The real estate market is hot right now, but if there’s one thing the last few years have taught us, it’s that what goes up, eventually comes down. I don’t know when or how the next recession will unfold, how severe it will be or what will have the most impact — and neither are you. That is largely irrelevant. Whether a correction occurs in three months or three years, most investors agree that we are currently at the top of the cycle.
That said, it would be a mistake to sit on your hands hoping for a horrific crash that allows you to duck in and pick up properties for pennies on the dollar while the rest of us make money. . There are ways you can continue to grow your portfolio now while protecting yourself and your investors from much of the downside risk that the next cycle brings.
Before I get into the details, let me quickly give you the highlights of where we are in the cycle and why a correction is looming in the shadows like a TMZ reporter in Justin Bieber’s trash can. Then I’ll hit you with a little advice.
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the Federal Reserve
This man writes about the Federal Reserve?! yawn. I get it. But understanding what the Fed has done is probably the most important factor to understand if you want to know what’s happening in real estate.
It would take a whole book to really get into the weeds of the Fed, but here’s the short version.
Interest rates are like the one ring that controls them all when it comes to investing. When the Fed keeps interest rates artificially low, investors begin to make bad decisions based on misinformation. They’re starting to take too much of a risk. Why? Because returns on traditionally “safe” assets are too low. The market is disrupted. So they are stretching themselves, and everyone is shifting the risk curve, buying riskier assets and chasing returns. Speculate.
This is the cause of the housing market boom. The other things everyone blames — greedy banks, no-doc liar loans, credit rating agencies, hedge funds, etc. — were symptoms of the bigger disease, which is free money sloshing around the capital markets, desperate for a home.
Like me in college when it came to tequila, the Fed’s wise overlords have had a hard time drawing lessons from the past. For the better part of a decade, we’ve had essentially 0% interest rates and QE out of the wazoo. Treasuries don’t get you anywhere, so everyone is forced into speculation looking for yield and chasing higher yields everywhere they can find it. This also includes real estate.
Investors today make no distinction in their choices. They see little need to get a lot of premium for investments in riskier assets. A 1980 value-added deal with two-meter ceilings trades very close to the maximum rate of a 1995 value-added deal with three-meter ceilings. If you’re an active investor, I don’t need to tell you how crazy people get when they bid on deals. It is ridiculous.
The good news is that, even in a pretty severe downturn, solid multi-family homes tend to hold up well. It’s usually not a catastrophic drop in income that kills you – it’s overpaid and poor structuring. If your investment is properly underwritten and structured, you can come out relatively unscathed should the market turn.
So, what should you do? I don’t know, I’m just a guy on the internet. But here’s what I would do.
If you’re new to investing, keep your day job. Keep working, enjoy your steady income and build up valuable experience so you can get aggressive when there’s blood in the streets. But maybe don’t jump in with both feet and risk everything.
Work together and do some deals that are structured as described below. If you are trying to buy a big deal from a reputable broker, shall pay too much. Serious. The only way they will ever grant a new guy a deal in this market is if you pay a lot more than the next guy.
Now, if you own a good amount of real estate, consider selling some. I say don’t panic and dump everything. Keep the high cash-flow stable deals with long-term debt. Sell some of the more fringe things or deals that have debt maturing in a year or two. Take advantage of the low cap rates and position yourself to buy at better values. Be patient and keep some dry powder available. You can be a buyer and seller at the same time.
If you buy, understand that there are differences between underwriting and structuring a real estate deal. Doing both correctly becomes important again.
Remember what I said earlier about investors being arbitrary in selecting assets? Most people at this stage of the game are just making deals to achieve a certain IRR or cash-on-cash return. Those annoying details you read about in your real estate books, such as location, visibility, proximity to work, entertainment, schools, hospitals, job creation and new offerings, didn’t matter until now. It’s hard to say no to a deal when the model is spitting out the right IRR. The rising tide has lifted all boats, rental growth has been great and no one can tell what is a good or a bad deal.
