The Fastest Way To Build A Six Or Even… Seven Figure Real Estate EMPIRE!
Over the last year, the Fed has taken interest rates from zero to 4.75. Treasury yields are at 3.5. Transaction volume is down, buying power is down, and sellers who financed their deals with shorter-term bridge loans are caught between a rock and a hard place.
If you’re one of those sellers, you might end up needing to sell or refinance when you don’t really want to–and this can have devastating effects on the value of your portfolio and your returns.
So, with that in mind, today’s episode is all about how to prevent this operational threat to your business from torpedoing your profits. You’ll learn how to use long-term debt to protect yourself from skyrocketing interest rates when you structure your deals, prevent your properties from ending up in purgatory, and continue to grow as your competition scrambles to get their costs under control.
Key Takeaways with Josh Cantwell
- How rising interest rates can negatively impact your cash flow, your expenses, and your selling power.
- Why there are so many properties hitting the market right now in an attempt to cut their losses.
- How to lock in long-term debt to stabilize your cash flow in times of economic uncertainty.
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Josh Cantwell: So, hey there. Welcome back to Accelerated Investor. I’m your host, Josh Cantwell. And today we’re back with another episode of talking about operational threats to your multi-family empire. Today, we’re going to talk about refinancing and selling at the wrong time. Here we go.
Josh Cantwell: So, hey there, guys. Welcome back. Hey, it’s Josh and I just wanted to say thanks for following along, for listening to this episode. So, let’s go ahead and jump in. Today, we’re talking about operational risks. And one of the things that you’re seeing in 2023 that’s a result of the Fed increases in all the interest rates last year. You remember that the Fed was raising the Fed funds rate by 75 basis points every month for about four or five months in a row. And the Fed funds rate literally went from zero. Right now, as we sit here today, they just did a quarter-point increase on February 1st and now the Fed funds rate is around 4.5 to 4.75. And so, that is a direct impact on bridge financing. It’s a direct impact on residential lending. And the ten-year Treasury yield has also gone up from it was at 1.6 back in October of 2021. It jumped all the way up to about 4.4 in October of 2022 and then has settled back down to about 3.5 as of this recording.
And so, that Fed funds rate is directly impacting bridge financing. It’s directly impacting residential financing, but bridge financing for commercial real estate because commercial lenders, okay, write this down if you’re listening, is that bridge, whatever the cost of that is, is the SOFR rate plus anywhere from 450 to 600 basis points. So, 4%, 4.5% to 6% on top of the SOFR rate. So, as I’m recording this, I’m going to look at this real quick. So, the SOFR rate stands for Secured Overnight Financing Rate and the SOFR rate as of today, it’s about 4.55. So, if the SOFR rate, which is essentially the bridge rate for commercial real estate for multifamily is at 4.55, then lenders will add on, tack on basis points or percentages on top of the SOFR rate to come up with a bridge financing rate. So, if you’re at 4.55 and they tack on 400 bps, that’s 4%. So, 4.55 plus 4 equals 8.55. That’s going to be the rate of your bridge loan. If they tack on 600 bps, it’s 4.55 plus 6%, 6.00, which now means that your bridge financing rate is 10.55. So, that’s how they price out bridge financing.
Now, when they price out bank financing or when they price out Fannie Mae, Freddie Mac permanent financing, instead what they typically do is they take the ten-year treasury. The ten-year Treasury yield as of today, as of this recording is sitting at about 3.6%. And like I said, that jumped up back in October to over 4.4, dropped back down into the middle fives. And it’s been hovering for about the last four months since about December, late November to now in February of 2023 has been sitting somewhere around the middle 3.5%. So, the way that banks priced out their bank financing is they usually take the ten-year treasury and then add about 200 to 250 basis points, okay, 2% to 2.5%. So, if you take 3.6 and you add 2%, that means the rate of your bank financing is about 5.6. If they’re adding 2.5 basis points or 2.5%, that means that you’re financing has to be 3.6 plus 2.5, which is going to be that bank financing at about 6.1%. Same thing with Fannie Mae and Freddie Mac. They’re going to have overlays or a yield spread. And that spread is going to be what the lender is making over and above the Treasury.
