Yesterday’s Fed’s rate hike of three-quarters of a percentage point was the highest increase in 28 years. What does this mean for REEP Investors like yourself?
Not much, because we planned for this. Our experienced underwriting team takes into consideration potential rate increases and includes safeguards in the business plan to mitigate the impacts of interest rate increases.
Interest rate increases only have the potential to impact floating-rate debt. Therefore, our properties with fixed-rate debt are not affected by rate changes. To mitigate the impact of interest rate increases property’s with floating-rate debt include the following additional financial safeguards:
1. For each floating rate loan, we purchased an Interest Rate Cap. An Interest Rate Cap puts a ceiling on how much the floating rate index can increase on the loan, this essentially acts as an insurance policy/contract on floating rates. As interest rates increase the mortgage payment increases until it hits the Interest Rate Cap that was purchased to protect the property. It will not be allowed to go higher than this capped rate.
2. If the market’s floating rate index exceeds the Interest Rate Cap, the Cap Provider pays the difference to cover the difference in the loan payment. Our underwriting takes the cap into account. In other words, we planned for this worst-case scenario and planned the business plan around the potential higher interest rate – up to the cap amount.
As an example, on a loan with a floating rate of SOFR (index) plus a 2.0% spread, we purchased a 2% interest rate cap. If the Interest Rate Cap coverage is 2.00% and SOFR resets at 2.50%, the Cap Provider would pay the 0.50%.
We stress-test our underwriting on all investments prior to purchase at various levels of interest rates to account for these scenarios and account for the additional debt service.
For example on the recent acquisition of 51TEN Townhomes (formerly Smoketree Townhomes), our Investment Returns and underwriting were based on a 4.75% Interest Rate, whereas the actual interest rate is 4.15%, again demonstrating our conservative underwriting. On the following chart, you will see that in the worst-case scenario modeled, with the interest rate at 6% each year during our projected hold, the property still cashflows and has exceptional total returns and equity multiples (EM).
Jacob & Arleen Garza
Co-Founders, REEP Equity