Phoenix, and Las Vegas.

Investing in a non-cyclical market like Dallas or Memphis is your best bet for predictability and strong cash flow.

As we mentioned before, multi-family and self storage facilities also tend to be promising defensive assets for your portfolio. When it comes to increasing cash flow each month, it’s much easier to increase rent for a self-storage facility than a multi-family unit.

Multi-family units are typically more price sensitive because significant rent increases can deter tenants, so make sure you invest in an area that supports rent increases.

Strategy #5: Diversification: The Simplest Yet Most Powerful Strategy

More than likely, you are no stranger to the concept of portfolio diversity, but you may not be aware of how important this concept is in the world of investing.

The purpose of diversification is to protect yourself against certain assets, certain regions or certain sub-sectors that are taking a downturn. Real estate is “local” in the sense that certain markets will correct or be heavily affected by rising interest rates and others may not. It’s highly unlikely that real estate around the country will rise or fall at the same time.

3 Ways to Diversify Your Portfolio

  1. Look at the number of assets, their size, and their cash flow.
  2. If you have a few large assets with built-in equity, you may want to find a partner, sell some equity, refinance, or, if you have a heavily appreciated asset, take out some money without hurting the DSCR.

    For example, you bought a property for $1M and today it is worth $3M. You are still sitting on a mortgage that was originally $750K and is now $600K. You have a lot of equity in the project, but very low leverage. You can refinance the asset and get a $1.5M mortgage on a $3M property (50% leverage) and use the extra cash from refinancing to invest in a more defensive asset.

  3. Look into Small Balance Real Estate (SBRE) Funds.
  4. There are a lot of big REITS, but more than likely, they’ve had their run-up, and their growth will likely slow down. Small real estate funds (like the Tempo Opportunity Fund LLC) have a competitive advantage because they can invest in smaller projects due to economy of scale.

    Funds like the Tempo Opportunity Fund LLC, by nature, are diversified investment vehicles because of their asset diverse investment classes. If you find a good fund with a solid track record, you can achieve diversification by investing in the fund while still reducing your overall risk.

  5. Participate in Syndications.
  6. At TF Management Group LLC, we participate in some syndication deals, ones in which we pool our capital with that of other investors, because these opportunities can be good for diversification and can break up the risk for all investors even further.

However, syndication deals require a certain level of experience because most syndication occur on larger deals with more professional sponsors, investors, funds, etc. When you invest in a fund, the fund managers manage the syndication deals for you.

Final Thoughts

Each of these strategies will enable you, as an investor, to reduce your risk in the age of rising interest rates. Taken alone, they are powerful strategies, but given the current market climate of potential rising interest rates, they are even more valuable.

What if rising interest rates have a less dramatic downward influence on the market? Even if the market continues to climb, these strategies will not hurt your investment portfolio. They will simply add a more conservative aspect to it so you can rest at night knowing if the market does take a downward turn, your investments are safer.

Finally, it’s important to remember that with the right perspective and strategy, rising interest rates simply bring new opportunities for investors.

If you’d like to hear more about how the Tempo Opportunity Fund LLC can diversify your portfolio, please contact us, and we’ll be happy to talk with you and answer any questions you may have.

Thanks for reading,

Mike Zlotnik
CEO, TF Management Group LLC

This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor.

TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.