Capital Appreciation

Over the last several weeks, we received two extremely positive batches of data including the first significant sign of job creation as well as an unprecedented month-over-month up tick in retail sales. Now with Greenspan announcing that the economy has entered a period of "more vigorous expansion" the yield on the 10-year Treasury has been bullied from a March low of 3.73% to today's 4.50%.

While Mr. Greenspan was answering questions from the panel, federal-funds futures were pricing in a 50% chance of a quarter-point rate increase at the Fed's June meeting, and a 100% chance of an increase at the August meeting. Prior to this recent testimony, the market was pricing in about a 30% chance for June and an 80% chance for August. These events viewed in the context of a seemingly ever expanding federal deficit have many well-known pundits predicting a 5% Treasury by year-end. Others looking out further, including Wells Fargo's chief forecaster, are expecting increases of as much as 200 basis points within the next 12 to 18 months.

For many industry veterans there is nothing surprising about these developments. At Steelhead, we have a number of clients that have been modeling a substantial interest rate increase since last spring. Their concern is based on, if nothing else, a gut interpretation of the cycles. And although increases in Treasury yields seem to be arriving later than expected, there is little doubt among economists and industry veterans alike that a period of significant and maybe even dramatic transition is eminent.

To compound matters a bit, aside from the recent 40 year lows in interest rates, cap rates are at levels that induce a nervous titter among even the most optimistic bulls. With the strong possibility for rising interest rates exerting downward pressure on property cash flows, cap rate growth is inevitable.

In trying to better understand what interest rate increases and their natural antecedent, rising cap rates, could potentially mean to our clients, we began by modifying our underwriting model for a recent apartment deal we were involved in. In particular, we wanted to size-up the impact of rent growth and whether significant year-over-year improvement would be enough to overtake moderate increases in cap rates. Our growing concerns about current market conditions were reinforced by what we found. In this quarter's newsletter, we share a summary of our findings:

The Initial Financing

Today, like so many of the submarkets in and around the Central Valley, a typical, class B multifamily asset trades on a cap rate somewhere between 6.0% and 7.5%. The property in our case study sold is under contract for $3,895,000 with an implied cap rate towards the bottom of the range at 6.5%.

Charged with obtaining the financing, Steelhead was able to obtain an 80% loan of $3,116,000 at 5% interest-only for 5 years with annual debt service of $200,728. The annual CIF or "cash-in-fist" (as one of our favorite clients likes to say) landed at $58,521. With the equity requirement of 20% plus transaction costs, the client was required to contribute $840,000 yielding a theoretical cash-on-cash return of 7%.

Calculating Sale Value (Scenario 1)

Since one of the key purposes of our study was to understand how rent increases affected value on sale, we started by holding all other variables steady and inflating gross rents and expenses at 3% year-over-year for a 5-year term. The resulting high-level figures were as follows:

Applying the 3% year-over-year increase in rents and expenses to determine a before debt cash flow figure, we then divided by the 6.5% cap rate implied in the purchase price to determine the approximate value on sale at the end of the loan term.

$293,670 / 6.5% = 4,518,000

Since we originally paid $3,895,000, the combination of the $623,000 delta ($4,518,000 exit value - $3,895,000 purchase price = $623,000) with ongoing cash flows represented a 17 IRR over a 5-year period. In this first scenario, the 3% growth in an interest rate/cap rate neutral environment generates a solid return for an already stabilized asset. If the investor could reasonably believe in the assumptions (6.5% cap rate, 3% growth, and all other variables remaining constant), this would be a solid acquisition.

Calculating Sale Value (Scenario 2)

Having established our baseline in the fist scenario, we moved on to developing a model that would show us theoretical exit values in a rising interest rate/cap rate environment. First, we had to establish a ratio of some kind between interest rates and cap rates. If interest expense went up, what kind of response could we expect from the market in how properties were valued? In order to better understand the relationship, we ran different interest rate increases in our models and then looked at the amount of cap rate increase required to keep our net cash flow number steady. Albeit an extreme estimation, the correlation was surprisingly simple. The resulting cap rate : interest rate ratio turned out to be roughly 1:1.

Armed with this 1:1 relationship, we picked what we believed would be a reasonable increase in interest rates of 200 basis points and used this to calculate our new cap rate of 8.5%. Applying the same rent and expense growth of 3% year-over-year we arrived at the following value:

$293,670 / 8.5% = 3,454,941

Surprisingly, with growth of 3%, our calculation produced an asset valued on sale that was $440,000 less than the original purchase price ($3,895,000 purchase price - $3,454,941 exit value = $440,000 loss). And although the annual positive cash flow made available by the 5% interest rates helped to offset some of the losses, in the end, the investor chewed-up 11% of the asset's value or more than half of their original equity.

However, the most alarming discovery came when we calculated the rent growth required to offset the 8.5% cap rate. We found that when we assumed a 200 basis point increase in cap rates, rent growth would need to outpace our 3% expense assumption at 2:1 or 6% year-over-year for a 5 year period in order for this investor to approach break-even on sale. In other words, this investor would need to see an extraordinary improvement in market fundamentals to simply get their equity back; a radically different outcome than most of us would expect with rents growing at this pace.

Acquiring New Debt

If interest rates were to rise and the ratio we modeled between interest rates and cap rates was correct, even with aggressive assumptions on the fundamentals, this investor could only sell at a loss. Since the investor would likely be keen to hold longer-term, we next wanted to look at the feasibility of acquiring a new loan. In this case, our investor would need to satisfy the $3,116,000 ballooning at the end of the 5-year term. In order to qualify, the minimum requirements for both the debt coverage ratio (DCR) as well the loan-to-value (LTV) would need to be addressed.

We found cash flows at the end of the 5-years to support a loan amount of $3,065,000. Although shy by $51,000, the coverage was close enough not to inspire too much anxiety. However, when we addressed the LTV issue, we hit a wall. Unfortunately for this investor, with a property value of $3,454,941, max leverage of 80% leaves them with a capital call of $352,048; the rough equivalent of the sum of the cash flows we generated since we purchased the property 5 years ago.

Conclusions

Is doesn't seem possible that even with 3% rent growth and no adverse change in our cost structure or occupancy, this borrower can't sell or refinance after five years without bridging a substantial equity gap. Indeed, our greatly simplified approach is far from conclusive. Our case study only focuses on a 5-year horizon and our models do not explore non-stabilized assets where vacancy can be substantially improved or costs reduced. Additionally, our cap rate to interest ratio is, at best, a very rough guess with no sensitivity to lags in the market or variances between product type.

Even so, the models have to make you wonder. Has the typical commercial real estate investor overextended himself or herself? Are many looking down the barrel of yet another threat on par with what happened in the equity markets in 2000? Cycles are inevitable. Our willingness to plan for them isn't. At Steelhead, we're doing our best to direct clients to give careful consideration to the risks of their transaction, and whenever possible, identifying and providing multiple alternatives with terms and LTVs appropriate to an investing environment primed for change.

Peter Slaugh

Editor of the "From the Street" newsletter, Chief Executive Officer Peter Slaugh founded Steelhead Capital in 1999. In the relatively short period since its inception, Slaugh has built Steelhead into a leading resource for debt and equity placement nationwide. Slaugh is primarily engaged in growing the company and its lender relationships, as well as working on financings. Email Peter

At Steelhead Capital our mission is to enable the long-term success of small and midsize CRE investors. Our actions are guided by the notion that all disciplined investors deserve equal access to reliable institutional financing products supported by effective transaction management and consistent client communication.

Call us today toll-free at 888-951-6600 or click here for your confidential and complimentary loan review.

View highlights of recent loan closings here