All Forum Posts by: Chester Transo

@Chester Transo 

Yes, the way you summarized the post is correct. The key points being that depending on your time horizon, a disposition in the near term with a cap rate that is moving in line with interest rates will value the property much lower (last outflow in the IRR calculation) then one that is delayed further down the line. The other factor is the NOI which has more to do with the lease structure and timing.

I think since everyone is expecting inflation and investors are preparing for upward movement in cap rates, we won't see an immediate jump (the buffer compressing instead).  It's cap rate increases that investors don't expect that usually panics everyone.

I guess we'll see what happens.

@Chester Transo getting 30 yr fixed should be no problem on 2-4 units (and SFH of course.) most banks offer them as standard fare. You're paying a bit more interest than 5 yr fixed, but since I'm keeping my props very long term, it's worth it for me. I can always get seconds or heloc's when I want to pull cash out. I just don't think rates will go back down, so chances I'll want to refi due to lower rates in the future is pretty nil. These are my bread and butter properties, and I want full control over future mortgage expanses. I'm quite happy, and feel fortunate I was able to take advantage of this low rate environment.

@Chester Transo 

I appreciate @Victor Menasce 's approach and look forward to his response to your questions.  

Regarding the premise of the discussion in protecting oneself in a rising interest rate environment, it may not be as straightforward as:

rising interest rates = higher cap rates = weaker property values

A couple of reasons for this would be that the spreads between the 10 year treasury yield and current cap rates are significantly higher than the historical average (500+ basis points) vs. an average of 300 basis over the last 20 years.  That gap provides an extra buffer that can help maintain property values before they start getting effected.

In addition, although most people do think interest rates are going to rise, they also expect economic and employment conditions to improve (real GDP growth).  This helps with rent growth, occupancy, etc (also helping to buffer).

The reasons these buffers matter is that they delay the weakening of property values and buy time. If the cap rate changes happen later down the line, you're overall IRR will be higher in the end. Of course, if cap rates move directly in line with interest rates and you have a short term horizon, it's going to hurt. Considering the other variables, it doesn't seem that is likely to happen though, but as you say, nobody knows!

the leverage/risk/reward equation is one of the most important ones to get right in RE investing in my opinion, as it will dictate your long term success.  None of us can predict where interest rates will be in the future. It's a macroeconomic phenomena that effcts all markets, and is influenced by domestic, as well as global macroeconomic circumstances. 

For that reason, and especially because rates are basically at record lows, I've shunned away from commercial properties (where 5-10 year fixed periods are the norm.)  All my residential properties have low 30 year fixed notes. I consider that a competitive advantage that I will have in the long run. All of my investments are long term buy and holds in a very desirable market (San Francisco), so that allows me to establish certainty wrt my mortgage payments.  

IMO it's not a question if rates will significantly increase, but a question of when.  I don't see the Japanese economic model (stagflation) as an equivalent to the USA for many reasons. Chiefly that they are not the global economic engine of the USA, their currency does not rule internationally like the USD, and they don't have nearly the debt that the US gov has (nor the capability to generate it due to their currency status.) 

The easier way for the US Gov to deal with its debt is through inflation. It's the least painful way, and is almost guaranteed in some form at some time. Depending on how that manifests (rate of inflation, economic conditions, global dynamics, etc.) it will effect our local RE markets. So having a fixed guaranteed rate at that time will be a benefit. And it could be huge.  If rates shoot up quickly, short term RE values will most likely get depressed.  But basics like rent, food, transport, energy, etc. will have to increase in price. And salaries will also have to get inflated.  They have to or else there will be revolution in the streets as people can't feed their kids. And after a certain lag, RE prices will also get inflated.  Usually inflationary periods are short but intense, and then you're living in a brand/brave new world. (Just ask Thailand and Argentina.). As an RE investor, if you can survive that sh!tstorm, you will probably come out in a very good position compared to most people out there.  Look, there are A LOT of political and economic uncertainties out there, and inflation is one of the economic axis that will probably get tested.  So I am preparing for that potential scenario by securing long term low fixed rate positions while I can. 

I think the 53k of principal reduciton is not a good way to add to your Cap rate, since its really a liability, not cash flow.  It's a trapped equity, not cash flow.The case study you presented is an awful one because of the horrible return.

Here is the property I bought in april: 

 purchase 400k, dp175k (low risk for now), total rent 36k/year.

My positive cash flow after mortgage and tax is 10.3% after mortage and property tax.  That's not the best, but it's Ok.

