The federal reserve recently announced one of the largest interest rate hikes in decades. This sent shockwaves through the stock market as many individuals who were investing in the late 90’s got eerie reminders of the dot com bust. These changes ripple their way through the economy ultimately impacting all markets. Interest rates on mortgages also have been on a steady clip upwards reaching their highest rate in about 20 years.
It’s clear that there are going to be some headwinds in the economy in the near future. As an investor you may be wondering whether to push forward and make your first or next investment or if it is better to sit on the side lines. Rising interest rates means that debt financing will be more expensive and deals with high returns will be harder to find.
One benefit for real estate investors is that the ability to easily leverage debt financing is one of the most powerful tools of real estate investing. Debt can be a friend or foe depending on how well you understand and use it. If used incorrectly good debt can become bad debt.
What does the rising interest rate environment mean for investors?
Rising interest rates can be good or bad depending on what perspective you have. In simple terms rising interest rates mean that the market is changing. One truth that remains however, is that whether interest rates are high or low investors are able to make money in real estate. If you want to continue to make money in real estate despite the changes in interest rates you have to understand what good debt is and how to use it to your advantage. In this article we will take a look at what is good debt and what is bad debt.
What is good debt?
Is there a such thing as good debt? If you think about the idea of good debt conceptually then you would quickly respond “yes, there is a such thing as good debt in real estate!” Good debt is generally thought of as any debt that could be used to increase your net worth, increase your incoming cash flow and/or grow income producing assets. Good debt is considered good because of how you use it. In short, the debt is used for activities that not only help to pay off the debt but at the same time provide a pay day for you as well.
It doesn’t end there, however. Just because you are buying an income producing asset with debt this does not automatically make that debt a good choice for that specific asset. To truly refine the definition of good debt you should consider good debt structure. For real estate investing you have to consider how the terms of the debt align with the intended use of the investment vehicle.
Good debt structure will have terms that match the business strategy of the investment. One major consideration is the length or duration of the loan. The length of the debt should be as long as or slightly longer than the expected time period the debt is needed. If the investment is scheduled to undergo many significant changes in a short period of time, such as a heavy renovation, then perhaps a short-term bridge loan would be best. On the other hand, if the investment will just be business as usual and you plan to sell in 5 years you should consider getting 7–10-year debt terms so there is cushion if things don’t go as planned in 5 years.
When terms don’t align with intended use, good debt can become bad debt.
What is bad debt?
Bad debt in real estate would be the opposite of good debt. Bad debt structures are investments that have debt that does not align with the intended investment strategy of an investment or which create little margin of error.
An example of a bad debt structure would be using a short-term bridge debt loan which matures in 2 years when the property is expected to be held for 10 years and there is not expected to be any major changes in the operations or valuation of the property.
Another indicator of bad debt structure is the selection of a debt structure that does not align well with market expectations. If you are holding and investment property for 10 years and the expectation is that interest rates would continually increase over the next 10 years, then it may not be wise to take on a variable rate loan. If a variable rate loan is used, then it would be smart to also have a rate cap which limits the potential increase in interest rates. If interest rates are not fairly predictable on the property, then that would impact the predictability of potential returns on the investment.
If an investment has bad debt structure this could lead to a forced sale of the investment due to the loan maturing too soon or lack of ability to make debt payments in agreement with the lender.
Why should I care about debt as a passive equity investor in a syndication?
As a passive investor an understanding of the “capital stack” is highly important. The capital stack represents the mix of debt and equity sources of capital used to fund an investment. Capital providers have different rights and obligations based on where their capital is located on the capital stack.
Although as a passive investor you are likely to provide equity capital, you should have a good grasp on the other sections of the capital stack which you are not invested in. Specifically, especially in this rising interest rate environment, it is important to understand the debt used to fund a multifamily apartment real estate syndication.
What questions should a passive investor ask about the debt structure in a syndication?
When reviewing an offering memorandum, you should ask the deal sponsor team the following questions about the debt structure:
What are the terms for the debt?
Is this long-term permanent debt or short-term bridge financing?
What interest rate will the debt have?
Is the debt fixed rate debt or is the debt variable rate debt?
If the debt is variable, is there a rate cap?
When will the debt mature?
Are there plans to refinance the debt?
Are the returns quoted inclusive of the refinance?
What is the debt service coverage ratio?
What is the lowest occupancy you can have and still pay off the debt?
What is the lowest occupancy you can have and still pay off the debt and pay off investors?
Is the loan assumable?
Are there prepayment penalties?