And so, when you look at this operational threat to your business, the one thing you don’t want to have happen is having to sell or refinance at the wrong time. So, over the last six months, the transaction volume has gone down because sellers don’t want to sell but some owners, some sellers are being forced to sell because three years ago, two years ago, five years ago, those deals, the buyer bought them with bridge financing that was only locked up for maybe two years or three years or four years. It was essentially like getting an adjustable-rate mortgage. Remember back in 2005, 2006, 2007, 2008, the whole economy got in trouble. Why? Because of adjustable-rate mortgages that were done with no income, no asset verification. So, in the commercial world, what’s happened over the last three or four years is that a number of buyers have come in and in order to get the maximum amount of financing they could get, the maximum amount of loan to value, the max amount of proceeds, and also to get non-recourse financing, they went with a bridge loan. Well, those bridge loans were only fixed for maybe two years, three years, four years.
So, they would have a floating rate loan with what’s called an interest rate cap. That cap means that the interest rate could not go higher than that amount, and it would be locked for, let’s say, three to four years. Well, guess what’s happened? Since March of 2022, when the Fed decided to start bumping up the Fed funds rate, the interest rate skyrocketed, the SOFR rate skyrocketed, the ten-year Treasury skyrocketed, and it went from about 1.6% on the ten-year Treasury up to almost 4% between March and about late June, early July. So, within four months, the ten-year Treasury went from 1.6% to almost 4%, okay, 3.5% to 4%. So, all of a sudden now, instead of the bank financing being at roughly 4%, the financing went to 6.25. And so, if somebody had, an owner had a loan that was a floating rate loan, guess what happened to their mortgage payment? Well, the mortgage payment went up by 25%, 50%. In some cases, the mortgage payment went up by 100%, which means it doubled. I mean, can you imagine?
Can you imagine owning a building where your mortgage payment is, let’s say $50,000 a month, and then all of a sudden you have a floating interest rate loan? That floater starts to move because the Fed is raising rates, that SOFR rate starts to jump. Now, your mortgage payment jumps and your mortgage payment doubles. I mean, that’s going to crater your deal. It’s going to crater your cash flow. Then you go to refinance or sell the building and guess what happens? The new buyer who’s buying the building, they have a much higher cost of interest and so their price expectations are going to drop. They want a lower price because the cost of their debt is higher. Cost of debt goes up. The cap rate should also go up, which means prices should come down. Now, what’s happened is, is that obviously the Fed can snap their fingers and make the rate go up. It happens like literally overnight and the market reacts and prices go up on the cost of the debt. Well, sellers and buyers, buyers can immediately change their pricing with that new rate. So, the Fed can change quickly, buyers can change quickly. But guess what? Sellers are not so quick to change. They want the pricing. They want the deal that they should have got a year ago.
And so, today, those guys that have bought buildings on these SOFR bridge loans that are now coming due, guess what happens? They do not have the option to refinance because the banks, the new banks will only give them so much new loan because it has to what’s called cover the debt service coverage that it has to be enough cash flow to cover the new debt payment, the new debt service payment. And that’s usually at a 1.25 or a 1.3 coverage ratio. So, if the new debt is much more expensive, but your cash flow is the same, that means you’re not going to cover. And if you’re not going to cover, that means they’re simply going to give you less proceeds. If they’re going to give you less proceeds, now you’ve got to raise a lot more equity. If you’re refinancing, you’re not getting enough proceeds to cash out your investors. If you’re buying, you’re getting much less proceeds, which means you have to raise more capital. In both circumstances, prices come down.
And so, you’re starting to see now a number of sellers and owners who are bringing their properties to market, hoping that somebody will buy that property for yesterday’s prices so they can clear the deck, pay off the loan, pay off the debt, pay off their investors, and move on when they’re willing to walk from the deal with making no money because they just want to get out of it. Because now what’s going to happen is now their debt’s going to be called due or the interest rate cap, those interest rate caps are only good for a certain amount of time, maybe two years, three years, four years. So, now their payment goes up. Now, they hit the cap. Well, they bought a cap. It’s essentially insurance. That insurance is essentially a cap that the payment can’t go up past that. Well, that insurance is only good until a certain amount of time. It’s only good until like three years out, four years out, five years out, and then the cap expires. When the cap expires, we have to pay to rebuy the cap, essentially rebuy the insurance to keep the interest rate flat. Well, do you think the cost of that insurance has gone up or down? Cost of the insurance has gone up. So, now you have a huge payment that you have to make to keep the interest rate the same. Or you can let the interest rate cap expire and now your loan becomes a floater, it becomes a floating rate, and now your mortgage payment is going up even more.
