How Rising Interest Rates Affect Project Financing: A Look at Debt Structures
In an attempt to cool inflation, the Federal Reserve has raised interest rates at a faster rate than it has in more than forty years.1 These rising rates have consequences for real estate investors. Understanding the implications rate increases may have on your real estate investments will help you can make informed decisions about how best to manage those investments. As some banks recently discovered, not understanding the underlying dynamics of a changing interest rate environment can have painful consequences. Today’s blog post examines what increased borrowing costs mean for different types of investments. Stay tuned for further insight into managing interest rate risk in your real estate portfolio!
Rising interest rates impact both new acquisitions and many existing projects. Understanding the type of debt in your investment portfolio and how managers are controlling those various types of debt will help you manage your investment portfolio.
For new acquisitions, and assuming no other differences for the project, higher interest rates mean lower returns to equity investors as more of the existing cashflow will be used to pay interest expenses. Some ways investors may be able to mitigate those risks include: ensuring the purchase price for the project adequately reflects the higher borrowing costs, ensuring the project has sufficient cashflow to service the debt, and by ensuring the risk adjusted returns for the project reflect the total cost of capital for the project inclusive of debt and equity. Projects with short-term debt or with the ability to refinance the debt may be an opportunity to acquire new assets at a lower price than in a low interest rate environment, creating a profit opportunity when financing rates change again.
Existing projects face different issues in a rising rate environment. These considerations are impacted by the stage of the business plan, when the project was acquired, what type of debt was used in financing the project and when the project is expected to be marketed for sale. To manage these dynamics, a manager will need to assess options to increase operational cashflow, increase investment cashflow, and/or increase cash through financing.
Market dynamics and the skill of the manager will determine whether a manager can increase operational cashflow. For example, a manager may be able to increase rents as tenant leases renew. Property types with shorter-term leases such as multi-family housing or self-storage are better able to take advantage of these types of opportunities as those leases typically renew on an annual basis. Managers should also scrutinize operational expenses and identify areas to reduce costs and free up cashflow to investors. Strong managers are always looking at opportunities to grow revenues and reduce spending to deliver additional value to investors through their operational excellence.
Certain assets may be able to increase cashflow through investment activity. Some commercial real estate projects can be carved up to sell a portion of the project to another investor. This may take the form of the sale of an outparcel, the sale of one building in a portfolio, the sale of adjacently owned land to another investment group, or in some other form. Understanding how the real estate is situated, what local zoning regulations will allow, and having an experienced, entrepreneurial manager may produce opportunities to bring in cash for a project’s investors that had not been anticipated at the outset of the deal.
Lastly, managers may increase cashflow through financing activities. While there are many ways to approach this, a few options could include refinancing the existing debt, adding additional debt, or making a capital call. Refinancing an existing loan and increasing the overall size of the loan, if key revenue indicators are being met, may be the least costly way to add cash. If the cost of the new debt is less than the anticipated total cost of capital for the project this should be an option managers consider. It is not always possible to refinance the debt, but may be possible to add a second loan, often called mezzanine or mezz financing. Mezz financing often requires a higher interest rate than the primary loan on the project due to its security position being after the primary debt. In spite of this increased interest cost, this could be a good solution in some circumstances as it prevents further dilution for equity owners, limits higher interest costs to a smaller loan versus refinancing the entire primary debt and may often be a faster solution to implement. Lastly, managers may also have existing equity members add capital to the deal in the form of equity. Managers may use this option if, in their view, the cost of the additional equity is the most efficient and lowest cost of capital for the project. While capital calls for syndications are rarely welcomed by investors, the call itself is not necessarily an omen that project is impaired. Debt market pricing, business conditions at the asset, loan covenants and other reasons may all dictate the need to use equity versus adding additional debt. The ultimate objective for the manager should be to capitalize the project in such a way as to maximize returns for equity investors which includes managing the financing risks for the project.
Rising interest rates also create new debt investing opportunities. As traditional forms of financing become more restrictive, limited, and expensive, the need for additional capital from real estate managers still exists. This opens opportunities to achieve above market returns when working with a partner who can provide access to debt opportunities such as loan participation agreements, lending to a fund with diversified assets, or even investing equity into a fund whose primary purpose is to make loans to real estate projects. These investments can generate real time income for investors and often do so with less risk than an equity investment as repayment of debt is prioritized ahead of an equity investment.
All projects come with risks, and working with changing interest rates adds tension to any investment portfolio. Through planning, investors can take steps to safeguard their financial well-being even in a rising interest rate environment. Understanding the business plan and capabilities of the managers in your existing projects and evaluating other investment options available can help ensure a portfolio that meets your investment objectives. In the end, careful planning today is key to securing a sound financial position tomorrow.
1 https://fred.stlouisfed.org/series/FEDFUNDS
Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.
