We were at a speech recently given by Charles Evans, the President and CEO of the Federal Reserve Bank of Chicago. When the Fed speaks, people listen, and we are no different. What he had to say has an impact on every RV park owner and buyer, so it’s good to know what the future holds.
Yes, rates are going to go up eventually
The “Great Recession” is in its 8th straight year, and the Fed has kept interest rates at near 0% throughout the whole ordeal. Most Americans have just come to expect that 0% is the new norm, since the U.S. economy never seems to get any traction on improvement. However, the Fed has been trying for a while now to brace everyone that rates do eventually go up. Interest rates have been cyclical since the founding of the nation, back when rates were 6% in 1776. You cannot assume that rates will not go up, any more than you can assume they will not go down when they are higher than 0%. So the bottom line is that we all need to get ready for higher rates.
The target is around 2 points
The Fed cannot give a highly detailed analysis, because they are never going to commit to a certain rate on a certain date since economic performance can change the enactment date and size of the increase, but the target that they showed on their slide show is up 1 point in 2016 and up a second point by the end of 2018. That’s not a huge rise, but nevertheless very significant and something that you need to be aware of. Rising rates mean that the interest on your loan will cost more, and cap rates will typically rise in turn.
Much more, and the U.S. will collapse
But it’s important to note that the chart showed that the highest they could forecast rates rising until the end of this decade was only one extra point – and that was dubious. For those who endured Reagan’s interest rates that hit 15% (and saved the nation in the process), you have to wonder why the Fed is only seeing 3 points up as the final frontier – and that’s starting from 0%. There’s a simple reason. When Reagan raised the interest rates to the mid-teens, it was at a time in which the U.S. government had $900 billion in debt. Today is has $18 trillion – 20 times more. So, with the U.S. government the largest debtor in the world, it cannot possible afford rates much higher than 3 points. In fact, if rates went up even 6 points, we would probably end up a hunter/gatherer society again, like in the movie Mad Max.
Focus on the spread
It’s a very simple formula to hit a 20% cash-on-cash return. All you need to do is buy at a 3 point “spread” between the cap rate and the interest rate on the RV park you buy. So when interest rates are in jeopardy of increasing, you need to be very mindful of your “spread”. For most RV park transactions, the spread is plenty healthy enough to withstand an increase in interest rates. Many RV parks are being bought with 5 point spreads; the cap rate is 10% and the interest rate on the loan is 5%. But you would never want to be caught buying RV parks at a 5% cap rate when interest rates are at 4% and destined to rise – that would be financial suicide.
Don’t drink be fooled into accepting low cap rates
Despite the potential increase in interest rates, many brokers and sellers will try to convince you that low cap rates are perfectly fine. Nothing could be farther from the truth. If you buy a park at a cap rate that is ultimately lower than the prevailing interest rate on the loan, you will be in huge trouble. Not only will you be having to “feed” the park each month, but you now own an RV park that is worth less than what you paid for it. Never buy into such arguments as “they’re never going to raise rates” because they definitely are. And soon. Not a lot. But enough to make that argument a complete lie.
Conclusion
Charles Evans of the Federal Reserve has gone on record as saying that rates are going to go up. He’s suggested by how much. Don’t argue the fact; work with it. It’s easy to maintain a great spread with an RV park, so you’ll be fine. But be aware that now is not the time to buy RV parks with tiny spreads. Better safe than sorry.
