The Real Risk you Might be Missing

[Account Closed]

A common question I see on the forums relates to where we are in the real estate cycle and whether or not now is a good time to invest. You should absolutely keep looking to buy, but do it eyes wide open with a full understanding of ALL the risks. To me, the risk is not in an economic downturn per se; the risk is in the debt. Let me give you an example. Say you buy a pretty good multifamily deal at a 6.50% cap rate for $3.7 million. There are 50 units renting for $800/mo each and there is a 50% expense ratio, so your NOI is $240k. You've read all of the blogs about how smart it is to use as much leverage as possible so you can buy more deals at high returnsand you find an aggressive bank that gives you 80% LTV at 4.5% on a 30 year am schedule and the maturity is in 5 years. We can all agree that this is a common deal and a good real-world example.

Now let's say the economy/your market is just ho-hum. No major crash, but nothing exciting. We enter a stage of stagnant or slow growing rents. At the same time, the Fed or the bond vigilantes finally realize that the historically (insanely) low interest rates we're enjoying now must come to and end. So interest rates rise about 3.5% on average. While this may seem high, a rate around 8% is pretty run-of-the-mill by historic standards. Attached, I've copied in a quick and dirty, over-simplified analysis of what the deal may look like in 5 years. Assuming you can grind out 1% rental increases despite a weak economy and a down cycle, and hold the line on expenses, you've grown your NOI by $24k. You've also amortized your debt down from $2.9MM to $2.7MM. Cool, right? You should be fine...

But a new buyer, if we assume wants the same return/DSCR as you had, will only be able to pay around $3 million for the deal at 8% interest.

So now your loan is maturing, and the bank is hounding you like a jealous ex-girlfriend. They want their money back (and their sweater, and their Alanis Morissette CD) . You can sell and pay the bank back, taking a $400k loss (54%). Ouch!

Or, if you happen to have $270k lying around in a tight market where values are down, you can bring that to the table and get your LTV back to 80% to refinance, which would bring down your returns but keep you alive. Ouch again.

If you brought investors into the deal, get ready for some really uncomfortable conversations.

Imagine how much worse it would be if you had an IO loan and a second mortgage up to a higher LTV. You'd be wiped out entirely.

The moral of the story here is this: How you structure your deal matters. Leverage is great when used wisely, but it has the same magnifying effect on losses too. If you have high leverage and interest rates go up, it doesn't take some crazy, unimaginable crash for you to be in a really tough situation when your loan matures. 

Here are a few tips to think about when you're buying at this stage in the cycle:

- Moderate LTV - In the example attached, a 60% loan would be a lot easier to refi than the 80% and wouldn't require you to bring in new capital. You could refi and go on with your life, slightly lower cash flow but you're fine.

- Look for value-add deals that don't require market rent growth to see appreciation.

- Try to extend your loan maturity out as far as possible 10 year options are available, especially at lower LTVs.

- Amortization is your friend. We all love cash flow, but if you can avoid IO, do it. If you can get on a 25 or 20 year am schedule consider it.

There will be a time and a place to leverage to the hilt and hit some home runs. I;ll be the first in line to do it, but now is not the time.  Hit singles and doubles and avoid getting wiped out. 

Thanks for Reading. 

[Matt Popilek]

@Account Closed thanks for your food for thought. One key component I am always educating my investors on is the Freddie Mac Small Balance Loan. With rates rising (They Are!) any purchase at or above $1M on a stabilized asset should in most instances go through the Freddie Mac program.  10 year Fixed 30 Year AM is a great way to alleviate the concerns of a slow market. 

One very important note about that product is the ability to Assume the Debt. Lets say the market rates rise, and you have a 5 year exit strategy which is very typical. With another 5 years of a fixed rate that is assumable your property value will be higher than the competition based on the DSCR because the interest is fixed at 4.75% versus a property the Buyer would need to purchase at the market rate of 8%. Based on the example above.

There are more hoops, and it takes a little longer to close on the deal but 10 year fixed, Non-Recourse, Assumable are 3 factors that absolutely make this product a win win for the investor.

I also wanted to note that Bank of the West is providing a 10 Year fixed/ 30 Year Am on MFU for stabilized property. So if you don't want the hoops of Freddie you might get connected with a good connection of BoW.