The following Q&A was completed as part of our conversational Commercial Real Estate FAQ Interview Series, we hope you find it helpful.
Real estate is unique in that it’s nearly completely financed and structured based upon debt, and because of this value is tied closely with interest rates and changes. When interest rates go up, values go down in direct correlation with the lowering of NOI. When one has to pay more to pay toward a loan, the cash that goes to the bank is added to the NOI of a property. When rates go down, however, these property values go up. In today’s post-Covid world, while interest rates are low, trends are emerging depending on what types of commercial properties are doing well during these unprecedented times.
Richard Wilson: How are interest rates tied to property prices and why do investors watch the fed so closely on changes and rates?
Ben Marks: I think first, I think it’s a great question and it’s a good place to start. I think the first thing that’s important for most folks, particularly who are looking to get into commercial real estate especially if they are coming from another industry, real estate is very unique in that it is almost entirely financed and structured based on debt. And so a typical multi-family deal for example where say there’s 100% of the capital stack, 80% is financed typically by a lender, by a first mortgage, and sometimes more, we’ve had a couple of deals where that’s higher but typically 80% is fairly common. And the other 20% is either a combination of equity, preferred equity, or some other type of structure.
So, getting back to your question, when you have 80% of anything being financed based on interest rates it’s highly leveraged interest rates. And that’s why if you take a longer term view back when I started in the late 90’s, in our first yield we’re getting financed at about 8-8.5%. Today we just, literally today, locked in a new structured refinance we were in the process of doing it – 2.5%. So if you go from 8.5% to 2.5%, that’s 600 basis points, what that really means is that it’s cheaper to finance and that the same existing cash flows that you get in a piece of real estate are worth more because it’s cheaper to finance. And so that’s why the relationships between interest rates and prices are directly and almost exclusively inversely related. As rates go up, values tend to go down.
Richard: Right. That makes a lot of sense, so in layman’s terms if rates start to go up, then NOI is going to drop, the free cash flow will drop, because you’re going to be paying more to the bank to borrow that money. There will be less profits for the investors so those things just move in inverse directions essentially is what you’re saying, right?
Ben: Correct. I’d say it’s inversely related because so much of it is so often financed by debt. Literally it’s one of the most, I think one of the most, levered industries to interest rates that’s out there.
Richard: Right. Okay. What insights can you share for those looking to start to invest in commercial real estate properties?
Ben: Wow, where to begin? I think I’ll start with this – I think especially for younger companies and younger folks going into the industry, and you’ll see this is a running theme for what we’re doing operations now, the industry you know is always changing. But I would say especially post-Covid, the rate of acceleration and the rate of disruption in every asset class is really completely bifurcated. When I say bifurcated I mean you can have similar asset classes in different parts of the country behaving differently, you can have different assets within a given city, in the same city like Miami, Florida, but we are – multi-family has never been better, office and retail not so much. So I think getting a handle and really deciding on where you want to specialize is probably more important now than it’s ever been, because up until a couple of years ago if rates were down, every asset class went up. And inversely if rates were up every asset class went down. That is beginning to change, but even though per the prior question, interest rates are incredibly important, but almost as important now is the nature of the asset and whether it’s disruptable. And I think that’s becoming a key issue in the world out there.
Richard: Right, great.