In late 2022 and early 2023, private equity real estate investors sharply pulled back on funding. They caught on—in some cases, too late—that rising interest rates were going to annihilate deals funded by floating interest debt and drive cap rates higher (pushing prices lower).
In our own passive real estate investing club at SparkRental, our members (myself included) have become more cautious. When we first started going in on group real estate investments together, we focused on potential returns. Today, when we meet to vet deals together, we focus far more on risk.
Anecdotally, I’ve also heard a lot of active real estate investors pull back over the last 18 months, and I hear a lot of hemming and hawing and hand-wringing about interest rates. When will the Federal Reserve start cutting rates? How quickly will they fall? How will they impact cap rates?
You’re asking the wrong questions.
Why Everyone in Real Estate Frets Over Interest Rates
At the risk of stating the obvious, higher interest rates make properties more expensive to buy and own since most buyers (residential and commercial) finance them with debt.
That puts negative pressure on prices, especially in commercial real estate. Cap rates typically rise in tandem with interest rates, meaning that buyers pay less for the same net operating income (NOI).
In residential real estate, the sudden leap in interest rates has caused many would-be sellers to sit tight. No one wants to give up their fixed 2.5% interest 30-year mortgage to buy a new home with a 7% rate. So, housing inventory has been extremely tight.
Residential investors want to know when financing will become affordable again, at least compared to the low rates we’ve all grown accustomed to. Commercial investors holding properties want to see lower rates drive cap rates back down so they can sell at a profit, or refinance properties currently losing money to high variable interest loans.
So yes, I get it: Interest rates matter in real estate.
Why You Should Stop Fixating on Rates
First and foremost, you and I don’t have any control over when and if the Fed cuts interest rates.
I don’t believe in timing the market. Every time I’ve tried, I’ve lost. The best-informed economists and professional investors get this wrong all the time, so it’s sheer hubris to think you can do it when they can’t.
Instead, I invest in new real estate projects every single month as a form of dollar-cost averaging. Our Co-Investing Club meets twice a month to discuss passive group investments, and members who want to invest small amounts can do so.
Is it a harder market to make money in today than it was five years ago? Probably. But two years ago, everyone was euphoric about real estate investments because they performed so well for the previous decade. Every syndicator rushed to show off their sparkling track record. So, investors flooded their money into real estate projects without properly accounting for risk.
In retrospect, the real estate projects from two years ago are the ones most in trouble today. Superstar investor Warren Buffett’s quote comes to mind: “Be fearful when others are greedy, and be greedy only when others are fearful.”
Over the last year, investors have felt far more fear. And from the dozens of passive real estate deals I’ve looked at over the last two years, I can tell you firsthand that syndicators are underwriting much more conservatively today than they were two years ago.
What Investors Should Focus On Right Now
Investors should focus first on risk mitigation in today’s market.
I don’t know when interest rates will drop again. It could take years. I also don’t know where inflation will go or the economy at large.
In late 2022, many economists forecast a 100% chance of recession in 2023. That didn’t happen, and now investors seem to assume a 100% chance of a soft landing with no recession. That seems equally presumptuous.
The good news is that I don’t need to foresee the future. I just need to identify the largest risks facing real estate investments right now—and invest to mitigate them.
Mitigating interest rate risk
After all that talk about interest rates, how do you invest in real estate to avoid rate-related risks?
First, beware of variable interest debt. Although, to be frank, it’s a lot safer now than it was two years ago.
Second, beware of bridge loans and other shorter-term debts of two or three years. Don’t assume that interest rates will be lower in three years from now than they are today.
Instead, look for deals with longer-term financing. That could mean deals that come with assumable older debt.
For example, I invested in a deal a few months ago with a 5.1% fixed interest rate with nine years remaining on the loan. I don’t know if there will be a good time to sell within the next three years, but I’m pretty sure there will be a good time to sell within the next nine.
