The Current MF Market and Potential Repercussions of a Correction

[Jason V.]

Good Morning BP!

Summary: How do smart investors hedge against market corrections in the commercial multi-family sector? And should required reserves for a property be factored in to calculations for CoC and/or IRR?

The whole thing:

As I get more and more comfortable with the SFR and Small MF properties I currently own, and the ones I'm working to acquire right now, I keep looking forward to what comes next. The logical (or maybe traditional) progression is to move onto larger and larger properties, which I've had my eyes open for. But as the market looks more and more like it's approaching the top, at the top, or starting to tip over (lots of indicators in a couple of leading markets, Phoenix, Houston, etc., but that's not the focus of this post) I find myself thinking about what it would look like to buy a commercial MF property right now, and especially what the next 5-7 years of living with it would look like. Primarily, I have concerns about the financing side of things, especially with how that relates to the property's valuation.

Say a deal lands in my lap tomorrow, and I have everything in place to pull the trigger on it. I pay $1 Million for the property, 75% bank financed, down payment and reserves out of pocket. Let's assume I'm smart and lucky enough to buy something with an opportunity to add value without a lot of out of pocket cash (reduce expenses and manage it better, for the sake of argument) and 12 months from now it's normalized and worth $1.3 Million. I re-fi, get all my cash back, and have a note for $1 Million (I rounded up for easy math) on a 5 year term and 25 year amortization at 5%.  Again, for the sake of argument (and because I've seen a lot of stuff selling at this price point) let's say I bought at a 6 Cap (which would be a steal in San Francisco or Denver!) 

Fast forward 5 years, and let's assume what a lot of folks are thinking might happen proves to be correct: there's been some inflation, lending rates are up, and despite my best efforts, I bought in a market that was hit by some sort of unexpected economic drop, so vacancy rates are up, rents are flat (or down) and Cap rates have gone up significantly in the area. 

Because I'm not a smart guy, or a savvy investor, I don't know how much cap rate traditionally swings in a particular market, but even if it only goes from 6% to 9% (which my research says was the industry average in the early 2000s) my property value drops ~33%, and now I'm looking at being upside down in a loan I need to refinance (because I'm at the end of my term.) So I'll have to put cash in to meet equity threshold, and if vacancy is up and rents are flat or down, I probably don't have a lot of cash - especially if this isn't my only property (because if I'm taking my cash from the first refi to the next property, it's probably all tied up.) And with rising rates, monthly debt service will also be increasing. 

I saw this happen on the residential scene during the 2008 correction (typically with people using interest-only mortgages or ARMs who were expecting the crazy appreciation to continue) but I guess I'm just starting to realize that this is the potential risk with commercial MF all the time.  

And yet I never hear anyone talk about this risk - why is that? All I ever hear is keep buying, and keep cashing out. I know there are a lot of folks a lot smarter than me investing in commercial MF properties, and who have done so successfully for a long time. What is typically done to hedge against market corrections with a single property? As the likelihood of this situation increases, are investors just raising the amount of their reserves? Reserves help to weather the storm, but at that point, aren't you just throwing good money after bad? 

I know we typically talk about Cash on Cash returns, total returns, IRR, etc. when it comes to real estate, but if you have a significant amount of money tied up as reserves for a property, that's money you don't have available to invest - yet I never see required reserve amounts factored in to the CoC or IRR calculations. Shouldn't it be, since it's money tied up by the investment, albeit indirectly?

Congratulations if you made it all the way to the end of this post, and thank you!

[Brian Burke]

@Jason V. your cautious mind will serve you well.  You are right to be concerned but you can prepare for the worst ahead of time to mitigate some of your downside risk.

It starts with the acquisition underwriting.  It's too risky to underwrite to perfection, yet people do it all the time (oftentimes to their own demise).  In my opinion, at some point during the investment cycle of any property purchased now, there will be an adverse market cycle.  You want to make sure that your underwriting is conservative enough such that you can ride through the adverse cycle and sell at the next market cycle peak.

This means factoring in a higher than market vacancy rate.  And a conservative collection loss.  And for move-in concessions even if those aren't currently being offered.  Because in a downturn all of these things will be part of your daily vocabulary.

Your capital structure should reflect the reality of your business plan.  In other words, you don't want a five year loan if the plan is to hold for 20 years.  Nor do you want a 10 year loan with yield maintenance if your plan is to sell in three years.  But you also don't want a 3-year loan because your maturity could be ill-timed if your three year exit plan is thwarted by an adverse cycle.  And in all cases, you don't want to over-leverage.  This is the biggest risk factor and yet people do it all the time. 

How do you avoid being over-leveraged? Value-add is a must. Maybe you buy with 75% leverage but after improving the property and raising the income, the value goes up and by year 2 or 3 you are at 55% to 65% LTV. You can refinance and take cash out using the higher value, which will increase your risk because of the higher leverage, but decrease your risk if you have little to no capital in the deal. The risk is transferred to the lender to an extent, as long as the debt is non-recourse. And of course you're using non-recourse leverage, right? Well, easier said than done in smaller deals but for larger deals it's much more common. If the debt has to be recourse, you might want to re-think the cash-out refinance strategy.

As to your question about factoring reserves into the CoC and IRR, the answer is no. You can still invest those funds--either in interest bearing accounts, stocks, mutual funds...anything liquid, and earn a return. And one set of reserves can be used for multiple loans. In other words, if your lender requires 6 months PITI, you could have a lot of loans covered by the same amount, you don't have to have 6 months PITI for every loan (just the biggest one and the rest will be covered).

As to cap rate, yes you should expect them to rise.  You should be underwriting your exit to a higher cap rate than is market today.  But realize that interest rates and cap rates don't trend in parallel.  They are related, but more like third cousins. 

Speaking of market cap rate, you can't take the seller's income and divide it by the purchase price to arrive at a market cap rate. That is an over-simplification. Just calculating the cap rate from the asking price or purchase price requires that you adjust the property taxes for what they will be after you buy (called a tax-adjusted cap rate, which is more true than an unadjusted rate). And that's still not a market cap rate. That can only be ascertained by calculating the tax-adjusted cap rate of other properties that have sold in the submarket that are similarly situated and of the same class. The market cap forms the basis for your exit planning, it really has no other bearing on the price you should pay. Your strike price comes from underwriting to an IRR as you work backwards from your forecasted exit price and map out the annual income given your forecasts for rent growth and economic vacancy factors and layering on expense growth inflation and cost of debt.

And since the value is dictated by the income, investing in areas where rents are likely to rise the most gives the best hedge.  Believe it or not, rents can actually come down (gasp!) and that will cause a decline in property value for two reasons--the declining income and a decompressing cap rate (which will happen because the real estate is less desirable without the rent growth). 

This is why I buy value-add class B & C properties in growth markets.  You need both the value add and the strong job growth driving rents to successfully execute a multifamily strategy given where we are in the cycle today.