This article was posted on Wednesday, Jan 01, 2014

One of the concepts behind How I Met Your Mother (now in its final season) revolves around the characters having unique memories of the same event, with one recollection often being very different from another. Recalling things differently is not unusual: people tend to remember the points that are important to them. That’s why that old joke is still funny – a tailor returned from an audience with the Pope and was asked “So, what’s he like?” The tailor answered, “A 42 Regular”. Various people having dissimilar recall of the same event is the Rashomon Effect and has been used as a theatrical device for an awfully long time.

It’s also why forensic evidence of a crime is often more credible than eye-witness accounts.

In addition to observing an event, the Rashomon Effect can, less often, refer to different people drawing contrasting conclusions from data alone.

For example, a recent article by Hans Nordby ( addresses how rising interest rates will not hurt commercial real estate’s relative value. Mr. Nordby is well respected and someone whom others listen to. He’s the Managing Director of Property and Portfolio Research (PPR) and advises pension funds, pension fund advisors, and REITs on acquisition / disposition of institutional quality commercial properties.

He wrote that (paraphrased):

- Advertisers -
  • The economy is experiencing economic growth, thus you would expect the Fed would announce a tapering its QE program.  It should not surprise anyone.
  • In a growing economy both rents and occupancy levels should rise “mitigating some of the increase in interest rates”.
  • Commercial real estate is a partial inflation hedge, in that rents increase with inflation (most easily accomplished when leases are short), and also because inflation improves the value of existing buildings. If it costs more to build a competing property, then the value of existing properties automatically goes up as “construction is both more expensive and more costly to finance”. Mr. Nordby’s point here is that the value of something has little to do with its purchase cost and everything to do with its replacement cost.
  • Uber-investors (sovereign wealth funds, pension funds, etc.) diversify among mostly stocks, bonds, real estate and commodities, comfortable that each class will eventually have its day in the sun. That being the case, asset classes that promise the greatest relative value are the ones most in demand at any given time. That demand, of course, increases their cost (reducing projected return) and pretty soon another asset class becomes the new momentary favorite.  But historical analysis suggests that “over the long run, research demonstrates that commercial real estate generally performs somewhere between stocks and bonds”
  • For these three reasons (improving rent and occupancy levels, rising replacement costs, long term return between stocks and bonds) a “normalized interest rate environment is not going to be the end of commercial real estate’s value to investors.

Here’s where the Rashomon Effect appears, because I don’t read the data quite that way. Mr. Nordby’s observations, like the tailor’s, may be true for his clients without being very useful to us. His clients are interested in relative values, as in “Where should we place new money?”, but we don’t benefit from that problem. Firstly, the people I work with – except when they refinance an existing apartment building – seldom get checks big enough to buy another 150 units. Secondly, very few of my clients have significant investments beyond their buildings. I could count on three hands the number of my people who have meaningful stock or bond portfolios. For this discussion, significant or meaningful investments are those amounts that, if lost, would change their life style.

Because their only significant investment is their apartment building(s), any adverse change in (a) income or (b) value is worrisome. That is not necessarily the case with the uber-investors Mr. Nordby advises. Remember, institutions invest large amounts on a regular basis, so relative returns are ok with them. We invest much smaller amounts only a few times in our lives, so we’re focused on absolute returns.

Why absolute? Because my clients mortgage their buildings and nobody wants to be underwater. And because my clients live off the income from their buildings and nobody wants their primary source of income to . . . stop. Our concerns are basically twofold:  Is the building underwater and my down payment lost? Am I going to make the same spendable that I did last year? With those two questions in mind, let’s look again at Mr. Nordby’s points.

The Fed will probably move to end QE.

One day, yes. That’s not even really arguable. Nobody knows when the end of Quantitative Easing will come but it’s already the “longest period of government-subsidized interest rates ever”, so it will probably end sooner rather than later.

A growing economy should mitigate some of the increase in interest rates.

If you have triple-A tenants net leasing your properties with automatic annual Cost of Living adjustments, sure. The typical AAA tenant normally sells a needful product to the public at a profit, so they can offset rent increases by indexing their sales to inflation. And moving is a costly, time-consuming endeavor not to be lightly undertaken.

