If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com.
Net Operating Income (NOI) divided by Price equals Cap Rate. Ex 1: If we have an investment valued at $100,000 and it pops out a $5,000 NOI, we’re making a 5% cap rate ($5,000 divided by $100,000 = 0.05). Ex 2: If we paid $50,000 for the investment and got the same $5,000 net cash flow the cap rate would be 10% ($5,000 divided by $50,000 = 0.10). Ex 3: If the price was $155,000 our cap rate would be 3.23% ($5,000 divided by $155,000 = 0.323).
The Capitalization Rate is the yield (in decimals) you get from the cash flow off an investment. It’s a “cap rate” if the yield comes from a direct investment. If you get it from your guaranteed bank deposits it’s called “interest”. If it were from stocks, it would be called “dividends”. The name used indicates your relationship to the source of the funds, with different names representing different financial relationships. I don’t know why that is.
It’s “cyclical” if prices are linked to a business cycle (normally, 12 months). Gasoline costs more in summer and heating oil in winter.
Its “secular” if values chart a persistent trend line longer than one business cycle.
A “huckleberry” is exactly the right person or thing for the job. Lots of people don’t use the word anymore, but they should.
“Net Operating Income” (NOI) is actual income minus all expenses associated with the investment. It’s what you could put in your purse at the end of the year if you had no mortgage. Don’t forget: mortgage payments are deducted from the NOI to get Cash Flow Before Taxes (CFBT).
A “secure” investment means you probably won’t lose your principal.
A “prosperous” investment means your net worth will likely increase.
So here we are in an environment of extraordinarily low rates. As we saw from the cap rate examples, low rates inflate the values of all streams of income. In the earlier example the $5,000 stream of income was worth $100,000 when capitalized at 5%, but inflated to $155,000 if the cap rate dropped to 3.23%? As rates go down, values go up, that’s the rule. The counterpart is that as rates go up, values go down. For example, that same $5,000 stream of income capitalized at 10% it would only be worth $50,000.
Mortgages were at 10% as recently as November, 1990, but rates have been trending downwards for a generation, since well before 1990, overriding numerous business cycles. Most of our investment career has been spent in a secular decline of interest rates resulting in ever increasing values (even if the net cash flows remain unchanged). It’s the old values go up when rates go down principle and means that all of us have been investing with a tailwind.
For illustration only, let’s assume that cap rates and mortgage rates were identical (in real life they are not). And remember the earlier examples: that if we paid $50,000 for an investment in November, 1990 at a 10% cap, it would be worth $100,000 in March, 2009 when a 5% cap rate was first available. Recently, with rates at 3.23%, that same investment would be valued at $155,000. That illustrates the beneficial tailwind we’ve noted.
Notice that nothing intrinsic to the investment changed. We continued to receive the same $5,000 net income that we bought in November, 1990. That stream of income is just as secure today as it was back then. Not even the payment dates have changed. The only variable was the change in capitalization rate, which is not intrinsic to the investment. Cap rates float with the economy.
A turn of the secular trend in rates changes things. We know that when the shift happens it’ll be with us for a pretty long time. What we hope to do is to watch the horizon and when the clouds start to form to examine our investments from a different perspective: how will they do when interest rates double or triple or even more?
When we shift to an environment of increasing interest rates, the wind is no longer our friend. What used to be a tailwind is now a headwind. If rates climb to 5%, that $155,000 investment will be worth only $100,000. If they go to 10%, as in November, 1990, the investment’s value will be reduced to $50,000. We bought it for $155,000 and now it’s worth $50,000. Geeesh, that’s not good. We got caught in a downturn in values caused by increasing interest / cap rates. When rates go up, values go down.
Although we illustrated the secular decline in interest rates by choosing the beginning date of November, 1990, that was just an example. The fact is that the long term slide began much earlier. (http://research.stlouisfed.org/fred2/data/MORTG.txt). The mortgage rate in October, 1981, was 18.45%. That means that rates dropped about 8.5% over 9 years (1981 to 1990), roughly 1% a year.
The fact that we shifted into a secular downtrend in interest rates in late 1981 – over 30 years ago – means that very few investors have significant experience in secular markets of rising interest rates. I sure don’t. So the discussion that follows should be used only as a starting point in your own investigations.
Proper investing means that we are both secure and prosperous. Security means we probably won’t lose our principal. That means we don’t overpay. Nobody wants to buy a $1,000,000 property and wake up tomorrow finding that something terrible happened overnight and now it’s only worth $700,000. It’s true that all listed properties are sold in an auction-type market and the only way you’re going to buy any building is to pay more than anybody else, but that’s still no reason to be someone’s huckleberry.
Prosperity means that our net worth will likely increase over time. In a headwind environment that is probably more likely to happen through amortization rather than the rapid appreciation we’ve been accustomed to. Appreciation comes with declining interest rates (the tailwind), but we think we’re entering a period of rising interest rates. Under rising rates our net worth will increase with greatest certainty through amortization. Amortization simply means paying down the debt on your apartment building(s). It’s something the tenants do for us, and we’re grateful for that (but never obsequious).
How important is amortization? Well, if we’re facing headwinds it’s vital. Hypothetically, let’s presume we put 25% down and got a 30 year mortgage for the balance. We’re not even going to consider any cash flows or tax benefits we’ll receive. All we’re talking about right here is amortization, the benefit of getting something that someone else pays for. Daddy’s little princess likes that feeling.
