Cash-flowing real estate is one of the assets most equipped to handle rising interest rates from inflation. I know the typical knee jerk reaction is to assume that an increase in interest rates will negatively impact an investment’s Net Cash Flow (NCF) based on the following formula:
NCF (Net Cash Flow) = NOI (Net Operating Income) – Interest Expense
The problem is that investors only focus on Interest Expenses and ignore the other factor – NOI – when considering the impact on Net Cash Flow from an increase in the cost of higher interest rates.
Private commercial real estate investments are equipped to handle higher interest rates because of the NOI factor that can keep pace with any increased costs associated with higher rates.
The same economic factors that are putting upward pressure on interest rates can also be leveraged to push NOI.
When the Fed raises interest rates, it’s typically due to inflation – a sign of a strong economy. A strong economy means lower unemployment and higher wages. This also means tenants who can afford higher rents.
Private commercial real estate with expiring leases can leverage inflation to charge higher rents upon renewal to offset any increased costs in borrowing. And the private real estate assets with short lease terms like multifamily with initial lease terms as short as 3-6 months are ideal for pivoting in response to rising interest rates.
Here is a summary of how inflation and a strong economy can benefit private real estate NOI:
Higher Rental Rates – Rental rates typically rise with inflation, with some assets like affordable multifamily even experiencing rental rates that exceed inflation. That’s because affordable multifamily demand is relatively inelastic in the face of inflation. Since the Financial Crisis, there has been a gross undersupply of affordable housing in the U.S., with the gap only widening with time. Higher rental rates will not be expected to narrow this gap.
Lower Delinquencies – A strong economy and low unemployment should improve tenants’ ability to pay their rents on time. This reduction in delinquencies will reduce collection and eviction costs – leading to improved NOI.
Reduced Vacancies – A strong economy and low unemployment also mean lower vacancies. Higher occupancies translate to higher revenues.
Lower Incentives – A strong economy, lower unemployment, and higher wages all translate to higher demand. High demand means less need for operators to offer incentives to lure potential tenants.
Move-in specials such as one-month free rent or other concessions such as free cable or WiFi can be eliminated to boost bottom lines. The elimination of concessions, which average 1% to 3% per year of total gross revenue, can significantly improve NOI.
Private real estate is well-equipped to handle higher interest rates, with improvements in NOI expected to exceed any higher costs. Enhanced NOI is comforting, but there are additional safeguards operators can take to protect themselves even further.
One of these strategies would be to lock in fixed interest rates today or shortly to beat the onslaught of higher rates in the future. Locking in current interest rates will help you ride out the storm because interest rate hikes are typically short-term.
Even if short-term interest rates lingered for 2-3 years, loan terms of 5+ years are more than adequate to ride out higher rates and refinance when rates begin to fall again.
There’s no need to fear inflation if you’re interested in assets ideal for absorbing higher interest rates from inflation; there is no stronger asset than private real estate.
Kyle Jones is a co-founder and Key Principal of TruePoint Capital, LLC. Kyle is responsible for the company’s strategic planning, investment decisions, asset management, and overseeing all aspects of the company’s financial activities, operations, and investor relations.
Kyle obtained a Bachelor of Science degree from Texas State University – San Marcos, where he also played Division 1 Baseball.