Smoky Mountain STR Punchbowl Confiscated

[John Carbone]

The topic of “I can’t get the numbers to work” seems to be an almost daily discussion on here. Some will argue if you manage better, then the sky is the limit. Management absolutely matters, but you would be delusional to think that you can take a cabin earning $200 a night into one that earns $300-$400 a night based on management alone.

It's been a wild ride reminiscent of the Wild West days over the past several years in the smokies. STR in the area have been around for decades, with a few legacy folks on this message board who were in this market while many were still riding the bus to school. It used to be that an out of state investor would use a local PM, and they would set it and forget it, as long as it covered expenses, that met their expectations (in the long run they would be in a great spot). Nowadays, people want cash flow (this may change again as reality sets in), and a new generation of investors came on the scene with technology allowing for remote management. With remote management, investors didn't need to pay for a manager at 30-40 percent, so the bottom line numbers looked unbelievable, which in turn caused real estate prices to rise to reflect this new way of doing business (people across the world were creating themselves a part time management job). To add the cherry on top , was the spiked punchbowl of free money which further resulted in the excessive bidding up of real estate values. The smokies are ripe for this too, with the ultra low property taxes and no state income tax for individuals, if the only metric is coc or roi, then the only thing that ultimately matters is revenue and interest rates (day to day cost to operate are typical anywhere). Over the course of the last 6 months, interest rates have risen at the fastest pace in most peoples lifetime, suffice to say the punch bowl has been CONFISCATED.

I checked with a local lender on investment properties today, and I’m being quoted a little over 7 percent now. My thinking for a while has been that prices will drop to reflect the higher rates, but after digging into it, maybe that’s not the case (with one major caveat I’ll mention at the end.) 

I think this needs to be grouped in a few categories of investors:
1) People who owned prior to 2020.

2) buyers during 2021/early 2022 (approx. 18 month window) 

3) prospective buyers now

Revenues have been steady through Covid and now. A lot of people are not quite matching 2021 numbers this year, but I’ll give an example assuming 2022 income is the same as 2021. For people who owned prior to 2020, nobody is really feeling any effect from the 7 percent interest rates because they are locked in at both a low purchase price and a lower interest rate relative to revenues (best of both worlds)

So, it comes down to what will it take to get transactions closed in this new market. Let’s assume someone who bought before covid (500k purchase, 100k down, with a solid 30 percent cash on cash return), so a 30k profit on a 100k down payment. They earned this in 2020, 2021, and 2022 so they recouped essentially their whole down payment, and are now getting a 30k annual dividend as long as they hold, with rents flat or improving. This person decides to list their property now though, and in order for a new investor to come in and get a 20 percent coc return, which is what most people are seeking, what needs to happen to get the deal closed? Let’s assume the seller has a 3 percent fixed rate note on their 400k mortgage ($1686 payment), and a new buyer will be paying $2661 to service the same 400k note with current rates, so that is $975 more a month over 12 months, that is $11,700 in additional expenses for a new buyer. The prospective buyer wants a 20k profit on the property. If we take the 30k profit it’s generating, and subtract the increased interest cost of $11,700, that leaves the buyer in a spot of making a $18,300 profit on a 100k down payment (18.3 percent coc, not their ideal goal but an acceptable return for them)

But wait….the above example is not the reality for the buyer. Prices in the smokies have gone up substantially since then. That 500k cabin in early 2020 now sells for $1,000,000… let’s see how reality looks to a new buyer now.

Sale price: $1,000,000 (200k down): $5322 payment (5322-1686) x 12 months equals $43,632 more in mortgage expenses than the current seller has. subtract the 30k profit seller is making currently, and the new buyer is looking at a -$13,632 annual NEGATIVE cash flow on the same property at the asking price. Buyer needs to have the payment $1,136 lower a month to break even. what is the sale price for the new buyer to expect to break even? A loan amount of $620,000 ($4,125 payment), so a purchase price of $775,000 with a 155k down payment). After seeing reality, the buyer is willing to lower expectations to a 10 percent coc, so they determine the max they can pay is approximately 600k, with a 120k down payment. Their mortgage will be $3,193 (the original seller has a $1686 payment) so 3193-1686 = $1507 month change x 12 = 18k in additional annual expenses. the seller had a 30K profit, so we need to subtract the 18k more that the new buyer is paying a year now to service the higher mortgage, at the higher price, and that leaves a 12k profit a year on a 120k Dow payment (a modest 10 percent COC). people will argue your getting principle paid off as well, to which I say, but there is also an opportunity cost now with higher rates, you can take the 120k and get 4 percent a year now risk free return.

Hold on again though….to get a new buyer a modest 10 percent coc return, they need to pay 600k, so real estate prices need to drop 40 percent from the peak. will the seller accept such an offer of $600,000 to appease the new buyers bottom line of 10 percent coc return? If the seller accepts, this leaves the seller with a 100k profit on the sale, factor in commissions, and it’s more like 60k net to the seller in this case. The seller then takes the $60,000 profit and invests in 4 percent short term yield bonds for a paltry $2400 annual profit instead of the $30k annual dividend by holding the asset. Obviously, the seller will not sell for 600k, so that leaves a stalemate. There is no possible way the seller and buyer can agree to terms on a sale in order to make sense for both parties.

Let’s look at a buyer who hypothetically bought this at $1,000,000 at the peak (late 21/early 22), but at the still low rates of let’s say 3 percent. 200k down with a 3373 mortgage - 1686 initial sellers costs = 1687x12 = $20,244 additional expenses, so roughly a 10K profit on a 200k down payment (5 percent coc). If this person tries to get out of their investment now to a new buyer, they need to take a loss of several hundred thousand to have a new buyer have the same coc that they had, so these types of people are not selling.

But a crafty person looks at this and says, they have the solution! If nobody will sell, I’ll just build new construction, A builder can do this for me at 700k. but after factoring in the time it will take to finish, and the interest only payments along the way, and the opportunity cost of tying up capital in a 2 year project, the prospective buyer will still be looking at a paltry coc return (maybe even negative)…plus more supply will be on the market which will slowly lower annual rents.

Lastly, a realtor will say, but what about the cash buyers. Surely they will pay $1,000,000 for that cash flowing cabin…However, as mentioned before, that investor now has a guaranteed 4 percent treasury to park their money in for a locked in 40k profit sitting on their couch (no VRBO or AirBNB App needed)…there is a large opportunity cost now, of which did not exist for the past several years until now, so these prospective cash buyers are drying up, as they should.

From an objective standpoint, real estate in the smokies should be at a standstill, and it mostly is. Of course there will be people who need to sell, or who are in a panic now and think prices will crash and are trying to get out now, so there will be occasional “potential” deals to be had. But generally speaking, someone is making a bad deal in the smokies when a real estate transaction occurs, and if you are buying or selling, run your numbers to see if you are the one making the bad deal.

The fed is getting what it wants here. The brakes are being applied to this economy, and we are in a deer in the headlights moment. The smokies is ground zero as it had one of the biggest bull markets during Covid. In the beginning, I mentioned that there is a caveat to all this. If there is a deep recession/depression where the unemployment rate rises substantially, and demand decreases, resulting in much lower annual rents, then look out below. It very well could be a bloodbath reminiscent of 2008, and there is no telling how low some properties will go due to forced liquidation.