The majority of our tenants are not triple-A. Both husband and wife may have great jobs and their rents may never have been a day late, but what happens if one of them gets laid off? Or another tenant, a young person shortly out of college and grateful to begin his career at In-‘N-Out gets his hours cut from 40 to below-the-healthcare-threshold 29? Most of our tenants, when they’re faced with lower income, find moving to cheaper accommodations to be the obvious solution. It can be done over the weekend.

Both property value and rents go up with inflation.

If rent increases were unrestricted and free to mirror inflation, then it could be possible that an 11% inflation rate would be met with 11% increases in Net Operating Income and the local cap rates would find it necessary to adjust. That might seem a reasonable proposition if we were in the Faculty Lounge.

But here in the Cafeteria we understand that inflation refers to an increase in the cost of living. It does not necessarily mean that income will go up with inflation. As a matter of fact, in an inflationary environment there is huge incentive for a company to minimize their wage costs, so income may well not increase to match inflation. We discussed that a couple of paragraphs up.

“Over the long run, research demonstrates that commercial real estate generally performs somewhere between stocks and bonds”

This comforting observation isn’t really actionable for us. Stocks and bonds are usually – not always, but usually – bought for cash. Similarly, very large institutional investors commonly – again, not always, but commonly – make their real estate purchases for all cash. For example, if bonds yield 3% and stocks have a total return of 7%, then the all-cash institutional investor might expect a 5% cap rate.

Some people do buy for cash, but most people do not. Almost all private investors leverage their apartment buildings. The total return numbers are overwhelmingly positive: there’s the cash flow, the equity buildup, tax advantages and (usually) appreciation. The total return from well located, well managed, properly financed apartment buildings would make a pass-book saver gasp.

Of course, there’s another side to this. In the early years it doesn’t take too many vacancies, with the income loss and renovation expenses, to wipe out the small initial cash flows. And that starts the death spiral. Insufficient net income means you’ll have to postpone paying the gardener, the manager, the painters, carpet-installers, and eventually the utility company. Postponing these necessary costs of business only accelerates vacancies. Income drops further and soon there’s not enough to pay the mortgage.

Leverage is a grand thing in good times, but it can be devastating when rents don’t keep up with inflation.

A “normalized interest rate environment is not going to be the end of commercial real estate’s value to investors”.

Agreed. People will always need a place to live. But that does not mean that commercial real estate (apartments) will maintain their values. It all depends on whether or not the Net Operating Income increases with inflation. Even if the NOI does, it still does not mean values will remain where they are, especially for leveraged properties.

As an example, presume someone recently purchased an apartment building rented at $2,000 per unit. Further, presume that operating expenses and reserves were 40%. The NOI on a per unit basis would be, in this case, $1,200 ($14,400 annually). Given an interest rate of 4.5% and a Debt Coverage Ratio (DCR) of 1.2, that NOI would support a loan of $197,000 per unit. With one-third down ($99,000), the building might be priced at $296,000 per unit. Annual cash flow would project at $2,400 per unit, giving a cash-on-cash yield of approximately 2.4%.

Everything else being the same, if interest rates were 9.5% that same NOI would support a loan of only $119,000 per unit. Using the same one-third down ($59,000) scenario, the value of the project would be $178,000 per unit. Mortgage at $197,000 a unit, now worth only $178,000. Not only did we lose our entire down payment, but we can’t even sell the property for enough to retire the loan. Ooopsie-daisy!

Sidebar: The previous paragraph is predicated on “everything else being the same”, an artificial constraint that is probably unlikely. We used the restriction only to illustrate the possible effects of higher rates. In reality, in the time it would probably take for interest rates to double, income would almost certainly go up as well. It may even go up enough.

Takeaway: Well located, properly managed and suitably financed apartment buildings can be splendid investments. However, if NOI does not increase to offset inflation and interest rate hikes, then both cash-on-cash and the owner’s equity are at risk . . . so try to minimize your interest rate hikes.

Disclaimer:  This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].

If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at

Leave a Reply