Interest Rates & Real Estate Syndications / Real Estate Funds: Capital Stacks, Swaps, & Valuations

Understanding the effects of high interest rates on real estate syndications or funds is crucial for any aspiring sponsor. High borrowing environment typically poses a challenge to cash flow and property appreciation, compressing the Internal Rate of Return (IRR) when the property is under debt. Simultaneously, high interest rates present attractive returns for investors in safer avenues, making it tough for riskier real estate deals to compete. The capital structure in such deals usually comprises a debt component from lenders and an equity piece from shareholders. While lenders hold more power and control, shareholders bear a higher risk. However, they are rewarded with higher returns.

In scenarios where interest rates are variable and tied to indices like LIBOR, you can mitigate risk through interest rate swaps. By swapping variable rates for fixed rates, you can ensure your payments don't increase dramatically if interest rates rise. Conversely, if you have a fixed rate loan, you can switch it to variable rates if you anticipate a drop in rates.

Another crucial aspect is the impact of interest rates on property valuation. As cap rates generally rise following an increase in interest rates, property values may decrease. However, foreseeing a drop in interest rates can present arbitrage opportunities, enabling you to buy at higher cap rates and sell at lower ones, thus maximizing returns for your investors.

Read more about real estate syndication - What Is Real Estate Syndication?: https://www.moschettilaw.com/what-is-real-estate-syndication/

Read more about real estate syndication - How To Syndicate Real Estate: https://www.moschettilaw.com/how-to-syndicate-real-estate/

Moschetti Syndication Law Group is a boutique syndication law firm, serving small and growth-bound syndicators, as well as private equity firms. Our attorney, Tilden Moschetti, is determined to keep the firm’s ‘boutique’ size so we can tailor the services to each client’s unique needs without turning the firm into a faceless factory churning out private placement memorandums or passing unnecessary overhead expenses onto our clients. (As our client, you’ll only pay a fixed fee, so no surprises.) As for the client experience, we give real-time answers with Tilden Moschetti without making you book an official appointment or get passed along to associates or paralegals. We’ll work with your ambitions and overall vision to help you close the current deal and fill in that ‘missing’ piece – whatever you need – to keep adding more syndications to your portfolio. We keep syndicators syndicating (TM).

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Episode Transcript

(00:00):
In a high interest rateenvironment, just what are the

(00:02):
effects on a real estatesyndication or real estate fun?
They must surely it must haveeffects. In this video, we're
going to go through exactly thattopic.

(00:23):
My name is Tilden Moschetti. Iam a syndication attorney with
the Moschetti Syndication LawGroup. One question that always
is in the back of all mysyndicators and all my fund
managers head is what is goingon with interest rates, I often
get asked, What do I think wasgonna go on with interest rates?
Well, let's go through exactlywhat that effect is where I

(00:44):
think it's generally going andhopefully, that'll give you some
guidance. So what the interestrate risk is, obviously, is in a
very high borrowing environment.So when interest rates are very
high, it is going to have aproblem with the cash flow and
probably the appreciation ofyour property, right. So that

(01:04):
IRR is going to get compressedwhen interest rates are up if
you have debt on the property.Now, there's two things kind of
going on at the same time. Sowe've got that pressure that
takes place if you have debt onthe property. But one thing I
don't want to leave out is thatsecond area, and that second
area is if we've got highinterest rates, we probably also

(01:28):
have a lot of products on themarket that are paying investors
a return in order to save money,for example, in CDs, something
like that, we have a returnthat's getting paid right now
that return can be around fouror 5%. So an investor
automatically can make in verysafe money, not perfectly safe,

(01:49):
but very safe. Money can putmoney into a bank, make four or
5%. Now if your risky realestate deal is paying four or
5%. Why on earth would they takeit, so that's obviously a
negative factor that goes on toit as well. Now that other piece
of it is the borrowing is therate that you're borrowing. So

