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How Do Interest Rates Impact REITs?

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The last few months have been choppy for stock markets. The S&P 500 [SPY] index which is an indicator of the overall market has experienced at least three sharp declines since October this year.

With the tariff war looming large and interest rates set to rise again, are the stock markets still a viable investment option? Should you diversify and invest in REITs instead? Here we look at the relationship between rising interest rates and their impact on REITs or real estate investment trusts.

REITs are high-yield financial instruments that are obligated to pay at least 90% of taxable profits to shareholders. The maximum amount of returns are driven majorly by dividend payouts instead of price appreciation.

Rising interest rates

Generally, a rise in interest rates is driven by economic growth. There are several reports that suggest REITs outperform the S&P 500 in periods of rising interest rates. The response to an interest rate hike is the depreciation in asset value.

This is because investors think that higher interest rates reduce the present value of future cash flow from investments. However, contrary to public opinion, a period of higher interest rate has resulted in an increase in REIT share prices.

The leverage ratio is a key metric

Currently, the leverage ratio for REITs is at the lowest point in the last 20 years. The ratio of debt-to-book assets fell 95 basis points last year. This fall in leverage will lead to lower interest expense for REITs.

The interest expense for REITs was far lower at 22% last year compared to the high of 38% witnessed during the financial crisis of 2008. Another reason why rising interest rates will not impact REITs is that almost all debt is allocated at a fixed rate. The average maturity for REIT debt is around 75 months.

According to Brian Cordes, a senior vice president at Cohen & Steers, an investment company focused on real estate, “If interest rates are going up because the economy is improving, that can be positive for REITs because landlords can raise rents to cover the rate increases.”

You can sell off your REIT holdings in times of economic uncertainties or an economic downturn when the interest rates rise. But hold on to them if the economy is strong and investors will be rewarded.

Real Estate Investing

Commercial Real Estate: Property Types And Classes

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Before you start investing in commercial real estate, regardless if it’s via online crowdfunding or through a syndication, you want to know what sort of investment you are getting into.

In general, crowdfunding and syndications both invest in commercial real estate. Single-family properties are too cheap for developers to raise capital on. There is a fixed cost of raising capital. So, developers focus on $1m+ properties.

And usually those are commercial real estate projects.

Since commercial real estate is new to most investors, we’re going to cover the different property types within commercial real estate, as well as the different classes of property and neighborhoods.

Asset Class vs Property Type vs Property Class

An asset class is a group of investments that have similar characteristics and behave similarly in the marketplace.

Equities (stocks), fixed income (bonds), and cash equivalents (money market) are the 3 traditional asset classes. Additionally, there are 2 alternative asset classes that are extremely common as well – real estate and commodities.

There are a whole host of alternative asset classes which professionals may agree or disagree on them, such as valuable art, numismatics, or other collectibles. Increasingly many are looking at crytpo currencies as an alternative asset class.

Each asset class can further be broken down. For example, there are 11 sectors for stocks (healthcare, industrials, technology, etc).

A lot of people will ask about asset classes in real estate. What they actually mean to ask is about property types within the asset class of real estate. There are no asset classes within real estate because real estate is an asset class.

Property types are what the real estate asset class is broken down into. Just like stocks have 11 sectors, real estate has a variety of property types from office to multifamily.

Real estate does have a “class” rating system as well, which may be part of the reason why people confuse the terminology.

Property classes in real estate are referring to a rating system we use in the real estate industry to help us categorize neighborhoods and property types. This is generally on an A to D rating scale where A is the nicest properties and D is the oldest and most run down.

Real Estate Property Types

The asset class is an overarching and very broad type of investment. Within real estate, there are 4 primary types of property which include:

  • Residential
  • Commercial Real Estate (CRE)
  • Industrial
  • Land

Each one of these can be further broken down. For example, farming and resource extraction (mining and oil) are uses for raw land.

We’re going to focus on commercial real estate because that is what most investors are buying when they want to buy income producing property.

Types of Commercial Real Estate

There is almost an unlimited number of types of commercial real estate, but here are the most common ones you’ll see.

Multifamily

Multifamily is a type of commercial real estate because the owners buy it to produce income, not to live in.

Multifamily is anything that is 5 units and above (in the United States).

