Rising Interest Rates

In the last sixty days, the 10 year treasury has jumped from roughly 1.7 to 2.7. While still very low from a historical standpoint, it is nontheless an extreme move up in a very short period of time. This has caused a spike in interest rates. Again, they are still low (for the moment), just not extremely low.

I’m curious what other investors thoughts are.

Since MHP investing is very much a function of cash on cash returns, do you think cap rates will rise to offset the cost of higher borrowing?

This will surely drive up the cost of borrowing. Obviously, there is no way to know exactly what the Fed will do with interest rates. However, we’ve been expecting this for some time. These ridiculously low rates can’t last forever. Strike while the iron is still warm as they say!

Interest rates normally run in cycles. What you have now is the low point of the cycle (you can’t get much lower than 0 in many cases), so you have to be prepared for a rise in rates at some point in the future. The recent increase has had no impact on cap rates that we’ve seen (the rates are still incredibly low by historical standards), but the key to timing the eventual rise is to make sure that you don’t have a loan that comes due when they are on the high part of the cycle. For example, if you have a park on a fixed interest rate for 10 years, the only time in which interest rates matter (assuming you don’t want to sell the park during that time period) is what level they’re at when the note comes due. They could cycle as high as 20% and it would not matter, as long as they come back down to earth when it is time to sell or refinance the park. So the key is to get yourself in a position to have as much latitude as possible to “time” your next move in keeping with the cycle. That’s why we’ve been moving most of our debt to 10-year fixed interest rates with conduit, or seller carry with either 10 year terms or the option to “buy” an extension to get the term to 10 years. We figure that we can pick the moment during that 10 year term that the rates cycle low again to refinance or sell. If it’s 7 years in, for example, we can refinance or sell the seller carry with no penalty, and defease the conduit at a fairly low amount.

Another important function of higher interest rates is, traditionally, higher inflation. We are completely in favor of that, as the amounts we paid for the parks are set in stone, and not subject to change, but the amount we can sell them for is subject to increases from inflation. Real estate performs extremely well in times of inflation (which is something we have not had on our side for years) and parks do well in particular, as we can raise our rents much more aggressively than the other real estate niches.

So if you look at the big picture, we actually hope for significantly higher rates as part of the normal cycle – but we suggest that everyone be very watchful on their loan terms to make sure that you can time the event properly. I know that a 3-year note term is probably a loser, but I"m not sure that 10 year is a necessity – so what is safe? That’s what you have to decide and act accordingly.

There is always a delta between the prevailing interest rate and the CAP rate. Except- in some really funky markets in California and other areas- for reasons I really do not want to discuss but some markets track a bit different.

So- values will drop per $ of net income- which might lead to higher rents as owners try to bump values to refi or sell. I believe the real estate curve we seen cycle over and over will have a very flat recovery on the value side for several more years. The interest rates in the market today are very unhealthy, but they have kept the money flowing.

here is a quick look at the effect-

assume 70,000 of NET operating income

8 CAP- 875,000

8.5 CAP- 823,529

9 CAP - 777,777

9.5 CAP 736,842

10 CAP 700,000

10.5 CAP 666,666

11 CAP 636,363

11.5 CAP 608,695

So as you can see- on 70,000 of income with each 1/2 cap point you lose about 45,000 in value. Each point is pretty close to 10% of the value. The real problem here is- there is not a equal increase in the income of the population to offset the interest bump- so something in the market will have to give as our economy begins to get back to a healthy operating status.

Now the good news is- this really has little effect on you unless your selling or must refi. Your cash flow should cover your debt service and expenses. I coach everyone who engages me one of your exit strategies needs to be- hold it forever. If you have entered your purchase with that in mind- you will be fine. If your a buy and flip the park person- you better factor the higher CAP into your buy side or you will be giving away value as CAPs bump.

Keys in this market of raising interest rates-

lock in LONG term financing. Even with a owner carry, build in something where you can pay some equity down to extend the term of the loan. Buy knowing the market will probably be flat for then next several years. If you are going to partner with someone- be on the same page knowing you might have great cash flow, but upside down if you sell- so be ready to wait out the storm. If a partner needs out- write in where they need to exit at the current values, not the purchase values- that way one partner needing out does not topple the entire partnership.

One last thought- it will be VERY important to keep homes in your park. So be proactive. I have noticed over the last few years many of the parks have really started to lock down the homes for sale and the repos in their parks. That trend will strengthen I believe, so homes will be harder to find.

I know many people will not agree with my outlook here- I am not looking for a fight- just stating my opinion. I invest in a pretty conservative way, lots of people make way more money and are less risk averse than I am…

and for the record- I love this market and am in the buying mode.