The Ramifications Of Your Debt Decisions

Oct 30, 2021 | Wildhorn Insights

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One of the best things about investing in real estate is your ability to use leverage. The $100 you have to invest allows you to buy $300-$400 of real estate when you apply leverage.  It’s a powerful tool that you obviously have to pay attention to–and be very careful with. 

Our view is that multifamily is not that complicated of a business.  If you buy quality assets in good locations within great markets (like Austin and San Antonio), and you keep them full then you’re going to perform and beat your business plan.  It’s the best asset class for preserving capital.  Where people can run into trouble is when they get over-levered.  Running up 80%-90% loans, with preferred equity slugs on top.  At that point you have little margin for error, and if you have the slightest hiccup in market or deal performance you can really start to stress the deal.  

At Wildhorn, we like debt. We also respect it.  We have a house rule that we’ll never go beyond 70% leverage.  Sure, taking more debt would allow us to show a higher (potential) return to our equity investors.  But it also adds risk.  Our goal is to minimize risk while taking advantage of the benefits responsible leverage can provide. 

To truly take advantage of those benefits though, you really have to think through and understand the debt options out there–the risk and benefits of the different types of products and which one(s) best fit your business plan.  Things like loan term–should you get 3-yr or 10-yr loans?  Work with a debt fund, a government agency (Freddie or Fannie), a Life Company, or something else entirely? Fixed rate vs floating rate? Do you want to maximize your interest only period or start to pay down your principal immediately?  Do you need construction financing?  The variables to think through can really be mind blowing–or mind numbing–if you don’t know what you’re doing.  

And the decisions you make today will have an impact on your business plan, and your exit options, in the future. 

Amongst all those decisions, the one that has the potential to make the biggest impact on your business plan and future exit options is whether you want a fixed rate or a floating interest rate.  When you opt for a fixed rate, you are essentially guaranteeing a certain return (let’s say it’s 5%) to the bank over the term of your loan (let’s say 7 years).  Once you close on the loan, you are locked in to providing that return to the bank (and their ultimate investors).  The benefit to this is obvious–you’ve eliminated the risk of any interest rate fluctuation.  The downside is even if you want to sell the asset before the loan expires, you have to deliver that guaranteed return to the bank.  That shows up in the form of a pre-payment penalty if you decide you want to pay off the loan before the 7 years is up. 

On the other hand, if you opt for a floating rate loan, you haven’t guaranteed a return to anyone so you have more flexibility in looking at exit options.  If you want to sell your asset early, there is no pre-payment penalty.  However, as interest rates fluctuate you’re monthly payment can (and will) change  In today’s low interest rate environment, you have to calculate the risk of whether or not you think rates are going to stay low, or if they’ll start to increase–and then make sure you can afford to pay your higher mortgage payment every month. 

When you start to have these conversations, the old joke is that if anyone could predict what was going to happen with interest rates, they wouldn’t be buying real estate and would be a very wealthy person.  In our position we think about this question on a daily basis. 

Across our portfolio we’ve executed loans in just about every fashion–10-year terms, 3-year terms, fixed rate and floating rate.  We really do try to match the loan to the business plan for the asset.  And we try to look at the market and what makes sense for the deal. Three years ago, with interest rates sitting around 4% we decided to get fixed rate loans on a couple of assets we were buying in Austin.  On both occasions, we loved the locations and long-term nature of the business plan.  Fixed rate debt made sense. 

Fast forward to today, and interest rates have continued to drop.  Meanwhile, multifamily asset prices have shot up across both Austin and San Antonio.  Investor interest and demand for Central Texas continues to lead the nation and rental growth rates are eclipsing 15%.  In a few cases, values on our assets today are where we expected them to be in five or seven years from now. Suffice to say things have gone very well for the market and our asset values.  But as we sit and evaluate the business plans, those pesky fixed rate loans show up.  The ones with the big pre-pay penalties where we locked in a return to the bank.  

To be sure, it’s a good problem to have. But as we wrestle with options to maximize value for investors, writing the bank a check for $5,000,000 or more stings–and impacts investor returns. Maybe fixing those interest rates wasn’t such a smart idea, with hindsight always being 20/20. 

On the buy side, we think about the deals we’re closing now.  Interest rates again sit at all time (and new) lows. But now, the Fed is promising to start tapering their lending–and ultimately raise rates.  The treasury rates have shot up over the last 60 days and the market seems to believe interest rates will rise.  If we lock in a fixed rate loan and rates rise, we’ll look really smart 3-5 years from now.  Conversely, if we sign up for a 7-yr loan and rates don’t rise, we would again face a pre-payment penalty if we wanted to try and sell early. 

The old adage goes that as soon as you opt for a fixed rate loan, rates will drop–and when you opt for a floating rate loan they’ll rise.  It’s a bit of a joke that the market is never really your friend.  So it comes back to buying assets you believe in with realistic business plans. And if you’re sitting here trying to make decisions about early exit fees and big pre-payment penalties, it probably means you’re way ahead of the plan for that asset and investors are going to win either way. 

As we ponder whether to fix or float the rate on our next deal–we’ll let you know.  You should immediately place a bet opposite of what we do.

Andrew Campbell

Written by Andrew Campbell

Andrew Campbell is a native Austinite and Managing Partner at Wildhorn. He is a real estate entrepreneur who first broke into the business in 2008 as a passive investor. In 2010 he transitioned into active investing and management of a personal portfolio that grew to 76 units across Austin and San Antonio. He earned his stripes building and managing his personal portfolio before founding Wildhorn Capital and focusing on larger multifamily buildings. At Wildhorn, he is focused on Acquisitions and maintaining Investor Relations, utilizing his marketing and communications background to build long-term relationships.

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