Background: Ultimately, if one looks deeply enough, the market value of an investment is a function of interest rates. Market value is a specific term, and neither price nor cost is a complete synonym. How often does someone buy a new car at full MSRP? And, technically, cost is what you buy something for minus what you eventually sell it for. Market value is different. It is “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion” (International Standards Valuation Council).
Examples of the elements contained in the concept of market value are:
Estimated amount: Purchasing an item often has a degree of subjectively. Why buy this puppy and not that one? Because little Abercrombie refuses to put this puppy back in its cage. She’s still got him clasped in her chubby little arms and there’s a tear silently gliding down her left cheek. You see that. The breeder sees that. The breeder’s wife sees that. The price just went up. “Yes, the sign on the cage does say $300, but if you want the whole puppy it’ll be $425”. Because little Abercrombie’s immediate attachment was both unknown and unpredictable, it is not considered when estimating a market value.
Date of valuation: The date of valuation is the date of exchange of ownership. If the date changes, the estimate of market value becomes subject to change. A reasonable example is the purchase of a share of stock just before the dividend is paid versus post-dividend. The price adjusts (in the case of stocks, seamlessly) depending on which side will receive the announced dividend.
Willing buyer / willing seller: There are exceptions, but usually distress sales (or purchases) are not included in the concept of market value until they are so numerous they actually become the market. A recent example is the Hertz bankruptcy, which caused thousands and thousands of used cars to become suddenly available. This had a near-immediate effect on the prices of used cars. The distressed pricing on Hertz’s used cars for a short while became the market.
Arm’s length: In an arm’s length transaction the parties operate independently, without one party influencing another. There is no collusion and each party acts in their own self-interest. The transaction must be antagonistic: the gain by one party is a loss to the other party.
Proper marketing: The property (motel, mule, your mother’s Mikimoto pearls, whatever) must have been adequately exposed to the market before a “market” value can be extrapolated. A sale that does not include potential exposure to all interested parties is not considered to properly reflect the market.
Once these disqualifying elements are removed from the concept of market value, the most significant remaining component is the rate of interest (assuming the item can be borrowed against). If there is no financing, it is not uncommon for purchasers to still use the 10-year Treasury interest rate, but sometimes the projected return on equally desirable alternative investments, or something else entirely different is used. Without financing, there is no third-party (normally the lender) to monitor value. An appraiser is not quite the same thing as a lender. The appraiser’s fee is paid whatever is the result. He neither gains nor loses regardless of what the appraised value might be. The lender, however, has a dog in the fight.
The benchmark interest rate for investment purposes is the 10-year Treasury note. That establishes the lower limit of return: why go to the trouble of lending money if one cannot make a return at least equal to that offered by liquid, risk-free Treasury issues?
In addition to matching the Treasury rate, a lender is in business and requires (a) his overhead (costs) to be reimbursed and (b) an acceptable profit margin. The final interest rate to the borrower would be the sum of the three tiers: (1) the 10-year Treasury; (2) something for overhead, and (3) a bit of profit. For the purposes of this article, figure the 10-year rate plus 2.00 to 3.00%. Today’s 10-year rate is right around 0.50%. A hypothetical lender charging between 3.00 % and 4.00% can achieve the Treasury rate, cover overhead, and celebrate a little profit.
Over the last 50 years the yield on the 10-year Treasury has ranged from 13.92% (1981) to 0.99% (2019). As noted, at the time of this writing (2020) it is hovering around 0.50%. That is even less than last year’s extraordinary rate. Nonetheless, reversion towards the mean remains a real thing. It will happen. We just don’t know when. The average (mean) 10-year Treasury yield between 1969 and 2019 has been 6.20%. That would indicate a normalized mean interest rate for mortgages at 8.70% (that’s the treasury rate at 6.20%, plus an estimated 2.50% for overhead and profit).
The consequences of a normalized 8.70% rate could be devastating to the landlord.
Application: Consider Hieronymus Bosch’s (hypothetical) purchase of a $5.0 million property (all figures appropriately rounded): The terms of sale are $1,400,000 down to a new loan of $3,600,000 at 3.40% amortized over 30 years. Payments are $16,000 monthly. Interest rate is fixed the first five years, then adjusts to market and thereafter floats.
The gross annual income is $400,000. Fixed and variable expenses at time of purchase (including property tax reset and allowance for necessary reserves) are $160,000. The Net Operating Income is $240,000 and the cap rate at time of purchase is 4.8%. Gross income increases at 5% annually. Fixed and variable expenses increase at 3% annually.
With the table now set, let’s look at Mr. Bosch’s side of the transaction.
Maximum loan amount @ 1.25 Debt Coverage Ratio: $3,600,000.
Math: The Debt Coverage Ratio (DCR) is the maximum mortgage payment the building will support within the lender’s guidelines. It is computed thusly: NOI (in this case, $240,000) divided by DCR (in this case, 1.25) equals annual debt service. Divide by 12 to get monthly payment.
Net cash flow to Mr. Bosch: $48,000 annually. (3.4% on the buyer’s down payment)
Math: NOI minus annual debt service.