Good insurance is going to be important again. A 3% rental growth and a 2% cost growth on a deal is not a conservative underwriting assumption. I have access to multiple national research platforms and it is very rare to find a submarket where 3% rental growth is projected over the long term.
Leverage and deal structuring
Structuring a deal involves the mix between equity and debt and under what terms, as well as determining the appropriate level of reserves. This is where amateurs really run the risk of having their faces ripped off. For the purposes of this article, we will focus on the debt side of structuring.
The worst advice I’ve ever heard is that it’s okay to eat yellow snow. The second worst advice is that you should always maximize the amount of leverage you use to improve returns and buy more deals with the same amount of equity.
It is true that leverage can increase your returns. It also magnifies your losses. Misunderstanding the use of leverage and the associated risks is the fastest way to go bankrupt in real estate.
Let me give you an example to illustrate the point. I’ve put together a simple model so we can change some basic assumptions. Let’s assume we buy 120 units for just under $83,500 per unit, with a cap rate of 5.75% on a five-year hold.
Our “baseline scenario” is 3% rental growth, 2% cost growth and an exit cap 50 basis points (BPS) above entry. This is what most would call conservative, as rental growth over the past five years has been massive and is likely to continue for the foreseeable future.
Our ‘bad’ scenario will have 2% rental growth, 2% cost growth and a spread of 75 BPS on the exit cap.
Finally, our “worst” case is 0% rental growth, but let’s assume you can also hold the line at 1% cost growth. We are assuming here that our exit cap goes up 100 BPS from where we bought it.
When we originally used these numbers, we weren’t thinking about rent reductions or vacancy increases. COVID-19 felt like a screenplay from a post-apocalyptic movie — not our immediate future. But in many cities rents to have has grown despite the pandemic – and will likely continue to do so as the world stabilizes.
We will run scenarios based on 55% leverage at an interest rate of 4.75% and 80% leverage at an interest rate of 5.25%. Here are the outputs of the model.
|Shares on sale||$6,151,376||$4,742,699||$3,056,893|
|Equity % of value||54.96%||48.47%||37.75%|
|Shares on sale||$3,807,751||$1,928,786||$713,268|
|Equity % of value||34.02%||19.71%||8.81%|
What’s the main takeaway here? At the lowest leverage point, even in the worst case scenario, you paid out on average 4.87% in cash. You’re left with an equity position that allows you to refinance debt at a loan-to-value (LTV) of 62% and continue cash flow while waiting for the market to recover. Your base IRR of just under 12% looks terrible next to the 17% IRR with higher leverage, but your downside is much more limited. Your risk-adjusted returns here, given the potential downside, look just like me: quite attractive if you’ve had a few beers and look at it from the right angle. You could do worse.
In the higher leverage scenario, you could quickly find yourself in a situation where you have no options. Even in the ‘bad’ scenario, your equity position is now below 20% and threatens debt maturity. The bank is chasing you like a jealous ex-girlfriend. They want their money back – and their Alanis Morrisette CD. You just became a motivated salesperson. All your options are terrible. Try to put more capital into the deal so you can refinance? Selling in a weak market and giving your investors less than they put in? Your face just got ripped off.
Understand the risk – and mitigate it
In short, the way to invest successfully at this stage of the cycle is to understand downside risk and take steps to mitigate it. That means well capitalized and moderately leveraged.
I understand that lower leverage is not sexy. You probably have investors laughing you out of the room and going along with the guy offering the 17% IRR. But if you can sell the message correctly and get people to understand the concept of risk-adjusted returns, just imagine how many happy investors you’ll have in the future.
I fully expect that many of the deals made in recent years will not deliver the expected returns. As debts fall due, the undercapitalized and overextended sponsors and IRR hunters who stretched their underwriting to meet seller price expectations will find themselves in a difficult position. As Warren Buffet said, “You never know who’s swimming naked until the tide goes out.” In the next three to five years we will find out.
Until then, keep sharpening. And realize that lower, safer expected returns have their place in the real estate investment landscape.