There’s really no reason for it except that the primary mortgage lenders Fannie Mae and Freddie Mac will back personal/residential mortgages on any owner occupied property 1-4 units, but not 5 and above.

So, a homeowner can get a traditional mortgage on a 4 family, not on a 5 family.

4 family properties are technically multifamily. But, they are excluded because they are bought by typical homeowners. Commercial multifamily property is exclusively 5 units and above.

Garden style, mid-rise, and high-rise buildings are 3 sub-categories of multifamily to be aware of.

Retail

Retail is the subcategory of commercial real estate that includes all shopping. This includes everything from a building with a single retail tenant in it (such as a fast food restaurant), all the way up through shopping plazas or even shopping malls.

It is a really complicated space because there are a variety of lease terms that can directly impact the value of the asset. For example, a single tenanted building with a lease that is about to expire is worth far less than the same building with a new 10-year lease.

Additionally, there are different types of malls, shopping centers, outlets, and more that complicate the space.

Regardless of how they are broken down, they are all considered retail.

Office

Similar to retail, these can be multi-tenanted or single-tenanted. But, unlike retail, these can range from giant skyscrapers to small office condo developments.

Self Storage

Self-Storage is relatively new to the list and is not included in most other breakdowns of commercial real estate. But, it should be.

Self-storage is one of the fastest growing and most stable CRE investments available. Supply simply cannot keep up with demand in many markets, and available spaces are being leased up at unbelievable rates.

Hotel

These are properties that are owned and operated for the purpose of very short term rentals. Can also include motels.

Mobile Home Parks

Mobile Home Parks are a huge sub-category. It’s often overlooked or counted as a sub-category to multifamily, but that’s not accurate.

Mobile home parks were very popular in the 70’s and earlier, but few new MHPs have been built in several decades. As such, occupancy is high and stable.

On the other hand, infrastructure is aging and investments in underground water/sewer, roads, and electrical can be very costly.

Special Purpose

This just captures all the other unique types of commercial real estate out there such as amusement parks, bowling alleys, and more.

Classes of Property

In residential and multifamily, the property/neighborhood class is a rating from A to D. It describes the overall age and quality of both the neighborhood and the individual property. For example, you might hear that this is a C class property in a B class neighborhood.

Multifamily is anything that is 5 units and above (in the United States).

There’s really no reason for it except that the primary mortgage lenders Fannie Mae and Freddie Mac will back personal/residential mortgages on any owner occupied property 1-4 units, but not 5 and above.

So, a homeowner can get a traditional mortgage on a 4 family, not on a 5 family.

4 family properties are technically multifamily. But, they are excluded because they are bought by typical homeowners. Commercial multifamily property is exclusively 5 units and above.

Garden style, mid-rise, and high-rise buildings are 3 sub-categories of multifamily to be aware of.

Retail

Retail is the subcategory of commercial real estate that includes all shopping. This includes everything from a building with a single retail tenant in it (such as a fast food restaurant), all the way up through shopping plazas or even shopping malls.

It is a really complicated space because there are a variety of lease terms that can directly impact the value of the asset. For example, a single tenanted building with a lease that is about to expire is worth far less than the same building with a new 10-year lease.

Additionally, there are different types of malls, shopping centers, outlets, and more that complicate the space.

Regardless of how they are broken down, they are all considered retail.

Office

Similar to retail, these can be multi-tenanted or single-tenanted. But, unlike retail, these can range from giant skyscrapers to small office condo developments.

Self Storage

Self-Storage is relatively new to the list and is not included in most other breakdowns of commercial real estate. But, it should be.

Self-storage is one of the fastest growing and most stable CRE investments available. Supply simply cannot keep up with demand in many markets, and available spaces are being leased up at unbelievable rates.

Hotel

These are properties that are owned and operated for the purpose of very short term rentals. Can also include motels.

Mobile Home Parks

Mobile Home Parks are a huge sub-category. It’s often overlooked or counted as a sub-category to multifamily, but that’s not accurate.

Mobile home parks were very popular in the 70’s and earlier, but few new MHPs have been built in several decades. As such, occupancy is high and stable.

On the other hand, infrastructure is aging and investments in underground water/sewer, roads, and electrical can be very costly.