Time passes. Suddenly it’s five years later. The fixed rate period ends. The interest rate on the purchase money loan adjusts to reflect the (then current) market. Gross income has climbed 5% per year and is now $510,000. Expenses have gone up 3% annually and are now $185,000. NOI is now $325,000. Using a DCR of 1.25, the building’s maximum annual permitted debt service would be $260,000 (a little under $22,000 monthly).
Interest rates have gone up and are now at the long-term “normalized” mean of 8.7%. The 10-year Treasury has climbed, in this example, 5% in 5 years.
This is not unheard of. In 1977 the 10-year T note was 7.21%. Five years later (1981) it was 12.57%. That’s a rise of 5.36% in five years.
It didn’t stop there. The next rolling five year period began with rates at 7.96% (1978) and concluded at 14.59% (1982). That is a gain over that five year period of 6.63%. A rise of 5% in 5 years is historically plausible.
The largest loan the building will now service is $2,750,000 (again, all figures appropriately rounded). To review, the building was purchased with a $3,600,000 loan at 3.40%, which has (the fixed rate period now being over) increased to 8.7%. The building will no longer support the (revised) payments on the $3.6M purchase money loan. The loan, in fact, is underwater by $850,000. Using normalized ratios, the projected worth of the building itself is $4,125,000.
Considerations: The unfortunate borrower who finds himself underwater has few options. As one example, the borrower could sell / refinance other owned properties and apply the proceeds to paying down / paying off the threatened building. That means (a) Mr. Bosch is ultimately paying the original down payment (in this case, $1.4 million) plus (five years later) what amounts to a deferred down payment of $850,000 (the amount underwater). He will have paid $5,850,000 (total price: original $5,000,000 plus $850,000 for the underwater amount) for a property now worth, when his loan resets, $4,125,000. That is a huge $1,725,000 haircut.
Here is another possibility. No option is perfect and no one option is for everybody. What we are exploring is a way to reduce prospective loss when rates climb.
The fundamental problem is that rates, at the time the existing loan slips into its adjustable period, would not have been completely offset by rent increases. A longer fixed rate period would, perhaps, have allowed rent to catch up with the increased interest rate. A possible solution (not the solution, only “a” solution) is for today’s owners to refinance now, while rates are generationally low, in exchange for a loan with a 10 year fixed rate period. The biggest problem to overcome is that most existing loans have pre-pay requirements. That means that the lender charges the borrower a fee if the loan is paid off before maturity.
Pre-pays: There are two general types of pre-pay hits. One is the step-down, where the pre-pay charge (example) starts at 5% of the unpaid balance if the loan is paid off during the first 12 months after funding. This hit typically reduces 1% annually and drops off beginning in the 6th year. It’s often referred to as a 5-4-3-2-1 prepay. Because it’s declining every year it’s possible that a landlord’s pre-pay fee might be little or nothing, depending on how old the loan is.
The second type is yield maintenance. Yield maintenance is a prepayment clause that guarantees the lender will receive a certain amount of interest between loan funding and loan payoff. The advantage is that it makes the lender indifferent to an early payoff. The lender will make the same amount in interest whether or not the borrower pays the loan off early. In other words, if the lender is scheduled to receive $150,000 in interest during the term of the loan that sum (less interest already paid) is due – in addition to the balance of the loan – upon early payoff.
Simplified Example: Imagine Mr. Caravaggio acquiring a fifteen year $1,000,000 interest only loan at 6% interest. The loan has yield maintenance prepay. Total interest charge will be $900,000 ($60,000 annually for 15 years). Five years on he decides to refinance. It’s a 15 year loan and five years have passed: when he refinances Caravaggio will owe the lender interest for the ten remaining years of the loan, even though Caravaggio did not have use of the money for the full loan term. For this example, figure 6% of $1,000,000 equals $60,000 per year times the remaining 10 years equals a yield maintenance prepay of $600,000.
While an interest only loan was used in this simplified illustration, the same principles apply in amortized loans.
Theoretical Possibility: In normal economic times, it is not uncommon for the total interest paid on a 30 year loan to be twice the amount borrowed. Multiply the monthly payments by 360 months: the original principle amount will be about one-third of that sum, and the remaining two-thirds will reflect the interest to be paid. Under certain conditions it is quite possible for Mr. Caravaggio to incur a yield maintenance prepay equal to or even greater than the remaining balance on the loan.
No Prepay Loans: There are purchase / refinance loans sometimes available for income properties that have (a) 10 year terms, (b) often with fixed rates, and (occasionally) with no pre-pay. At the end of the 10 years the balance of the loan is due. But the lack of a pre-pay makes it feasible for the loan to be refinanced at any time rates drop during those 10 years. And there are 10 years (as opposed to 5) for rents to increase before refinancing is necessary. These two benefits could make this type of income property loan appropriate for many investors who would otherwise be facing a series of tough decisions as rates eventually increase. There are some negative elements associated with these loans, but the chance of being in Mr. Bosch’s or Mr. Caravaggio’s quandary is significantly reduced. If this type of loan interests you, call me and we’ll talk about it.
This article is for informational purposes only and is not intended as professional advice. Nothing in this article is presented as investment guidance. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].