No one anticipated interest rates rising as fast as they have. After the last FOMC meeting the sentiment is hawkish and interest rates are going to continue to climb.
-Jerome Powell
So, what does that mean for asset prices? For starters, something is only worth what someone else will pay for it. So, while sellers still want to sell for Q1-Q2 2022 prices, the reality is the buyer pool willing to pay that is disappearing.
Negative Leverage
SOFR is currently at 3.80% and the 10-year treasury is currently fluctuating around 3.85% after a 40-basis point drop last week. This means at best a floating rate bridge loan is 7% or more with the purchase of an expensive rate cap and a Fannie Mae or Freddie Mac loan is available at 5.75% to 6.00% fixed interest rate.
If your interest rate is 6% to 7% on new debt and you are trying to sell at a 3% to 4% cap rate, the buyer is going to have negative leverage. Negative leverage occurs when the borrowing costs are greater than the overall return produced by the property’s cash flow.
Take a $25 million property for example. At a 4% cap rate that property produces $1,000,000 in NOI. For $1 million in NOI at roughly a 6% interest rate you get a little over $11 million in loan proceeds if you size to a 1.25 DSCR.
That is 44% leverage. You need to raise $14 million for the down payment and at least another $1 million for closing costs and capex. To buy that $25 million property at a 4% cap rate you need to raise $15 million.
Take a look at the unlevered return versus the levered return:
| Unlevered | Levered | |
| Purchase Price | $25,000,000 | $25,000,000 |
| Loan Amount | $0 | $11,000,000 |
| Interest Rate | 0.00 | 6.00% |
| Amortization | 0 | 30 Years |
| Annual Debt Service | $0 | $800,000~ |
| Net Operating Income | $1,000,000 | $1,000,000 |
| Cash Flow After Debt Service | $1,000,000 | $200,000 |
| Cash on Cash Return | 4.00% | 1.42% |
As you can see from the table above the levered return is less than the unlevered return. This is negative leverage.
Bridge Loans
After the large runup in multifamily asset prices and syndicators making 2x to 3x in 2 to 3 years, multifamily buyers turned to bridge loans. This allowed them to bid up multifamily asset prices even higher. Read more: How Bridge Lenders Inflated the Multifamily Market – James Wilson
Buyers are still looking to bridge loans for higher leverage, but it is costly. To get 75% leverage on that $25 million deal you need a bridge loan. Most bridge loans will require a rate cap and to cap a loan of $18,750,000 at 2% for 3 years that will cost over $1 million.
So now you have a 6% interest rate payment on $18,750,000. Paying interest only, the annual debt service is $1,125,000. This is a negative cash flow situation which is worse than negative leverage.
Seller Denial
Whisper prices are still high, reality has not quite set in. There are some buyers still buying at low cap rates with assumptions or trying to get a deal for the bonus depreciation. There is also 1031 money that needs a home.
However, if interest rates remain at this level or higher, more buyers will come to the same conclusion—deals do not pencil. Once the assumption deals run dry and the bridge loans come due, new price discovery will likely occur—if rates remain elevated.
All bets are off if we get the Fed pivot and go back to 0% Fed Funds rate. If that happens, I expect a tsunami of refinances from bridge into agency or trading volume to return to Q1 2022 levels. However, I still suspect buyers to be more cautious moving forward after this year.
The reality of the new interest rate environment is difficult for a lot of sellers to come to terms with because times were good for so long. No one was prepared for the run-up in interest rates. Even the deals that exceeded their proforma will have difficulty refinancing at the higher rates.
Conclusion
No one that bought at a 4% cap rate is going to want to sell at a 6% cap rate. Look at the chart below. If you bought a $25 million asset two years ago you do not want to sell it for $16.7 million.
If interest rates are 6% or higher next year, then cap rates are likely going to expand. Next year there will be less buyers willing to buy a deal at negative leverage or negative cash flow.
The rising interest rates have a lagging effect on the economy. We have yet to see what affects recent rate hikes will have. Time heals all in real estate. Take any opportunity to refinance into longer term debt.