Longer-term financing could also mean fixed-interest agency debt. Sure, these often come with prepayment penalties, but I’d rather have the flexibility to hold properties longer, unable to sell without a fee, than be forced to sell or refinance within the next three years.
Mitigating insurance cost risk
Over the last two years, insurance premiums have skyrocketed, in some cases doubling or even tripling. That’s pinched cash flow and set up some investments that previously generated income to start losing money.
“Between 2023 and 2024, my insurance premiums climbed more than 30%, which has been a huge strain on my portfolio,” laments Andrew Helling of HellingHomes.com. Higher insurance and labor costs have wreaked such havoc on his rental portfolio that he may pause acquisitions entirely. “I’m considering exclusively wholesaling my leads until we get some clarity on what the Fed will do with interest rates later this year.”
This brings us back to square one: giving the Fed too much power over your portfolio.
But suspending all acquisitions is far from your only option. Another way to protect against unpredictable insurance costs is to buy properties that don’t need much insurance. For example, I interviewed Shannon Robnett a few weeks ago about his industrial real estate strategy, and while he does insure the bones of his buildings, his tenants insure their own units.
Likewise, our Co-Investing Club has invested in mobile home parks. The park does need to maintain a basic insurance policy for any shared infrastructure, but each mobile homeowner insures their own home. The same logic applies to retail and some other types of commercial real estate.
Residential real estate, including everything from single-family homes to 200-unit apartment complexes, need to carry expensive insurance policies. But that doesn’t mean every type of real estate does.
Mitigating rising labor cost risk
In many markets, labor costs have risen faster than rents over the past two years. Again, that pinches cash flow and can drive some properties to lose money each year rather than generating it.
“Labor expenses and average rents aren’t rising uniformly across markets, and in some, labor costs have risen faster than rents over the past two years,” observes Soren Godbersen of EquityMultiple. “Both factors contribute to which markets we are targeting in 2024.”
That’s one solution: Analyze the local market rent and labor trajectories before investing. But how else can you mitigate the risk of labor costs outpacing revenue growth?
Invest in properties with little labor required. In particular, look for properties that don’t require much maintenance or management. Examples include self-storage, mobile home parks, and some types of industrial properties.
For instance, many self-storage facilities can be nearly 100% automated, eliminating management costs. The buildings are simple, with little or no plumbing or HVAC and only the most basic electrical wiring. They need almost no maintenance beyond a new roof every few decades.
Alternatively, you could come at this problem from the other side: revenue. Our Co-Investing Club recently vetted a deal with a syndicator in a specific niche: buying Low Income Housing Tax Credit (LIHTC) apartment complexes and refilling them with Section 8 tenants.
The short version: The loophole is that LIHTC restricts how much the tenant can pay in rent but not the total amount of the rent collected by the owner. By renting to Section 8 residents—in which the tenant pays only a portion of the rent—the syndicator can, in this case, double the rents they’re collecting over the next few years. This means they don’t have to worry about expense growth exceeding rent growth.
My Outlook on 2024 and Beyond
I appreciated Scott Trench’s cautious, even gloomy analysis of real estate’s trajectory in 2024 and J Scott’s upbeat rebuttal.
Scott Trench isn’t wrong about the headwinds and risk factors, some of which we just covered. And J Scott isn’t wrong that plenty of tailwinds could cause real estate to perform well this year.
My view on all this: You should invest consistently and conservatively. You can’t time the market, but you can analyze the greatest risks in any given market—and protect against them.
I don’t need a crystal ball. By passively investing a few thousand dollars every month as a member of an investment club, I know the law of averages will protect me in the long run.
I remember the mood in 2010-2012 in the real estate industry: bleak. No one had glowing things to say about real estate investing. Don’t you wish you could go back and invest in real estate, then?
Stop assuming you know what will happen. You don’t. Stop worrying about what the Fed will do because you can’t control it. Invest instead to mitigate risk, and you’ll make money in both stormy and sunny markets.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
