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Focus on the Fundamentals: Why Cloverleaf Is Not Worried About Interest Rates

Focus on the Fundamentals: Why Cloverleaf Is Not Worried About Interest Rates

My eleven-year-old daughter, Georgia, wisely told me that she tries to focus her attention on things she can control more than things she cannot – that when she notices herself worrying about “what ifs,” she tries to do something more productive with her mind and time. In addition to feeling proud of Georgia’s perceptiveness (and grateful that she is already more grounded than her father), her comment reminded me why Cloverleaf has thrived for over four decades, and how we should proceed from here.

Owning commercial real estate is fraught with theoretical issues to worry about. While Cloverleaf contemplates them, we try to emphasize matters within our control, or for which we can plan. Implicit in managing risks is wagering guesses about a range of future trends and outcomes and creating an accompanying strategy. It is more challenging than ever to predict the timing and trajectory of external influences on real estate. There are more factors at play than ever before, and much like today’s rapid news cycles, the facts on the ground change more quickly than they once did.

Consider, for example, interest rates.

Changes in interest rates impact commercial real estate markets substantially, arguably more than any other single influence. Assessing when and how rates will shift over time is complicated guesswork. We of course do our best to project and respond to interest rate fluctuations; but even that undertaking is premised on being able to not only predict how rates will change, but how others will react when they do. For example, if interest rates increase, will more owners be motivated to sell because higher debt service weakens cash flow, or will they wait for a lower rate environment in hopes it will yield higher values? How might that behavior change based on the relative strength of investment alternatives, taxes, global economic indicators, proposed legislative changes, inflation…

So, while we do our best to stay informed and plan, Cloverleaf is best served by following Georgia’s advice: Focus the bulk of our attention and strategy on what we can control.

Other than being judicious with how we use debt, we have no control over interest rates’ impact on our portfolio. Therefore, we center our acquisition strategy on factors like location, rents, how we can improve and sustain leasing, and how occupancy changes will alter cash flow, regardless of whether rates go up or down. And importantly, we minimize the effect of rate changes by keeping our debt relatively low, a practice that has been core to Cloverleaf’s model since the company’s inception. Therefore, rate changes marginally affect our returns and do not limit our ability to continue buying across a range of markets. And importantly, once we own a property, our decision-making is rarely constrained by debt service considerations. For example, as rates increased substantially in mid-2022, our property in Granger, IN required additional funds for leasing opportunities and capital improvements. Because our debt was low to begin with, adding to it was uncomplicated. Cash flow stayed strong and, as discussed elsewhere in this newsletter, the enhancements we made allowed us to sell the asset profitably.

Also, like many other armchair prognosticators, we found it tricky to anticipate interest rate trends over the last 10-15 years. In response to a variety of scary economic indicators, the Fed began dramatically lowering rates in late 2007-early 2008, ultimately to 0.00% by the end of 2008. As several years of unprecedently low interest rates followed, Cloverleaf’s response throughout was twofold: We resisted the urge to borrow more, keeping our debt around 50% loan-to-value, and our forward-looking projections assumed rates would increase 2.00% over five years. As noted above, our low debt strategy served us well; but our guesses about rate increases were continuously wrong. The Fed kept rates historically low well into the pandemic, even as capital flooded into the markets and once-in-a-generation inflation took hold. Over the last few years, capitalization rates for sought-after assets dropped very low (i.e., prices surged) as demand was robust. Finally, about a year ago, the Fed began meaningfully increasing rates, including over 4.00% growth in that time. Commercial real estate transactional activity has dropped precipitously since then.

And that’s where we are today. What happens next with interest rates (and how others will react) may be impactful, but we cannot control it. As inflation and interest rate changes continue to bounce off one another, buyers and sellers will likely find a way to adjust to a new norm. Then just as they do, the situation will change again. Meanwhile, Cloverleaf will plan as best we can for different eventualities, but will not fret about matters like interest rates. Instead, we will focus on real estate fundamentals as we seek new acquisitions, and work on bettering our properties through concentrated leasing and management.