Financing Focus

Rising Rates

Investors should review their financing strategies in light of market changes.

Recent commercial real estate capital market demand has caused capitalization rates to decline significantly, which has inflated real estate values despite poor fundamentals. Yet most experts believe that cap rates soon will climb. Investors should assess their properties to ensure their capital structures meet their operating and investment goals.

Nonstabilized Properties; High-Yield Returns. Nonstabilized properties include new developments, redevelopments, and vacant and materially vacant properties, as well as buildings with significant anticipated near-term rollover. The operating strategy is based on meeting or creating demand for space. These investors typically seek overall internal rates of return in excess of 18 percent; value enhancement through lease-up and sale generates most of the return.

Commercial banks and savings and loan associations primarily provide nonstabilized new development or redevelopment debt financing, and the debt generally has been recourse to the investor. However, investors who buy materially vacant properties can mix and match a low loan-to-value nonrecourse first mortgage with a mezzanine loan secured solely by the property's equity interests. This tactic allows investors to secure nonrecourse debt financing at a higher overall cost of capital.

The primary capital structure consideration for this asset class is not affected by rising cap rates; however, the loan maturity is a concern, as the investor must ensure that he has enough time to execute the operating strategy without refinancing or renegotiating the loan during the process.

For example, an investor purchases a $1.3 million property with a 75 percent LTV, fixed-rate loan at a 6.16 percent cap rate. The property's initial $82,098 net operating income is assumed to grow at 10 percent per year for three years and 3 percent per year thereafter. If the cap rate increases to 9 percent by the end of the second year, the investor's initial $333,333 equity will drop to $129,085, and the property's value will decrease to $1.1 million. However, with steady NOI increases, the investor can expect positive refinancing proceeds by the end of year six. (See Table 1.)

Stabilized Income Properties; Medium Returns. This category encompasses all multitenant income properties and some single-tenant properties that are at or near full or stabilized occupancy. (Hotels and self-storage generally do not stabilize at or near full occupancy but may be considered at stabilized occupancy.) Investors in such properties generally seek current returns from cash throw-off and capital appreciation over the investment horizon. These investors evaluate both the equity return rate and the IRR, which generally is anticipated to be 10 percent to 15 percent.

Stabilized income property financing options generally come from conduit lenders, insurance companies, and commercial banks. This is the arena where investors most likely will experience investment risk due to rising cap rates. For instance, an investor who buys a stabilized property with nominal projected NOI increases at a relatively low cap rate and has any debt obligations that mature in the near term (three to five years) may realize a shortfall in refinance proceeds and may have to invest additional funds to avoid losing the initial equity investment.

For example, an investor purchases a $1.3 million property with a 75 percent LTV, fixed-rate loan at a 7.5 percent cap rate. The initial $100,000 NOI is assumed to grow 3 percent per year. In this example the investor does not achieve a break-even debt-to-equity ratio until the sixth year of the investment, which indicates that any loan maturing during the first five years cannot be refinanced at par and will require additional equity contributions. (See Table 2.)

Single-Tenant, Net-Lease Properties; Low Returns. Attracting many risk-averse investors, this property class is dominated by drugstores, big-box retail, and build-to-suit office and industrial facilities. Because these leases generally have few interim rental rate increases, most of the equity return is achieved through current income, with loan amortization providing any capital gains realized.

Any short- to mid-term (less than 10 years) balloon loan presents a significant financial risk to investors who have no income growth and rely primarily on loan amortization to compensate for value declines resulting from cap rate increases. To minimize this risk, equity investors can secure fully amortizing loans or balloon loans with short-term amortization periods (20 years or less), which reduces the balloon amount. This option reduces the current cash-on-cash return sought by net-lease property purchasers, but the reduced risk could be worthwhile.

For example, an investor purchases a $1.3 million property with a 75 percent LTV, fixed-rate loan at a 7.5 percent cap rate. Assuming only 1 percent compounded NOI growth per year, increasing cap rates will result in a refinance proceeds deficit until the end of the eighth year. (See Table 3.)

For all properties, an investment analysis incorporating the property economics and the proposed capital structure forecasting NOI and estimated value at loan maturity, as well as over the investment horizon, is absolutely necessary to determine if an investor is at risk. With the results, investors may be able to refinance early, before cap and interest rates climb substantially.

Paul L. Jones

Paul L. Jones is president of Pyramid Realty Group in Coral Gables, Fla. Contact him at (305) 665-2450 or  


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