To address rampant inflation, commercial real estate investors frequently ask about effective financing strategies. That is, as costs and interest rates rise, what’s the best way to structure a deal’s financing? In this article, we’ll address these items and outline the best types of commercial real estate financing in an inflationary environment.
Specifically, we’ll cover the following topics:
- Inflation and Interest Rates
- Real Estate Development & Construction Financing in Inflationary Environments
- Real Estate Acquisition & Stabilized Operations Financing in Inflationary Environments
- Final Thoughts
Inflation and Interest Rates
Prior to discussing inflation and real estate financing, we need to discuss interest rates. When the economy enters an inflationary period, the Federal Reserve, or Fed, will raise interest rates to fight that inflation. Increased rates lead to increased borrowing costs. These increased borrowing costs dissuade many companies from large-scale capital investments, which slows the economy and, in turn, combats inflation.
While the benchmark Federal-funds rate doesn’t directly affect commercial real estate mortgage rates, this metric has an indirect effect. Mortgages most closely track the 10-year Treasury, which tends to increase when the Fed increases its benchmark rate. Additionally, many variable-rate construction loans track indices tightly coupled to the Fed’s rate, which drives up these variable-rate products. Accordingly, Fed interest rate increases frequently result in increased borrowing costs for commercial real estate.
Real Estate Development & Construction Financing in Inflationary Environments
During the development and construction phase of a commercial real estate project, developers typically combine a mix of equity and short-term, variable-rate debt financing. The specific deal and current economic considerations will largely determine whether that capital mix leans more heavily towards debt or equity.
Issues with Variable Rate Debt Financing
With traditional commercial real estate lenders (e.g. banks and credit unions), developers generally secure variable rate construction loans during the acquisition and construction phases of a deal. For example, a lender may look at a $20,000,000 and offer a 70% loan-to-cost construction loan. This means that the developer has access to $14,000,000 in construction loan draws (issued as the project progresses) and must put up the remaining $6,000,000 in equity.
However, as stated above, in inflationary environments, rates tend to increase as the Fed looks to combat inflation. Accordingly, over the course of a two- to three-year construction period, the loan’s variable rate can increase dramatically. This exhausts a developer’s interest reserve more quickly than planned, resulting in additional cash requirements. If an underwriting model plans for a 5-to-6% rate range, but the rate increases to 8%, a deal can quickly swing away from profitability.
Equity Financing as an Alternative
Alternatively, developers can avoid the unpredictability of variable rate construction loans by securing equity financing for a deal. Rather than secure a construction loan for capital needs above and beyond developer cash, you bring in equity investors.
Due to rising rates, these investors will likely demand higher minimum required returns. But, these returns are only paid out when the deal performs well. Unlike debt, equity capital does not mandate regular cash payments. Rather, once the developers finish the construction phase and exit the deal, the investors receive their distributions. This system allows developers to more accurately plan for cash flow requirements during the actual construction phase, as they do not need to service variable rate debt every month.
Real Estate Acquisition & Stabilized Operations Financing in Inflationary Environments
When real estate investors acquire stabilized properties, they typically use a mix of equity and fixed-rate, long-term mortgages (as opposed to the variable-rate, short-term loans used during construction).
Solid Real Estate Performance During Inflation and Increased Equity Returns
Many commercial real estate types – particularly multifamily – perform well in inflationary environments. As inflation grows, landlords drive up rents accordingly. And, even when operating expenses increase concurrently, rents generally outpace this expense growth, leading to increased net operating income (NOI) and, by extension, valuations.
With an appropriately structured equity waterfall, deal sponsors (i.e. common equity holders) receive a disproportionate amount of a deal’s upside. However, even with this structure, preferred equity holders and other “investor members” will claim a portion of a deal’s upside, which, as stated, can be significant in an inflationary environment.
The Beauty of Fixed-Rate Mortgages During Inflationary Periods
On the other hand, fixed-rate mortgages offer two tremendous advantages during high inflation, both of which suggest deal sponsors should lean more on debt than equity with stabilized acquisitions.
First, mortgage loan principal does not increase with solid asset performance. That is, if a property performs well, the owner doesn’t owe the lender more money. As NOI increases, fixed-rate debt service remains the same, leading to increased returns (as opposed to equity, which requires increased distributions when properties perform better).
Second, inflation results in borrowers paying future debt service with “cheaper” dollars. When you secure a permanent mortgage, the principal and interest portion doesn’t change. For instance, say monthly debt service totals $50,000. In Month 1, $50,000 has $50,000 in purchasing power. However, during rampant inflation, each one of those dollars has less purchasing power. Accordingly, when you pay that $50,000 in debt service a year or two into an inflationary environment, it costs you less, as the value of each of those dollars has significantly decreased.
We only scratched the surface on commercial real estate financing in an inflationary environment. But, the important takeaway is that different phases of a deal dictate considerations that may favor debt over equity, or vice versa. In all deals, investors should analyze the unique situation and macroeconomic considerations to determine what blend of debt and equity makes the most sense.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated inflation implications.