The Ripple Effects of Higher Interest Rates on HOA Management Companies

The Federal Reserve just raised interest rates for the first time in three years. The quarter-point increase brought the federal-funds target range to 3.75% to 4.00%, and 16 of 18 Fed officials projected at least one additional increase this year.

HOA management company owners can feel the effects of higher interest rates in their day-to-day operations. A slower housing market, for example, can affect transaction-related revenue streams such as resale and transfer fees. But there is another, less visible way that interest rates can affect an HOA management company: its valuation.

Rising interest rates can influence acquisition valuations through two separate mechanisms. The first is immediate: higher rates make the economics of an individual acquisition more difficult. The second takes much longer to develop: if rates remain elevated, they can eventually reduce the amount of capital available to fund acquisitions.

The Math Gets Harder

Investment groups generally acquire companies using a combination of investor equity and debt. Much of the debt provided by private credit lenders is floating-rate, meaning the interest rate moves with an underlying benchmark rate rather than remaining fixed for the life of the loan. As interest rates rise, the cost of financing an acquisition can therefore rise with them.

Consider a simplified example where a buyer acquires an HOA management company for $10 million, financed with $5 million of equity and $5 million of debt. If the debt carries a 6% interest rate, annual interest expense is $300,000. If that rate increases to 9%, annual interest expense increases to $450,000. Nothing about the HOA management company has changed; its customers, employees, revenue and EBITDA are exactly the same. But the buyer now has $150,000 less cash flow each year because of the higher cost of its debt. Importantly, investment groups do not simply lower the returns they have underwritten for their investors because interest rates have increased. If the buyer still needs to achieve the same target return, something else in the valuation model has to change. The company could grow faster, the buyer could assume greater margin improvement, use less debt, or assume a higher valuation when it eventually sells the company. Alternatively, it could pay less for the company today.

This is the most direct connection between interest rates and acquisition valuations. The required return stays the same while one of the costs of achieving it has increased. Higher rates do not mechanically cause an HOA management company's multiple to decline, but they make it harder for a buyer to generate the same return while paying the same purchase price.

Higher Rates Can Eventually Slow Fundraising

The second impact takes longer to develop and relates to the overall supply of capital available for acquisitions. Private equity firms raise money from investors and deploy that capital over a period of years. Higher-rate environments can make fundraising more difficult because investors have more attractive alternatives when relatively low-risk investments are generating higher returns. Private equity fundraising has already slowed in recent years, while S&P Global has also reported that available private equity investment capital has declined from its recent peak.

If less capital is raised, there is ultimately less new capital available for acquisitions. As we discussed in our earlier article, “Can HOA Management Multiples Actually Decline?”, capital raised by investment groups today becomes acquisition capital in future years. More capital competing for a finite number of attractive HOA management companies can support valuations. Less capital can have the opposite effect.

Importantly, this happens with a lag. Existing funds and HOA management platforms may already have substantial capital committed for acquisitions, so slower fundraising today does not mean fewer buyers tomorrow. But M&A is a market, and valuations are ultimately influenced by the supply of businesses for sale and the amount of capital competing to acquire them. Assuming today's valuation environment will remain constant indefinitely is not prudent. If higher rates and slower fundraising persist over a sustained period, less capital competing for HOA management companies can eventually put downward pressure on valuations.