If I were to include principle, it's 12% return.

This this particular investment is not great, just decent. 

Anything below that is probably not worth it.... As an investor, doing an investment in your particular case study will certainly not build any wealth.

@Louis Leone @Chester Transo. All good points. We have several basic principles that we live by in my company. I recommend this for you too.

1) Yes. No Money down deals are the holy grail. But no money down deals are very difficult to create from inception. So we turn our conventional deals into no-money-down within 12-18 months by using a refinance as an interim exit.

2) In order for that to work you need to create 30% "net profit margin" as if you were going to sell the property. But you refinance it instead of selling it. That 30% lift is key. Not 20%, not 25%, it must be 30% margin.

3) Aim to refinance at 70% Loan to Value. Yes, you can theoretically get loans at 80% loan to value ratio (LTV). But they're much more expensive. The interest rates are much lower at 70% LTV. And if you face a cost over-run in your construction, then you have no margin of safety. If I target 70%, and have an over-run, I can refinance at, say, 75% loan to value. I'm still pretty safe. But if I aim for 80%, and experience an over-run, I have no place to go.

4) Choose locations that are next to VERY HIGH DEMAND areas. That means they're expensive. That demand will create value for your product by associating it with the high value neighbourhood. But you have to build a large enough project to be convincing to the marketplace. A single family home won't do it. You need to do several in a row. That way the market, the realtors, the bank, the appraiser will all be convinced that you've created value.

5) Finally, this gives you the flexibility of recirculating capital every 12-18 months into new projects. This dramatically improves the scalability of the business. 

Hope that's clear. I'm happy to answer any questions, except which specific neighbourhoods we're developing in. This is simply too public a forum for that.

@Louis Leone @Chester Transo. All good points. We have several basic principles that we live by in my company. I recommend this for you too.

1) Yes. No Money down deals are the holy grail. But no money down deals are very difficult to create from inception. So we turn our conventional deals into no-money-down within 12-18 months by using a refinance as an interim exit.

2) In order for that to work you need to create 30% "net profit margin" as if you were going to sell the property. But you refinance it instead of selling it. That 30% lift is key. Not 20%, not 25%, it must be 30% margin.

3) Aim to refinance at 70% Loan to Value. Yes, you can theoretically get loans at 80% loan to value ratio (LTV). But they're much more expensive. The interest rates are much lower at 70% LTV. And if you face a cost over-run in your construction, then you have no margin of safety. If I target 70%, and have an over-run, I can refinance at, say, 75% loan to value. I'm still pretty safe. But if I aim for 80%, and experience an over-run, I have no place to go.

4) Choose locations that are next to VERY HIGH DEMAND areas. That means they're expensive. That demand will create value for your product by associating it with the high value neighbourhood. But you have to build a large enough project to be convincing to the marketplace. A single family home won't do it. You need to do several in a row. That way the market, the realtors, the bank, the appraiser will all be convinced that you've created value.

5) Finally, this gives you the flexibility of recirculating capital every 12-18 months into new projects. This dramatically improves the scalability of the business. 

Hope that's clear. I'm happy to answer any questions, except which specific neighbourhoods we're developing in. This is simply too public a forum for that.

I find the interest rate interesting.  Does nobody remember the PANIC of 2009?  I watched major corporations lose half their value because people weren't sure if they wold be able to refinance relatively small loans that came due with a balloon balance.

If anyone is leveraging themselves with loans that have a balloon then good luck.  chances of a melt down are slim but you never know for sure.

Keep in mind too that the US has a 17 trillion deficit,  50k per citizen, 152k per taxpayer.

Debt Clock

The easiest way for politicians to get out of this hole is going to be inflation, don't count on them increasing taxes that much or cutting spending by that amount.  If your financing is fixed life will be good, if not it could get painful.  Who know when the bubble will pop but someday it will,

@Chester Transo, I agree that our projects are still leveraged. But we're not leveraged to the max. We recommend a loan to value ration of 70%. That still leaves 30% equity in the deal, even if there is no cash tied up. That's a pretty safe ratio. 

In addition, we target debt coverage ratios of 1.4 or better. Sometimes we don't achieve that in the real world and can only get 1.3. But that's still pretty strong. 

Finally, we tend to go long on our mortgage terms and secure fixed rates whenever we can. We'd rather pay slightly higher fixed rates that are locked in for a 10 year term or longer. In that scenario we don't really care what happens to the rate in the interim. We're protected.

There's enough risk in life. Best to eliminate some un-necessary risks.