Real estate investing is always impacted by interest rates, and commercial real estate is no exception. Find out how rising interest rates will impact commercial real estate investors and steps you can take to thrive as interest rates rise.
4 Impacts of Rising Interest Rates on Commercial Investors
Impact #1 – Demand: When interest rates rise real estate demand trends downward. The reason is simple: people cannot afford a mortgage anymore. As this trend continues, there will be a fear of the real estate market crashing.
Impact #2 – ROI: ROI is your return on investment, and rising interest rates cause your cash-on-cash return to drop because you will have a lower cash flow. In fact, if interest rates go high enough, your ROI will look so bad that you will be forced to walk away from a deal.
Impact #3 – Cash Flow: As mentioned above, as interest rates rise, cash flow decreases. The higher your mortgage payment the lower your cash flow. Climbing interest rates can kill real estate deals for this reason alone.
Impact #4 – The Economy: Interest rates rise usually to combat inflation, which means the cost of living is on the rise. Rising interest rates make things worse for the consumer because everything becomes more expensive. When the Fed handles inflation poorly, it can send the country into recession. And an economy in recession will impact commercial real estate investment.
Rising Interest Rates? Here’s How to Thrive:
#1. Don’t Wait!
When interest rates are high, our tendency is to wait to invest. However, this hesitancy doesn’t pay off. Case in point, I recently advised someone to buy a small apartment building. They were reluctant to do the deal because of the interest rates and felt the deal was too expensive. But now that the deal is done, they are glad they did it. Why? The economic downturn has driven more people into rentals, so now his property is more valuable. And even though the rates were high, he was able to raise rents by 10%! Had he waited, the interest rates only went higher and he would have missed out on all the benefits of owning commercial real estate. In other words, if you want to thrive you can’t wait!
Here are 3 more reasons not to wait:.
- During an economic downturn demand for rentals rises. I have experienced economic ups and downs as a commercial investor and navigated three economic crises. Each time the economy tanked, demand for home ownership decreased and demand for rentals increased. In the present economic downturn, as interest rates rise, many people are opting not to buy homes and are becoming long-term renters. This is great if you are invested in apartment buildings because the pool of renters rises while the supply of apartments shrinks. Higher demand means your property value increases, as well as rents.
- The US is in the midst of an affordable housing crisis. Supply and demand; it’s that simple. In America right now there is a crisis in affordable housing, and the problem is not going away any time soon. At present there is not enough construction to fill the demand for homes or apartments. Making matters worse is the fact that building costs have gone up with inflation.
- Apartment buildings aren’t getting cheaper. They say, “you don’t wait to buy real estate.” Apartment building prices are going up, not down. Some think they should wait for the market to crash. I don’t believe that will happen. If I am right, you will be waiting forever and end up missing out on an investment opportunity today.
Many of us want guarantees, which means very low risk. And yet we also value looking for opportunities, all of which involve risk. This is two separate ways of thinking. The “don’t wait” mindset is focused on opportunities now, not guarantees later.
#2. Implement Seller Financing
Another way to thrive as rates rise is to implement creative financing strategies. Creative financing can overcome challenges especially when interest rates are high. For example, I know an investor who recently closed on a large storage facility. At the time of purchase, the property was 40% vacant, which meant even if a traditional lender approved a loan, a large down payment was needed. And with the high interest rate, the numbers just didn’t work. But with some creative financing, the investor was able to the do the deal. In this case he put 10% down, and the seller financed the rest. Once the property was 100% occupied, the building doubled in value.
Creative financing techniques are a must when the numbers don’t work, and seller financing is a great solution in many cases. Here are four techniques for seller financing:
- Seller Agrees to Carry the First Mortgage: This is where the seller becomes the bank for the buyer.
- An Installment Sale: With this financing option, you buy the property from the seller in chunks or installments. This works great when rates are high and the numbers won’t work for traditional lenders. Another advantage to this option is that it helps the seller with their capital gains taxes.
- Use a Master Lease Agreement: Of all the creative financing options this is my favorite option. Here you essentially purchase the commercial property with a small down payment. There are no banks involved, no credit checks, and no appraisals. It’s just between you and the seller.
- Have the Seller Carry Second Mortgage: Here the seller assists the buyer with the down payment by taking part of the down payment that the traditional lender or bank requires, and then piggybacking it on the seller as a seller carried second mortgage.
All of these creative financing techniques need to be in your investing toolbox when interest rates are on the rise.
#2. Focus on Your NOI (Net Operating Income)
This takes discipline but is so important. You must focus on your NOI when interest rates are high. To calculate your NOI you simply subtract your expenses from your income. The remainder is your net income. This is the money you use to pay the mortgage and the rest is your cashflow. At all times, you need to manage your NOI well to make sure you have a consistent cashflow and increasing property value because when these two are working well, your options increase. You can retire, you can cash out and purchase another property, or you can cash out refinance and pay off investors.
The point here is, you need to be focused on your NOI when interest rates are rising because you have less margin of error. You need to be efficient in managing your money, marketing, management and maintenance to insure your cashflow isn’t challenged.
Whether you’re a beginner investor or a seasoned veteran, the NOI in this economic environment is extremely important. As the NOI goes up, so does the cashflow and property value. So, don’t focus on rising interest rates and prices going through roof. Instead focus on evaluating your property: what is the NOI today and how can I take it to the next level? Which means no bad deals allowed. There can be no sloppy evaluations of your property or business because high interest rates are not forgiving.
