Who's at the most financial/leverage risk in a recession?

[Scott Trench]

Hi Team - I wanted to walk through a couple of quick thoughts on what I see as the most at-risk parties in a potential recession. 

1) Middle-Class Homeowners - A middle-class homeowner reliant on one source of income, with a large mortgage payment on a recent purchase or refinance is at the highest risk of all parties involved in the real estate world that I can think of. Their wealth is likely highly concentrated in a single asset that is levered many multiples of their annual income. If they lose their job, they are screwed. If the property's value declines, their net worth becomes negative. Their saving grace is if they have a very long-term outlook and plan to live in the property indefinitely. They can, in this case, likely wait out any market timing issues, so long as they can cash flow the mortgage payments through thick and thin.

2) Syndicators, real estate private equity, and hedge funds - These folks scoop up properties, using other people's capital, and generate wealth on carried interest. Their debt is often financed with variable interest rates, balloon payments, and shorter amortization periods. They are also heavily dependent on market timing. While their terms may be flexible, they generally promise 2-5 year hold periods, and investors generally expect to exit within this timeframe. If the market drops, and does not recover, they are in trouble. If interest rates rise quickly, they see cap rates rise, and be unable to refinance or sell the assets. 

3) Small Mom and Pop Landlords using Creative Finance: DSCR, Seller financing, and other forms of private capital put these investors at substantial risk. If interest rates rise, they may be unable to refinance the debt at attractive rates, or sell the property. If rents and prices fall, the terms of their debt may force an exit at an inopportune moment.

4) Small Mom and Pop Landlords Using Conventional Loan Products - These folks are impacted by falling rents and prices, sure. But, if well-capitalized, they have tenants paying some/all of the mortgage payment on a cash flowing asset. They have their wealth spread across at least a few properties, rather than a single asset. They likely have a 30-year mortgage locked in at a fixed interest rate. They are in complete control of their selling time horizon, and can keep the property indefinitely until prices return.

While all of these players can win, I think it's important to recognize the risk profile and how the types of debt used to buy property can dramatically change the risk profile. The small time real estate investor using conventional financing is not getting rich as quickly in a bull market as some of the more "creative" investors. But, they are much less likely to lose their property or find themselves in a liquidity crunch in downturns as well. And, be smart about who you syndicate with, and understand that the projection models WILL NOT usually cover scenarios where cap rates rise by hundreds of basis points - and that scenario is all too realistic in a rising interest rate environment. 

No one can predict the market accurately, but we can understand the risks. 

Most of all, don't be the middle-class homeowner with the mortgage payment that stretches you to your financial limits. Unfortunately, that's the population that will get hit first and hardest in a real estate market downturn. The grind to dig out of that hole could cost many years of life. 

[Jay Hinrichs]

Scott,

You missed the safest player of them all.. the investor who pays all cash and slowly builds up a portfolio with zero or very limited debt.. All assets no debt.. there are more of these investors than many on BP probably realize and of course up until now the limited debt investors get drowned out on BP as crazy.. your leaving equity in the deal its dead equity blah blah blah.

But those are the folks that can weather any storm  I have bought many a foreclosure from number 4 when tenants trashed the units they could not get them up and running and just walked away disgruntled..

I know its not a popular position on BP  but since you brought it up.. So there is a balance for sure.. and that is why I like to suggest investors try to pay down debt when they can and try to have paid for assets and be very cautious on what type of assets they take debt on.