If you put $1 down on a $4 investment (that’s the same as a 25% down payment) and thirty years later the mortgage is paid off, your gain just through amortization will be 4.73% per year (compounded). Whatever inflation you accumulated during your holding period is in addition to amortization. Simply letting your tenants pay off the loan provides an assured 5% (rounded) return before cash flow or tax benefits or inflation, all this in a period when the 10 year Treasury Note is 2%. It’s pretty obvious why people buy apartment buildings, isn’t it?
It’s possible to not be secure, but still (eventually) prosperous. Imagine you bought that property we mentioned a moment ago, the one purchased for $1,000,000 and the next morning was only worth $700,000. Clearly, your investment was not secure but over the long term the tenants will still pay off your mortgage. You will become prosperous in that your net worth will continue to grow through amortization.
Should we stop buying properties during long periods of rising interest rates? My thinking is, probably not. I cannot think of another investment that would reasonably keep up with inflation while providing (a) an ever increasing cash flow and (b) amortization benefits of almost 5% per year. Clearly, it won’t be as easy as simply buying a fifteen unit building, waiting two years and refinancing to generate the down payment to buy a second 15 unit building. There probably won’t be that quick and / or massive increase in values we’ve seen over the past few decades (the tailwind is gone). But perhaps we can occasionally refinance an existing building and buy, say, six units. Don’t forget: the same forces that lower the value of our 15 units will also lower the value of the other property. We will still, as apartment investors, see our role as acquiring ever more units in ever nicer areas. It won’t be as easy as it was in the decades following 1981, but it’ll be far from impossible.
Eventually, and nobody knows when, maybe it’ll be as long as a decade from now, interest rates will rotate out of their long term uptrend and begin another pleasing secular decline. The interim upswing in rates will be brutal but, if we prepare, not disastrous.
Historically, rates have gone up a lot faster than they go down. As rates decline from whatever the future peak is, we’ll again experience tailwinds. Then we’ll probably return to the 1980 – 2013 approach to apartment investment: Buy. Wait for rates to click down and values to click up. Refi and pull enough money out to buy another building. Rinse. Repeat. We’ve seen that movie before, and we liked it.
In the Meantime
We expect, in a hopeful sort of way, that rents will go up. Fixed expenses (costs that are independent of occupancy levels, ex: real estate taxes) and variable expenses (costs that rise or fall with occupancy. ex water bills) will certainly increase. They always do. But our cash flow, the money we put in our purse at the end of the year, should not decline as long as rents go up faster than increases in expenses, unless . . .
Our fixed rate period has expired and we’ve transitioned into the variable rate years. In an increasing rate environment, variable rate mortgages often rise 1% every six months, but let’s restrict our hypothetical mortgage to a rise of only 1% per year. This is probably not realistic; it is for illustration only. Once again, the much more common increase in interest rates is 1% every six months. You might wish to check your loan documents and see what you’ll soon be facing.
Say we have an existing variable rate loan of $1,000,000 presently at 3.5% interest (payment: $4,490). There’s a secular shift in rates and they start to go up 1% a year, about the same as rates went down between 1981 and 1990. With the first adjustment they will be 4.5% and our payments would be $5,067 ($60,804 annually). The next year they’re at $5,678 ($68,136). The following year at $6,321 ($75,852). Then $6,992 ($83,904), $7,689 ($92,268), $8,408 ($100,896), and $9,147 (109,764). Payments more than doubled in 7 years. Our total loan payments during that seven year period would be $592,000 (rounded).
But what if we had refinanced while rates were low? Our loan would still be $1,000,000 but the new interest rate would be, say, 4.5% with the first 7 years fixed. Our payments over seven years would be $425,628. These mortgage payments were a little higher in the beginning (because we refinanced out of an uber-low variable mortgage) but over the next 7 years we saved $166,000. That deserves emphasis: One hundred sixty six thousand dollars saved. That’s what, almost 17% of our original loan amount?
So the first step in preparing for a secular shift in interest rates is probably to lock in today’s rates for as long as you can, even if today’s rates are higher than what you’re currently paying. We’re not comparing what we can get today with what we got several years ago; we’re comparing the interest rates we can get today with what we’ll have to pay in the near future. In the face of rising rates, just refinance your current mortgage. You don’t even need to pull any money out. Lock in the savings.
But it would clearly be better for a lot of folks (not all, but a lot) to pull money out. When are you going to borrow money cheaper? Park the money somewhere safe. Be ready to buy when values decline.
Takeaway: We’ve seen that it’s structurally easier to make money when interest rates are declining. But we can increase our prosperity even after the secular shift. We’ll just have to manage our interest rates with an eye towards the long term. In an environment of increasing interest rates, loans should probably be refinanced at the end of each fixed rate period. If we had 7 year periods of fixed rates (before the loan turned adjustable) we would only have to refinance four times and our interest rate would be fixed (albeit, probably at different levels) for almost the entire 30 years.
Here’s the “Takeaway” that I think is most important: If we serially refinance at the end of each fixed rate period we will almost certainly minimize our total interest payments even if rates go up the entire 30 year period, as unlikely as that may be. If they don’t go up for the full 30 years and the secular shift to lower rates returns, we’ll just stop refinancing and let whatever loan we then have slip into its adjustable period. In this way if rates go up, we’re “fixed” and protected from the rise; if rates go down, we’re “adjustable” and benefit from the decline. Perfect.
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].