What do you think? Yield ahead?

Question

Dear BP members

So many times I have received valuable insights and contacts through this forum... it’s pay back time!

Take a few minutes to read this: https://www.ccim.com/cire-magazine/issues/Jan-Feb-19/

Basically, to borrow the words of wisdom of the CEO of one of the major lenders: « we are in the 7-8 innings of the economical cycle but only in the 4-5 innings of the cap rates » as of February 2019.

So if you look at the commercial real estate price index, it has been plateauing around 130 for the last 2 years (big demand for CRE bcz people need to put their money to work somewhere). However, the fed increased its rate, and interest rates went up. So cap rates should also be going up (these 3 move in tandem) but they haven't and the spread between the interest rate and the cap rates is closing, which means that the prices are too high, you will get negative leverage on debt soon unless prices go down.

So that’s why cap rates are so dangerous when you look at them in isolation - they are a snapshot at a precise moment in time but they don’t tell you how your investment will perform for the next 5 years and it doesn’t take into account the economical cycle.

If you really want to do yourself a favor, take a CRE financial seminar , buy books, educate yourself on financial maths and soon enough you will know why the veterans are never negotiating on price but on return (yield cap rate, IRR, etc) and you will do the same! And plan your exit strategy even before you get in... what you should care about is return during the entire ownership period (which includes also sales proceeds) and find that sweet spot of LTV ratio that will bring you back the highest return on your equity.

And what seems appealing to an investor might not be to another one; if you are all about stable NOI, you will prefer a stabilized property. If you want the big pay off of equity at sale but you don't care as much about constant cash flow, then you will look for unstabilized properties. These have very different cap rates and yield rates and IRR. It all depends on what are your objectives and then which property can help you meet your objectives.

We are using a CRE advisor for our deals (not a broker) and we determine what it is that we want to achieve. Once we know, then we determine what Is needed exactly AND THEN we go shopping based on our criteria... that way we don't do impulsive shopping because after all; experience is what you get when you don't get what you want but first, you need to know what you want! (Borrowed from our advisor :-)

Cheers!

Kim

Russell Gronsky · Answer

@Chase Louderback, that makes sense if syndicating. So the exit strategy isn't necessarily important, it just depends on how you are entering the deal. Whew....I am looking at a multi-family right now and my exit strategy is to ride it until the wheels fall off....so reading the first post in this thread, I was good with everything up until the point she talked about exit strategy....that made me sweat a little bit.

Chase Louderback · Answer

@Russell GronskyDepending on how you structure the deal and what type of investor you are, then you may not be as stressed over the exit strategy. However, a lot of individuals in this space will be syndicating (fancy word for saying pooling together passive investment capital) or Joint Venturing (similar to syndicating but all members are active and there only a few). Because of this most of these deals are structured to where they will add value to the property and receive a certain CoC return over the few years, and then 3 to 5 years down the road sell the property to get their major windfall and achieve their projected returns. Therefore, if your exit cap rate is way off then you will sell for a substantially lower price than your projections. In that scenario, best case you receive less proceeds, worst case you are in the red.

Scott Morongell · Answer

@Kim Allard great info! Like Ivan mentioned, real estate is hyper-local and there are always deals to be had. That being said, if you have to choose between being a net seller or net buyer, i'd be a seller. However, all of our projects are still early and we continue to buy and will do so throughout 2019.

Ivan Barratt · Answer

@Kim Allard great post. cap rate and UST10's aren't perfectly correlated but certainly influence each other. in 06 the spread was 200bps at it's lowest point. Today the spread on UST10 vs my deals (the few and far between I do!!) are about 325bps. Additionally I'm only looking for value add so I can increase my cap rate from ~6% to 8 - 10% over the hold period.Bottom line: national, averaged figures don't paint the whole picture. REI is hyper local and there are opportunities in every market!That being said it's very refreshing to see someone studying finance and economics. They are a great arrow to possess in an investor's quiver!All the best on your journey!SPOILER ALERT! Rates will go down again soon. :) They have to... You heard it here first!! ;)

Chase Louderback · Answer

@Russell Gronsky Very true, just depends on your goals and what you ultimately plan on doing with the property. Also, there's multiple different ways of analyzing a property so it's all about what works for you!

Russell Gronsky · Answer

I'm a commercial RE newbie but why so much stress over the exit strategy? If it's a solid asset, wouldn't you want to keep it?

Chase Louderback · Answer

Hi @Kim AllardThanks for taking the time to write all of that information, it was very helpful. I feel the same way that you do about the cap rates in this current market.As food for thought, I was at a commercial RE conference this past weekend there was a well known apartment investor talking about how low the interest rates are and how they have actually gone down (slightly) in comparison to last October/November. Then, you add on the extra buying pressure the market is seeing from the new tax laws regarding bonus depreciation and that opportunity zones should have its guidelines finalized "soon" and we may see sustained buying pressure in the market. So who knows but it's best to just be very conservative in your underwriting.Where did you find a CRE adviser and how do you use them in your business specifically? That was really interesting since I haven't heard of anyone doing that before.

Gwyeth Smith · Answer

@Kim Allard. Thank you for your insights. I completely agree with the importance of knowing your goals, return objectives, and exit strategy before shopping. Also, the importance/unimportance of CAP rate is always a fun discussion to be a part of. I'm not as familiar with a CRE advisors and the roles they perform. Are you using them only on the acquisition end or for asset management and ultimately disposition as well? Would you mind diving into that a little bit and what their typical fee structure might look like? Thanks again for posting the article and your insights.