The Role that Debt Plays in Real Estate Market Cycles
The role of debt always becomes a big topic of conversation when the winds of economic fortunes start to shift with rising interest rates. Debt has a substantial impact on real estate—from impacting the length and depth of any downturn, to substantially impacting asset values, among other factors.
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The Impacts of Real Estate Debt
There are two main areas where debt influences real estate market cycles. The first is at the macro-economic level and the second is at the micro-economic level.
At the Macro-Economic Level
Debt has a major impact on macro-economic conditions. The amount of debt and cost of capital impacts both the start of economic upswings as well as economic downturns. It also impacts the severity of those downturns when they inevitably occur.
Within the Real Estate Sector
Debt has specific impacts on the real estate sector. At a more micro-level, the amount, cost and type of leverage (e.g., fixed vs. floating; amortizing vs. interest-only) affects the relationship between debt service and cash flow. This, in turn, can determine the economic success or failure of an investment, and, on the downside, can impact the likelihood of loan defaults and foreclosures (as well as lead to excellent distressed buying opportunities).
Any widespread disruption in the capital markets impacts financing alternatives.
This is especially true among non-bank lenders, like debt funds, that have been particularly active over the past few years. Many debt funds have started to pause real estate financing in the wake of the Russian-Ukrainian conflict, rising interest rates, and general economic uncertainty.
Less access to capital has a direct impact on the potential IRR to equity investors. The 70 to 75% financing at 3.5% interest rates has now increased to 6-7% interest rates. Unless equity investors adjust their return expectations, this will have a significant impact on asset pricing. As interest rates rise, asset prices will come down.
The Relationship to Cap Rates
As interest rates have risen, so have cap rates. In some markets, cap rates have gone from 3 to 6 percent over the past 12 months. Doubling a cap rate is essentially a 50% cut in value. If someone only has 30% equity in the deal, this means they are already underwater. Not only does this make it nearly impossible to refinance, but in some cases, lenders will demand that borrowers begin to pay down the debt until they reach a more sensible loan-to-value ratio. If they can’t pay down the debt, they may be forced to sell. In today’s market, the only people who are selling are those who have to.
In short, in a rising cap rate environment, investors want to be sure that their debt level and cost is locked in at a fixed rate for a duration that matches their business plan. This allows for sufficient time to increase net operating income, which in turn increases value during a time when asset values may otherwise be decreasing.
Debt Levels Today vs. Pre-Global Financial Crisis
Before investors panic, it’s important to look at today’s economic conditions relative to the environment leading up to the Global Financial Crisis (GFC) of 2007-2009. Specifically, let’s look at how the banking system is prepared to weather this recession compared to the last.
Mortgages, consumer credit card debt, and state and local government debt – as a percentage of GDP – is well below where we were pre-GFC. Real estate debt is also relatively low compared to where we were pre-GFC. This means that, barring some black swan event, the systemic risk of excess leverage in the financial sector is low currently. In turn, the economy should weather the next downturn relatively well. We don’t expect to see the banking system collapse, which appeared quite possible during the GFC.
More troubling, however, is today’s inflation and the amount of federal debt incurred post-GFC and as a result of the pandemic. Record levels of federal debt will undoubtedly impact public policy in the years to come.
The business sector also has astronomical debt compared to pre-GFC. This is alarming because an over-leveraged corporate sector could lead to more layoffs today and slower hiring as we come out of the next recession. Layoffs, combined with rising interest rates and already sky-high housing prices, could result in a hard landing within the next 12 to 18 months, through to mid-2024. We expect this will be followed by a sluggish recovery.
The Capital Stack: Why Debt Matters to Equity Investors
Equity investors often overlook the importance of debt on their returns. Remember, however, that most deals are financed with some combination of debt and equity. In the real estate capital stack, debt has the highest priority. This means that debt must be repaid before equity investors can receive any return.
When a sponsor becomes overleveraged, which often happens when asset values begin to decline, equity investors’ capital is put at risk. If debt is not repaid, equity investors may lose their entire investment.
Paladin’s Defensive Approach
At Paladin, we have always taken a defensive approach with respect to debt, regardless of where we are in the market cycle. It just so happens that this approach is even more important today.
Our strategy continues to be focused on:
- Targeting sectors with proven resilient demand, and
- Financing our investments with conservative levels of debt at fixed rates.
The sector that we target – workforce housing in Southern California geared toward renters by necessity – has proven to be resilient demand during market cycles. The area’s prolonged housing shortage and high cost of housing has made this asset class largely immune to politics and other economic disruptions.
We execute our strategy using conservative debt capitalization. Our last four transactions in Southern California have been financed with debt equal to about 50% of cost, all with fixed-rate financing. This helps us avoid the risk associated with rising interest rates. We match the loan terms with our assets’ business plans to ensure loans do not come due pre-exit, which ensures we are not forced into refinancing at higher rates or selling at an inopportune time.
Conclusion
There is a lot of volatility in the real estate market. This volatility creates inefficiencies that sophisticated investors will know to exploit. While periods of widespread distress in the market surface as the real estate cycle evolves, we know the most important defense is capitalizing our investment with plenty of equity and minimizing the amount of debt financing. Arranging fixed-rate debt to match the duration of our business plan for a property further protects our investments from changing market conditions.
Paladin believes it is making conservative investments, using debt carefully, with underwriting that assumes the potential of higher interest rates and greater exit cap rates. We believe our debt strategy is one of the best ways to preserve investors’ capital in any phase of the market cycle, but particularly during uncertain economic times.
Contact us today to learn more about Paladin’s investment thesis.