(02:10):
we call this this whole entityof how the money comes in the
capital stack. Normally, there'stwo pieces there, there's two
components into the capitalstack, we've got debt. So we've
got money from a lender from abank, something like that. And
then on the other hand, we havemoney, that is the shareholder
equity piece, that shareholderequity piece may look a lot like

(02:33):
that. Or it might just be pureequity, that will you know, that
beneficial ownership. So thebenefits of the investor is they
might even just be getting afixed rate payment, or they
might be getting the benefit ofactual ownership and that
appreciation, it depends, itdepends how you set up your
syndication or fun as to whichthey're going to get. So we've

(02:57):
got these two things as part ofthe capital stack, we've got the
the the equity side, and we'vegot the liability side, now
lenders are always on the debtside, it gives them a lot more
power, it gives them a lot morecontrol, they have the ability
to foreclose on the property,the ability to take that
property back to sell it, and tobe able to recoup their losses,

(03:18):
right, that's what they have.That's the main piece of the
liability side that a lenderwants to be able to get rid of
their risks that they're notgoing to be paid. Now, the
reality is on the syndicationside, is we have it the
shareholder equity piece, right,that shareholder equity is not
subject to foreclosure. So yourinvestors actually do have an

(03:42):
increased risk over the bank.Now the benefit to you is that
you, you know, there's lessscrutinizing the terms, you have
to find the investors that arewilling to do it. And most of
the time, in order to do that,you have to pay them at a higher
rate. So in order to pay them atthat higher rate, the benefit to
you is you don't have that riskof foreclosure, the benefit to

(04:04):
them is they get a higher rate.So that spread that difference.
It's always a balancing act,you're trying to figure out
which is better for your deal.Some deals, you're going to do
all shareholder equity, you'rejust going to load up on that
it's going to be an all cashdeal. Where all everything like
takes place at the shareholderequity side. The benefit here is

(04:25):
that suddenly now we canrefinance the property we can
take on bank debt, because bankdebt doesn't care at all about
the shareholder equity, not onlydoes it come before shareholder
equity, but it also has thatability to foreclose. If you had
given the shareholders apossibility of being able to
foreclose, you're not going toget a bank that's willing to

(04:47):
lend on it. It's not gonnahappen. Even if they've got
priority. They're not going todo it. Now they've got an
increased risk that somebodywho's in a secondary position
can take them out. So that'skind of a long explanation of
the capital stack of things. Wethink about as it relates to
them. So the interest rate riskis understanding how that plays
in. So we've got those twocompeting forces, we've got

(05:10):
possibility of high interestrates. And we've also got the
shareholder expectation of whattheir return should be. Now,
we've also got the riskmitigation thoughts that need to
take place. Now one strategythat you can do, because if I'm
going out, and I go to a bank,and I say, I need to finance
this property at 50%, loan tovalue, and I've got these other

(05:33):
shareholders here, they're not apart of this necessarily. But I
need to get a 50% loan to value.I answered, the bank comes back
and says, Okay, no problem,we're going to give you a loan
for that amount, and we're goingto do it at 10%. Because it's a
we've considered a somewhatrisky steal, and so that it's
going to be temporary. So butguess what, because we don't

(05:56):
know exactly where interestrates are going, we're going to
pay it to something like LIBOR.And we're going to make it a
variable interest rate loan. Andso although it's 10 years, it
adjusts every quarter. And we'regoing to do it over the next
five to 710 years, whatever thatdetermines. And it's going to be
variable. Now, you may say, asthe asset manager, oh, okay,

(06:18):
that's great. Because when atwhen, when the rates go down,
I'm going to do better, right,so now my payment goes less my
IRR is go up your rate youreverything's winning. But what
if those rates go up? What ifyou've decided, no, I'm not
exactly sure where it goes. Imean, where I sit today, we've
already seen, oh, inflationmight be still pressing. And