So, you’re caught between a rock and a hard place. If you’re one of the owners of these buildings, you’re caught between a rock and a hard place and that is you can’t really refi because you’re getting less proceeds because the cost of the debt is higher so you’re getting a lower amount of proceeds because it doesn’t cover. You don’t have enough cash flow to cover the payment. That’s number one or you have an interest rate cap that’s about to expire. And if it’s going to expire, that means your mortgage payment is going to go up because your interest rate went up. That’s number two. Or number three, you can pay for the rate cap extension but it’s tens of thousands or hundreds of thousands or millions of dollars and you have to come out of pocket for this big expense that you weren’t expecting. And so, this is the exact situation that a lot of sellers and owners are in who bought properties over the last three or four years using these SOFR loans with interest rate caps. They essentially bought an adjustable-rate mortgage. It was fixed for a while. Now, it’s going to be adjustable. And if they want it to stay fixed, they have to pay for that and they don’t have the money.
So, that’s a situation that a lot of people are in. You don’t want to be in that situation. How do you avoid that situation? Pretty simple. You lock in long-term debt. Long-term debt means 5 years, 7 years, 9 years, 12 years, 15 years, long-term debt so that at any time when these deals are moving and everybody else is freaking out about the interest rate caps and interest rates going up, you don’t have to worry about it. So, on my portfolio, especially the portfolio I have in Cleveland, it’s all long-term fixed-rate financing. I don’t have to worry about it at all. And so, we’ve never seen interest rates go up as fast and as hard as they’re going up. They went up from March until July and then they kind of floated back down in August. And then in August of 2022, they started skyrocketing again. They hit a peak in November of 2022. They’ve gone down and then they flattened out for the past four months. And this is one of the reasons why I’m so glad to have secured long-term financing four, five, six, seven, eight years of fixed-rate financing on our portfolio and not having to worry about selling or refinancing at the wrong time.
What am I expecting? Over the rest of this year, I’m expecting the ten-year Treasury to stay somewhere between 3.5% and 4%. I think it’s going to stay right there. It’s going to float around. But the market’s already baked in. The Fed going up this fast, this high that was baked in when we saw the rates at over 4%, 4.25%, 4.4% in November of 2022. And then as the rates have dropped, it’s because now the Federal Reserve Chairman Powell is signaling that we could have a soft landing. He’s signaling that we do not have to aggressively raise rates going forward. Maybe it’s a quarter of a point going forward. And because the unemployment has stayed down at around 3.5% to 3.7%, and it hasn’t gone up to 4.5% like he predicted, employment is still strong. Companies are still hiring. There’s still lots of jobs out there that people are not filling. There’s a lot of opportunity in the economy where the economy seems very resilient right now to that big shock in interest rates. And so, the risk going forward is just that these lenders are going to have to do a lot of workouts with these owners and sellers who have these bridge loans, these SOFR loans, where the interest rate caps are expiring.
They’re going to have to do a lot of workouts because no lender wants to make a loan on a $10 million or $20 million or $50 million, $100 million deal. No lender wants to do that and then have to take the property back. Lenders do not want to take properties back. They would frankly let these properties sit in purgatory than take them back and force back the taking back of the deal. They just don’t like that. They just do not want that. They do not want to take the deal back and put it back on their balance sheet and then have to manage it. So, I could foresee a lot of deals going into purgatory where the seller can’t sell, the seller can’t refi, the lender doesn’t want to repossess it, and it’s floating out there for the next year or two. Make sure you’re not one of those guys.
Josh Cantwell: All right. Now, listen, if you enjoyed this episode of operational risk and having to sell a refi at the wrong time, guys, please go ahead and smash down on the subscribe button. Leave us a five-star rating and a review. And don’t forget to check out all the other episodes in this series about operational risks and operational threats. We’ve talked about lack of a business plan, we’ve talked about capital improvements going over budget, we’ve talked about property manager risk, we’ve talked about regional manager risk, and now we’ve talked about refi or selling at the wrong time. I hope you enjoyed this episode of Accelerated Real Estate Investor. We’ll see you next time. Take care.