Increased Rates, Higher valuation?
Why some businesses, with high fixed debt, can increase in value as interest rates rise rather than decrease
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The Business Structure that Increases Its Valuation as Interest Rates Rise.
Investors accept as a near truism that interest rates act as gravity on business valuation. This is the case because investors are always weighing one opportunity against another. In comparing options, they must consider both their expected return and the safety of their principle. If you were to graph out an investor’s risk assessment with risk on the x-axis and expected return on the y-axis, you would expect to see a line that slopes up and to the right.
On the left side of the graph you’d find what investors refer to as the risk-free rate. Investors typically benchmark the risk-free rate to the US federal funds rate. They consider the Fed Funds rate to be risk free because both your principle and investment return are backed by a sovereign nation with the authority to both tax and print money to pay its debts. In other words, you’re not relying on a business outcome to ensure your return, but rather the continued viability of a nation’s finances.
On the far right side of the graph, an investor would place their most speculative investment opportunity. This investment might promise a very high potential return, but would couple that return potential with the possible loss of principle.
The aggregate risk reward assessment of all investors results in the yield curve seen in the real world. Beginning on the left side of the graph with the Fed Funds rate, and moving right you encounter first the highest grade corporate debt, then debt of more dubious quality, and eventually you work your way into speculative stock investments on the far right. Each move to the right offers less assurance of principle and a higher potential return to the investor, so that US treasuries are very secure and offer the least return, while speculative stocks on the far right offer no guarantee of principle but potentially unlimited upside.
With that brief review of the yield curve out of the way, why do rising interest rates act like gravity on stock prices? Well the answer is in the yield curve. Lets consider the world we’re in with a 1.68% Fed Funds rate. Despite all the talk of rising interest rates this number remains a historically low rate and in a 1.68% world an investor might be enticed to purchase a stock that yields 5% in order to increase their portfolio’s returns. Consider this, however, would that same investor purchase a stock that yields 5% if the fed funds rate were at 10%? The answer is, of course, no. Assuming no other factors are driving the investors decision, there is no reason an investor would sacrifice the known return provided by a US treasury bill in order to chase a lower prospective return and the reduced security offered by the stock.
So based on what we’ve covered so far, when the fed funds rate goes up the price an investor is willing to pay for a stock goes down. This is the case because the only way to increase your return on a stock investment is to pay less for the stock. Your investment has to provide an incrementally greater return with each increase in the federal funds rate. So all other things being equal, rising interest rates should drive stock prices down.
So what aspect of a business would cause its value to go up along with interest rates, rather than down? In short, the answer is debt, or fixed debt, to be specific. But why should that be the case? Well, to answer that question, let’s think in terms of a home loan.
When evaluating a new home purchase many consumers think in terms of their monthly mortgage payment. For the sake of example, let’s say that Joe can afford a $2,000 per month house payment. Once Joe has the $2,000 a month payment in his head he isn’t really concerned about the total price of the house because his monthly payment is mainly a combination of the home price, mortgage term, and mortgage rate.
Now under normal circumstances, the three variables I just mentioned don’t change dramatically during the course of a home purchase. This means that Joe knows he can afford a 500k house on a 30 year mortgage at 2.6%. But it also means that Joe can only afford a 400k house at a 4.6% rate if he wants to maintain that same $2k per month payment on a 30 year loan. In other words the higher the interest rate, the less assets Joe can afford to finance.
So how does this apply to a business model? Well, in business the acquirer purchases both the assets and the debt of the acquired company. This is unlike a private home transaction. When Joe purchases that new home he gets his own mortgage for the property. He doesn’t, usually, take over the existing loan, but in business the purchasing company does take over the target companies debt. This assumption of the target companies debt is the crux of the issue.
Purchasing debt that was created in a lower interest rate environment in effect allows the company to travel back in time and purchase more assets than they’d be able to buy today for the same annual financing cost. Let’s make the example more concrete with a specific example.
Back in episode 4 we covered Blue Rock Residential REIT’s acquisition and spin-off via a buyout from Black Rock. As of their last 10k, Blue Rock had 1.4 billion in outstanding mortgage debt. For simplicity sake, lets assume that all of that debt was carried at the 2021 fed funds rate, which is the month that Black Rock announced their intent to acquire Blue Rock.
The fed funds rate in Dec of 2021 was .06% and it would cost 46.8mm per year to finance 1.4 billion in debt over 30 years at that time. Rates have since risen to 1.68% and that same 1.4 billion would now cost 58.8 mm per year to finance. Increase the rate further to a 10% fed funds rate and it would cost 146mm to finance 1.4 billion over the course of 12 months.
Now to skip back to our personal mortgage example what if the buyer, in this case Mr Black Rock wanted simply to keep their monthly mortgage payment the same but still finance as much mortgage debt as possible. Well, at the low rate of .06% they could finance the full 1.4 billion for “just” 46.8 mm per year. Once rates jump to today’s 1.68 percent the amount they could finance on that same 46.8 mm per year drops from 1.4 to 1.1 billion. Raise the rates up to 10% and now only 440mm in mortgage debt could be financed.
So to bring the example full circle imagine that you are shopping for that dream home and you can either purchase a home with a new mortgage or assume another persons mortgage at a lower interest rate and that the payments will remain the same for both homes. If, through assuming an existing mortgage, you can purchase twice the home wouldn’t that be worth something to you? That’s exactly the benefit that a company gets when acquiring another company and their existing low interest rate debt. So in a sense the value of the company being acquired goes up when interest rates rise because it allows the buyout company to take advantage of interest rates and cheaper financing that are no longer available to them in the market. For this reason Black Rocks purchase of Blue Rock Residential REIT is likely a better deal for them with each increase in the feds interest rates.
Of course this example oversimplifies a complex subject. It doesn’t account for the fact that a REIT may be continually refinancing and taking on new debt. Continually assuming new debt could negate the effect discussed in this episode, but understanding the value of debt and how it behaves in a rising interest rate environment is important for the average investor none-the-less.
With that, I hope you enjoyed episode 35 of Special Situation Investing.
As a brief side note before I go, I’d like to make a quick announcement. We plan to release a few episodes of the show relating to financial independence. I will label the episodes with Financial Independence as a prefix to the show title so that you can clearly see which are the normal investing episodes and which deal only with financial independence. If you’re interested in the subject, I encourage you to check those episodes out, and if you’d prefer to stick with the regular content feel free to skip the financial independence specific shows. The new episodes will follow the same brief format, so they shouldn’t be a huge time commitment if you do listen.
With that I’ll wrap up the episode and look forward to seeing you again soon with another write up.