(06:41):
finally, the the perceivedinflation from the Fed might be
saying, let's keep interestrates higher, maybe they'll
decide let's bump it up a littlebit more, either. All right.
What if it? What if the what ifinflation jumped to 4% or 5%,
next quarter, suddenly, there'sgoing to be this increased
pressure from the Fed in orderto over to raise rates, and

(07:02):
that's going to drive ourinterest rate for that loan
that's paid to LIBOR, it's goingto make those payments higher.
Now, suddenly, everything we'vepromised the investors is, is in
trouble. So how do you mitigatethis risk? Well, what you can do
is you can buy what's called aninterest rate swap. What that
does is it says, you go tosomebody who based and you

(07:24):
basically say, look, I've gotthis variable rate loan, I want
to buy a fixed rate loan, I wantto basically trade it in, let's
give, let's trade our payments,you take on the variable
interest rate, you take on thefixed rate interest, or the
variable interest rates thatI've been paying. And I'll take
on the fixed rates that you'rewilling to give me, and you're

(07:46):
gonna make money through thatspread. And I'm willing to pay
for that. So what that does isit gives you that fixed rate,
well, I'm stuck at 10%. But atleast it's not going to go to
12. So at least your numbersaren't going to be thrown off.
So there's risk that on theother side of okay, I've done
that. But what happens now, wheninterest rates fall, what if
interest rates fell to five?What if they fell as low as

(08:08):
we've seen, like 3%, or justunder 3%? Oh, my gosh, she just
made a big deal. But he made avery bad decision. So you can
actually do the opposite. So saythe bank had given you a fixed
rate loan, you can actually sellthat fixed payment, you can
trade those though that cashflow that you're paying on the
fixed rate, and turn it into avariable rate and peg it to

(08:30):
something like LIBOR orsomething like that. So you can
actually buy a swap that goesthe other way. Now, of course,
the risk is that interest ratesgo up, and now you're back up
that 12% 12% interest rate. Sothat's sort of the the thoughts
that go into the risk mitigationpiece. The last topic that I
want to talk about is the impacton valuation. So if I'm buying a

(08:55):
single asset, or I'm buying amultiple pool of assets,
valuation of the individualassets is going to change based
on interest rates. And why isthis because cap rates are
somewhat correlated to the, tothe value of the asset. So cap
rates generally go up after someperiod of time after the

(09:20):
interest rates go up. Now, whyis this because people want to
make money from their assets,right? So if cap if interest
rates go up and the borrowingpower that makes it so it's I'm
getting less cash flow from it,they still have to, they still
want to enjoy that cash flow.The only way to make up of that
spread between the the cap rateand the interest rate is to

(09:45):
increase the cap rate. So theonly way the buyer of a
potential property we'll be ableto do that is to is to buy at a
higher cap rate. This can changethat valuation period. So what
this means is that You may be atrisk if interest rates go up of
having your values of yourproperties actually go down.

(10:07):
Because remember, if cap ratesgo up, that price goes down.
So what but it also introducesanother kind of issue, perhaps
there's an arbitrageopportunity. If you feel very
confident in the next threeyears that interest rates are
going to fall. And you're ableto buy as if that interest rate
is at this level, and so the caprate is up here. And suddenly

(10:30):
the interest rate is here. Well,now suddenly, you can sell with
a cap rate here, which means alower cap rate means higher
price. So that means you've justmade a massive amount of money
for your investors just on thenatural changes in the interest
rate itself. Now, I hope thisvideo helped kind of put some
perspectives on things that gothrough my head when I do my own

(10:53):
deals as it relates to interestrates. I also work with clients
for as a real estate syndicationattorney and help that guide
them through the legal aspectsbut also because I have so much
experience in doing real estatesyndications for me, I'm openly
share that if that informationwith my clients. Now if I can

(11:14):
help you, we'd welcome a call.Let's talk about your project,
what you're working on and seeif we have a good fit and maybe
we can work together