Using Fixed vs Floating Rate Debt for Real Estate Acquisitions
Why isn’t fixed always better?
At Ballast Rock, we tailor the debt structure we use to each individual real estate acquisition. We base our decision on the type of debt to use based on the nature of the property, the debt markets at the time of acquisition, our business plan for a given asset, which includes our assumptions for timing and size of capital expenditure (“Capex”) and the expected timeframe for holding the asset, along with many other factors. To understand how we decide between fixed versus floating debt, first we need to understand the different types of value-add we do when we buy an asset:
Capex Value-Add
This is the traditional value add you think of; adding/improving external amenities, renovating units etc. These all require an outlay of cash.
Operational Value-Add
These are non-cash value-add items e.g., improved marketing (both digital and physical), improved staff training, more efficient unit turn speeds, deployment of best-in-class technology (e.g., our AI leasing agent “LISA”) etc.
Fixed rate debt typically can't be used to finance the additional amounts needed for Capex Value-Add. So, we tend to use fixed rate debt where we expect the majority of the value-add to be operational in nature and less actual cash needed to make improvements post-acquisition.
Where we underwrite an asset expecting significant Capex Value-Add, it makes sense for us to use floating rate debt so we can borrow additional amounts to cover these capital expenditures and thereby not reduce overall deal leverage significantly. This helps us improve returns for our investors and makes our post-closing cash management significantly less complex.
Given the above, here are the pros and cons of fixed vs floating debt:
As you can see above, in almost all cases for a real estate sponsor like Ballast Rock, floating rate loans are the optimal debt structure as fixed rate generally reduces day-1 cash-on-cash rates, has higher pre-payment penalties, and is also rarely a good trade longer term. Additionally, floating rates don’t increase in isolation, the Fed rates to manage inflation, inflation which benefits our revenues (as rents go up) thereby naturally hedging our debt service coverage capacity as floating rates rise.
Some Fedspeak if you’re into that sort of thing (like I am!):
On Wednesday 21st September 2022, the Fed raised rates by 75bps, bringing the target Fed Funds range to 3.00-3.25%, the highest level in almost 15 years. It was the fifth rate hike this year and the marks three consecutive raises of 75bps. While the media pays most attention to the Fed Fund rate, the markets also pay a lot of attention to the “FOMC Dot Plot” - which is the Fed’s projection for the future path of Fed Funds.
As well as hiking 75bps in the last meeting, the Fed also shifted the Dot Plot notably higher, forecasting 4.4% by the end of 2022 and 4.6% by the end of 2023 (that’s 80bps above where the Fed was projecting just before the summer). The 10-year Treasury was volatile the day of the Fed announcement but settled about 5bps lower on the day at 3.51%, and the yield curve inversion between the 2-year and 10-year Treasuries also reached its steepest level since 2001 (–54bps), both signaling that the market is pricing in an increased likelihood of a hard landing/recession.
The bottom line is inflation is still a problem and Fed Chair Powell has indicated that he will do whatever it takes to bring it under control i.e., we are nowhere close to being done with rate rises. The market is currently pricing in two more hikes totaling 1.25% before the year-end. The Fed is entirely focused on the “stable prices” element of its mandate, even if that results in below-trend growth for the economy and a softer labor market.