Special Purpose

This just captures all the other unique types of commercial real estate out there such as amusement parks, bowling alleys, and more.

Classes of Property

In residential and multifamily, the property/neighborhood class is a rating from A to D. It describes the overall age and quality of both the neighborhood and the individual property. For example, you might hear that this is a C class property in a B class neighborhood.

This article originally appeared on IdealREI. Follow them on FacebookInstagram and Twitter.

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Real Estate Investing

What is Debt Service Coverage Ratio and Why it’s Important?

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There are few numbers more important in commercial real estate than the debt service coverage ratio.

It’s one of the first things and one of the last things that any commercial lender or broker will talk about. It’s first and last because it’s simply that important!

A lot of people toss this term around without explaining it while others are using it without fully understanding it. It’s a lot more than just a simple formula and when you understand the debt coverage ratio, you’ll be able to control it to get maximum financing.

Let’s dive into it.

Why the DSCR is Important

Imagine finding a commercial property worth $400,000 and you need to put 25% down.

You think, “alright, I can afford that!” and move forward with the deal, expecting $300,000 in loan proceeds.

As you approach closing, your mortgage lender calls you to say “The maximum loan we can give you is $225,000 because the debt coverage ratio is too low.”

Now what do you do?

This is real and happens every day. To avoid a situation like this, you need to fully understand the debt service coverage ratio before you make offers.

The fact is that it’s regularly used by banks and loan officers to determine if a loan should be made and what the maximum loan should be. If you don’t have the extra money laying around, you won’t be able to close the deal and you’ll lose a lot of money.

Debt Service Coverage Ratio Defined

The debt coverage ratio is a simple ratio that tells a lender how much of your cash flow is use to cover the mortgage payment. It’s known as the debt service coverage ratio, debt coverage ratio, DSCR, or DCR.

Debt Service Coverage Ratio Calculation

In general, it’s calculated as:

Debt Coverage Ratio

where:

Net Operating Income = Gross Income – Total Operating Costs

Debt Service = Principal + Interest

To calculate the debt coverage ratio of a property, first, you need to calculate the NOI. To do this, take the total income, subtract any vacancy, and also deduct all operating costs.

Remember, operating costs do not include debt service (principal and interest), or capital expenditures. Insurance and taxes are operating costs, so don’t forget to include them.

Next, take the Net Operating Income and divide it by the annual debt service, which is the sum of all principal and interest payments during the year.

To do this you must take the entity’s total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’s annual debt service, which is the total amount of all interest and principal paid on all of the property’s loans throughout the year.

How The Debt Ratio is Used

A Debt Coverage Ratio below 1 means the property does not generate enough revenue to cover the debt service while a debt ratio over 1 means the property should, in theory, generate enough revenue to pay all debts.

It’s very common for lenders to require a 1.2 DSCR, give or take.

If your debt coverage ratio is too low, the only way to make it work out better is to reduce the loan balance. Your NOI is the same but now your principal an interest decreases, making the ratio go up.

And that’s how you can get your loan proceeds cut dramatically.

Debt Coverage Ratio Example

Let’s say there is a property that generates $10,000 in revenue, has total operating costs of $4,800, and yearly debt service of $4,000

NOI = $10,000 – $4,800 = $5,200

Debt Coverage Ratio

In this example, the debt coverage ratio is above 1.2, so this would be a good risk for the bank and they’d likely give the loan.

Let’s say that interest rates change and the bank gives a slightly higher rate, causing a new debt service of $4,500.

DSCR

Notice how a small change can suddenly change everything!

The Bank Will Reduce Your Loan

Image result for bank loan

In this situation, the bank probably won’t reject the loan. Instead, they will reduce the loan balance until the payment comes in line with their minimum DSCR requirements.

In this situation, the lender will simply reverse the formula and determine what the maximum debt service can be. We can plug in the variables we know to solve for the allowable debt service

1.2 = $5,200 / Max Debt Service

Max Debt Service = $5,200 / 1.2

So, the maximum debt service can be $4,333. Now they just need to figure out what loan balance that will be based on their interest rate and loan term.

…and you’ll be stuck trying to squeeze some quarters out of your couch to pay for the extra down payment.

How the Debt Ratio Affects Returns

In the example above I showed how a loan can be adjusted down before the lender will give the loan. This can significantly reduce your cash on cash returns.

