What the US Credit Rating Means for Real Estate Investors

Episode Transcript:  

So in case you haven't heard, Moody's just downgraded the US credit rating from AAA to a double A one. Now, if you're a real estate investor, whether it's in a single family house or a hundred million multifamily dollar deal, this matters. Here's why and what to do. Now let's get REady2Scale.

Hey guys. My name is Jeannette Friedrich. I'm the director of Investor Relations here at Blue Lake Capital, where we invest and manage multifamily properties across the us. Now on May 16th, Moody's actually downgraded the US from AAA rating to a double A one rating. Mainly because the government's continued persistent budget deficits as well as rising interest cost.

Now, why does this matter? So first of all, it matters because it moved the markets. So the US treasuries are basically the foundation for pricing risk across the globe. So this doesn't just impact the US government. This doesn't just impact Americans. It actually has a global effect. And what it means is that it nudges borrowing cost up.

Even higher. Now you might be thinking like, why does this matter to me? But you'd be surprised the ripple effects are pretty far reaching. So for example, if you happen to be part of, say, a pension fund, and your pension fund is investing in the market, these typical pension funds and other large institutional have to follow certain mandates.

For example, many of them can only be involved in AAA rated debt. If all of a sudden they have us backed mortgage securities that no longer have that AAA rating, that immediately pushes them into the position where they have to rebalance, offload this now downgraded debt from AA to a one, and then in turn that ripples through the rest of the stock market.

So indeed, we did see the markets move. We saw the 10 year treasury jumped. To 4.5%. The 30 year topped at 5% stocks went down, the s and p 500 was down by 0.3%. The VIX spiked the volatility index. If you're not familiar with that, the dollar weakened and also. UK market started to fall too. Now, as a real estate investor though, why do you care about this and how does it matter for you?

So first, first thing to understand is that this nudge is debt up. So debt is now going to be more expensive, loans are going to be more expensive. Mortgage rates moved with the treasuries. Freddie Mac is now at a high that we haven't seen since April of 6.9% for a 30 year fixed rate. And going back to commercial backed securities, the gap on those actually spread by 20 to 30 basis points, meaning that even bridge loan financing is now also more expensive.

So if you're looking at getting into a deal right now. The rate that you can get into deals at may already have shifted and be higher than you were expecting. Second thing is that it puts equity values under pressure. So if you're involved in, say, a public REIT investment, these took a hit because when interest rates go up, that pushes the valuations down, which is painful for real estate investors.

In addition to that, it also happens in the private market, even though the private market tends to be a little bit delayed and behind. The public market, public REITs can have a lot of volatility day in and day out. It takes time for that to be reflected in private markets, but nonetheless, until it does ripple through.

A lot of sellers are gonna be stubborn and holding onto yesterday's price that they're trying to sell at instead of today's price, when now the data's even more expensive and buyers are going to want to see that reflected in the sales price. By seeing it slightly reduced, then you need to take into consideration refinancing.

So refinancing is very important because in the next 18 months there is 400. Billion dollars worth of commercial real estate loans that are coming due. That means if you're currently in a deal that's looking for an exit strategy that involves some type of refinance, the refinance is likely going to cost more money, which means that there really probably is a possibility that additional equity will have to be brought.

Into the refinance and that could potentially mean capital calls on investors. The other reason you wanna take it into consideration is you wanna look at your portfolio and make sure that you don't have all of the investments that you're in trying to do a refinancing strategy at the same time. 'cause that will also put more pressure on you.

So it's really important to pay attention to those refinancing windows that are part of many people's and bus and investments. Business plan to make sure that you don't have all of that happening at the exact same time across your entire portfolio. Another thing that's really important to take into consideration when it comes to refinancing is that if the treasury increases by just 1%, typically this is reflected by an increase of 5% annually on the cost of debt.

So that drags down overall returns as well. Now the, if you look at the bigger picture, this isn't a shock. This has actually happened back in 2011 when the s and p downgraded the US credit rating. And then again, it happened in 2023 when Fitch did the same thing. But it is a wake up call. So as investors, as real estate investors, what you can ideally do right now in this type of environment is be very smart.

And first of all, you wanna make sure that you are being conservative in what you. See in underwriting assumptions and make sure that credit spreads are realistic. You don't wanna see basically the price of risk underpriced. And what I would recommend is that if the treasury right now is at about 4.75%.

You wanna see deals that are showing that and reflecting on top of that, the lender spread, what they're gonna put on top of that when they are securing a loan with somebody. And so essentially, let's say, 4.75% for the treasury yield, and then let's say that the lender wants to charge another two and a half percent on top of that.

Okay, now you're looking at about a seven and a quarter percent interest rate on a loan. So if you're looking at a deal and they're underwriting, believing that rates are gonna go down. What if they don't? You wanna see deals that are underwriting with the expectation that the cost of debt is going to be high.

If they're wrong and it's lower, fabulous, that's great, but. If they are actually exactly that high or even higher, then the deal's not gonna offer the same type of returns or may begin to actually fall into negative returns. So you wanna make sure that underwriting assumptions for debt looks very realistic, not just today, but three years from now and five years from now.

The other thing that you wanna make sure that you're looking for is deals that are even better, which are locked in at. Fixed rates for longer terms. Another thing that you can also do is focus on the markets themself. Make sure that the markets have real demand and tight supply, and not a lot of new supply coming into the markets.

You also wanna make sure that the debt service coverage ratio is healthy, at least at 1.5 x. So look at the deals that you're currently in. See where it stands. Look at any new deals that you're considering getting into and see if that is also being reflected. You don't wanna get into a position where the deal and the debt is not able to be covered easily by the income that the property is generating.

And then last but not least, I recommend actually making sure that you hold onto some dry powder, because as this begins to ripple through the market over the next three to six months, typically you will also see a. Spike in transaction activity as some unfortunate deals are pushed into distress and will begin to hit the markets.

So I hope you guys found this helpful. I know it can be complicated, getting into everything from private real estate to the US treasuries to the us credit rating. But all of it is really important. It has a big impact even on private investments as it works its way through the entire market.

So I hope you guys found this helpful, and I'll see you on the next episode. Ready to Scale is brought to you by Blue Lake Capital, where we hunt down the best multi-family investment opportunities that we can find and invite investors to join in with us. We target class B value, add multi-family properties across the Sunbelt.

Our CEO Ellie Perlman, invest a substantial amount of capital into every deal. This means our interests are aligned with yours. If you're an accredited investor looking to expand your portfolio and diversify sponsors, be sure to visit us@bluelakecapital.com. Blue Lake Capital, be bold, be extraordinary, and keep moving forward.