For an investor, interest rates are one of the main financial elements that can make or break the beauty of a deal. The fact is that it is almost impossible to predict what interest rates are going to do. Rising interest rates can have adverse effects on investment real estate through higher borrowing costs, change in cash flow and bank repayments, and will alter your valuation formula for the property drastically. Fortunately, there are six different steps you can take to prepare your investment property for rising interest rates.
1. Use Sensitivity Analysis
The syndication sponsors I work with all perform sensitivity analysis as part of their deals to show investors what the impact of changes to rents, occupancy, cap rates and interest rates might do to the projections. Test the waters with the deals numbers by looking at how the property will endure higher interest rates and cap rates. It is important to do this to see what levels the property can endure and at what point the property will begin to lose money.
2. Reduce Leverage
The use of less debt on your property is another way to reduce the risks of higher interest rates, as this is the main finances affected by a rise in rates. This may be a hard thing to do in many investment cases, but it is one of the main ways to reduce your risk of increasing rates.
3. Use Value Add Strategies
Use value add strategies by focusing on class B or C properties and improving them to attract higher rents and reduce expenses is a great way to protect yourself. By doing this, you can create more value to increase the cash flow of the property and higher values at exit. This creates a cushion, where losses and rising interest rates will have less of an effect on your position and income generated from the property.
4. Be Savvy in the use of Fixed and Variable Debt
Variable or Floating debt is a loan that fluctuates over a set period as it is based on a benchmark interest rate that may change periodically. A variable or floating interest rate tends to be less expensive in the first few years compared to the traditional fixed loan debt rate. Most value add strategies are typically executed in a 18 – 24 month period and sold within 5 years so having a variable rate with a cap for 3 years and bridges out to 5 years can be less expensive and more viable than a fixed rate loan.
Fixed interest rates are not necessarily the solution to rising interest rate when investing in property. This is because rising interest rates will affect your exit strategy, not your ability to repay monthly debt. High leverage and the inability to refinance when needed should be of utmost concern. It is crucial that you are educated in the types of loans and set yourself up, so your exit strategies are flexible.
5. Sell as a Viable Exit Strategy
Good operators ensure they have exit strategies in place in their business plan and be willing to adapt to the market conditions once they have completed the business plan. Rates can change quickly, so having an array of tricks up your sleeve for your exit is a must. It’s common that once a property is optimized through the value add process, and the business plan is complete, to sell it. This strategy reduces the amount of money exposed to rising rates on invested capital.
6. Have Adequate Cash Reserves
Make sure to keep an emergency fund or back up of cash. In times of recession, which will happen, those investors who planned for the worst and kept a sum of cash safe will ride on through, keeping their investment above water in rough times. While those who throw it all in will have fewer choices, and we all know what happens next. WIPEOUT! Don’t be forced to sell in a bad market because you did not use the strategies above.
Over time, rates will rise and then they will fall. It is a certainty that we will never be able to predict what rates are going to do, and we will never be able to fully relinquish the risks rates may have on our investments. In saying this, as an investor, you can take specific steps and measure to best position yourself and your investments to limit the number of risks and vulnerability they have against rising interest rates.
Rising interest rates are usually a sign of solid and healthy economic growth, which can also increase the value of a property. At the end of the day, if an increase in rates is not sitting well with your property stress tests, it may mean that it is time to sit back and recalculate your investing approach. Be diligent in your research and make sure there are clear benefits to the investment deal you chose, in all situations.