Let’s say you are buying a property in the example above costs $100,000 and requires a down payment of $25,000.

Let’s also say that it generates $10,000 in cash each year and has an NOI of $5,200.

Originally the debt service was supposed to be $4,000 per year, leaving $1,200 in total cash flow.

Now, let’s calculate our cash on cash return. We know that it’s calculated as:

Cash on Cash Return =  Total Cash Flow / Total Cash Invested

CoC = $1,200 / $25,000 = 4.8%

This means that for every $100 you invested, you get back $4.8 every year, cash in the bank. This is not to be confused with the overall return on investment.

But due to some fluke, the terms changed and now the debt service will increase. Let’s say that the interest rates increase so your $75,000 loan is at 4.5% now and your debt service goes up from $4,000 per year to roughly $4,560/year. You can see that the new debt service coverage ratio is well below the 1.2 minimum.

I’ll spare you the math, but when I punch it into a calculator I find that the maximum loan value is now roughly $71,000. This creates a yearly debt service of $4,320, bringing you back to 1.2

Comparing The Two Scenarios

Since you’re loan has gone down, you will need to invest an extra $4,000. You’ll also have a lower cash flow because of the higher debt service.

Cash Flow = $5,200 – $4,320 = 880.

Now let’s compare two scenarios. Imagine if you were still able to get 25% down, your cash on cash would look like:

CoC = $880 / $25,000 = 3.5%

Not very good, right? But, that’s because of the increased interest rates.

Now, let’s see how the change in the loan amount affects your return. Remember, your down payment is no longer $25k because it became $29k.

CoC = $880 / $29,000 = 3.03%

Even worse…

Never Neglect the Debt Coverage Ratio

You can see how important this simple ratio is to banks. It can change your returns, your down payment requirements, and it can even kill your deal.

This article originally appeared on IdealREI. Follow them on FacebookInstagram and Twitter.

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Real Estate Investing

Real Estate: Is It In A Bubble?

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I originally wrote this article 6 months ago but the same question applies so I’m updating and improving it. The question still applies, is real estate at a bubble? Is it at the top?

I was at the bar for a friend’s going away party and a random guy at the bar started telling me how I needed to buy some new coin. Not Bitcoin, he said, but some other coin he had discovered that is going to make you rich.

In fact, he had just quintupled his money since this morning. I needed to hurry up and get in on the action!

…When the local regular at a small bar in small-town USA has finally started giving investing advice, it’s time to move on to the next big thing. So, I’m done with cryptocurrency (until it collapses).

Mind you, I wrote those words back when Bitcoin was was reaching new highs every day (it’s since lost 90% of it’s value)

But, What About Real Estate?

Ten years ago when I got started in real estate, everyone thought it was a terrible idea.

“If it was so easy everyone would do it.”

“Don’t you think real estate is too risky?”

You know the lines. I heard them all. But now, real estate is the best investment on the planet.

A huge number of friends and also former co-workers of mine have jumped into real estate investing within the last year. People who used to warn me how dangerous real estate was are now telling me real estate is probably the best thing to get into (except cryptos, of course!).

It’s the “best” because their best friend’s, uncle’s, nanny just house-hacked a home and earned $50k and quit being a nanny and is now a full-time house flipper!

Or…someone they knew bought a house 3 months ago and already sold it for $20k profit!

Maybe…their friend’s nephew just became a landlord though he’s 19 and doesn’t really even have a stable job (so he’s technically “retired”, right?).

The Vibe in Real Estate

If you’re getting this feeling or this vibe with any sort of investment, you need to be very cautious. Every time I’ve seen it, it’s been bad.

I turned 18 in 2003. Though I was young, I remember the boom years – I was 16 and everyone was offering me part time work at $10-$12 per hour to do construction work that I had no idea how to do.

When I was 18, 19, and 20, I was remodeling apartments at $10-$15 per hour though I had basically no experience.

Everyone was making money and throwing it around. Then I graduated college in 2008 and the economy collapsed.

It was the same feeling with cryptos. Everyone was excited about them, now I never hear about them anymore.

…and now, everyone I know has become real estate investors.

Real Estate & Economic Fundamentals

When your gut tells you something, you need to pay attention. But, I question myself at the same time.

Housing inventory is chronically low which is forcing housing prices to go up. House construction simply can’t keep pace with demand and the same is true with apartment developments.

Interest rates are dampening demand. If interest rates continue to rise, it could affect the entire economy, but the Fed has signaled it might slow or stop their interest rate increases.

The economy is great, unemployment is rock bottom, real estate prices are increasing. New wealth has been created by the trillions in the last year or two.

Stocks are going through a correction, but stock prices are not an economic indicator. If they get too low it can change people’s perceptions of the economy though and reduce spending. So, we need to pay attention to it.

Wages are growing faster than inflation for the first time in decades.

But, cap rates are amazingly low and property prices are ridiculously high compared to the income being produced. This means people prefer real estate over other investments.

Economists are constantly revising up their estimates for growth.

But… the yield curve inverted, at least on part of the curve, which usually signals an upcoming recession within 1-2 years.

So, which is it? Is real estate at the top or are economic indicators showing strong fundamentals?

Image result for real estate rates

Is it Rational or Irrational Exuberance?

Well, my crystal ball is as clear as yours. No one can predict the future but here’s my take.

I don’t feel that all signs point to bubble yet because there is enough conflicting thoughts to make me believe we aren’t quite there yet. Real estate is cooling down, but a lot of that is due to interest rates. If they don’t continue to rise, then real estate should be more stable or continue to rise.

For now, though, all we can do is to plan and to prepare. Here are your options.

Joining The Herd.

Most people invest a lot and take risks when times are great, but pull way back when times are bad. They dump $50k into stocks then when they drop 20%, they immediately sell to protect them from further losses.

Then once stocks have dropped 40%, they are too scared to reinvest until stocks are back up or higher than where they were before.

People jump into bitcoin when it’s 15,000, ride it to 17,000, then dump it when it gets to 10,000.

This is the herd mentality and is the absolute wrong way to invest.

Back in 2007, they were giving loans to anyone with a pulse but by 2011 it was basically impossible to get financing, even though housing was at rock bottom prices.

When properties could be bought for literally 40 cents on the dollar, nobody was lending and nobody was buying.

Bucking The Herd…

The hardest part of doing the opposite thing is you’ll have some serious FOMO (fear of missing out).

I know people who have made $200k+ in cryptos. FOMO was taking hold of me and I almost I actually invested $1,000 into bitcoin right around $15,500. I played with it for a week or two and sold it, losing roughly $3. That is not a typo.

I did it for fun because investing due to FOMO is the absolute worst reason to invest. A lot of people put a ton of money into it right at the wrong moment.

Instead, I believe people should invest when times are great and invest way more when times are bad. Also, I only want to invest in well known and historically good investments. In a way, it’s like dollar cost averaging.

Using the above example, if the market is hot, I wouldn’t dump all $50k into the market. Instead, I might dump $20k and leave $30k cash. As the market drops, I keep buying more. If it goes up, I buy more too, just more slowly.

In fact, this is almost exactly what I did during the market crash after Lehman Brothers collapsed. I invested my life savings in the beginning of september 2009 and lost half 2 weeks later.

I was somehow able to make all my money back within about 6 months because of dollar cost averaging.

Dollar Cost Averaging Works in Real Estate

The fact is that nobody knows when we will be at the top and nobody knows how hard the market will correct when we get there. It could come in 3 years or it could come tomorrow.

3 years ago I knew a person who sold a lot of their multifamily because they said we are at the top. 3 years later they lost out on a ton of money because it’s still going strong.

So, if you held back your investments today, you could lose 3 more years of a bull market.

My point is, I wouldn’t avoid buying. Just buy a deal or two, buy them right, and focus on adding serious value to keep you above water when the market corrects.

During a correction, use your capital reserves to really get in and buy as many properties as possible with as little money as possible. Don’t focus on adding a lot of value, just focus on getting them cash flowing.

Adding value means typing up capital. Tying up capital means buying fewer properties for huge discounts.

So, save those improvements for when the market is hot and deals are hard to find.

How Are You Planning to Invest in the Next Few Years?

Are you following the herd and diving in, or are you bucking the herd and doing the opposite.

 

This article originally appeared on IdealREI. Follow them on FacebookInstagram and Twitter.

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