All Forum Posts by: Ed Matthews

Ned: good point about the spread being insignificant at present. The benefit to going adjustable wouldn't be worth it, in general.

Thanks for the discussion.

Aside from statistics, do you see other reasons to expect rates to rise?

Yes, rates are at historic lows, but that by itself doesn't mean rates must rise. I think the Fed is stuck in a debt spiral and can't raise rates without major damage to the economy.

Why are we in a global ultra-low interest rate regime (even zero or negative rates)?

1. Governments, corporations, homeowners, students, car owners, credit card owners are awash in record levels of debt. Globally, $250 trillion. What happens to the economy if the interest rate on that goes up? The cost of the debt would shoot up, at the expense of spending elsewhere. Discretionary spending, capEx, investments would be slashed.

2. Right now, US taxpayers are paying only interest on the debt, and borrowing over $1 trillion more per year, with about 1/3 of that going to interest alone. If interest rates tripled, then all of that $1 trillion we borrow has to go to the interest -- and we'd need to borrow more to pay for mandatory and discretionary spending. That causes a spiral: we'd have to accelerate the amount we have to borrow in order to make interest payments, which increases the amount we'd have to borrow the next year.

3. Since Volker, interest rates have been deliberately lowered to "goose" the economy at every recession or major crisis. The last official recession was a decade ago - a record gap between recessions for the US. So if the US has another recession, will we go to higher or lower rates? The Fed will want to lower rates (this is admitted publicly; this is their way of thinking they can help the economy). In fact, Powell steadily raised rates until the stock market dropped 20% in Dec 2018, after which he flipped his position and started cutting rates. So even Powell, who talked about returning rates to historical norms, has thrown in the towel.

4. Outside the US, there are precedents for prolonged periods of ultra-low rates. Japan has had 30 years of that. Is there economy so different from ours?

So I don't see how or when rates can move up significantly. 

The world is drowning in debt, and that means two ways out, historically: inflation (pay off the debt with cheaper money) or outright default. I don't know which path we'll end up taking, but everything from the Fed suggests they are trying to get inflation.

Incidentally, although Powell has said negative rates won't happen here, I haven't seen an explanation for why they can't. So in my book, though I detest them, I think in desperate times someone may put that option on the table. If they can happen in Europe, they can happen here.

Circling back to my initial question, yes, fixed rates are normally more conservative. But we could take "conservative" to mean providing margin for handling risk. In an environment of falling rates, an adjustable rate loan could take advantage of that, and provide additional margin should the exit cap rates not be as high as planned.  

That's the context my question came from. (I hope some don't take this post as too political; I'd like to avoid getting into political discussions on BP. I see this as an assessment of the macroeconomic environment. I could be wrong, and am always open to new facts.)

Thanks for the discussion!

Thank you for the example.  

I think I get it. Let me know if this is correct:

If the property is bought and never sold, then the IRR = % cashflow (8% in the example). If the property is sold, then the IRR increases, and increases faster the sooner the property is sold:

FV = PV x (1 + r) ^ n, where 

FV = future value of investment (total cash flow + net sales proceeds + initial investment), 

PV = present value (initial investment), 

r = IRR, and

n = holding period (usually years). 

Do some algebra and that means: 

IRR = r = [(FV/PV)^(1/n)] - 1

So obtaining the same total return (FV/PV) over a longer period (greater n) decreases the IRR exponentially.

Doubling the investment in 4 years would be 18.9% IRR; 5 yrs, 14.9%; 6 yrs, 12.2%; etc.

So other things being equal, the deal with higher IRR would be preferred, which usually means selling the property sooner rather than later.

What situation would drive IRR to be better over a longer period? One common situation is the property value doesn't appreciate at a constant rate. For instance, if the market drops, the IRR would drop for a sale at that time, but if the owner waits for the market to return, then the IRR could go up (though it wouldn't be as high as it would have been had the market not dropped in the first place).

I agree with you - the long term play gives fairly predictable income, while the short term play favors wealth accumulation. In a market with greater uncertainty, do you favor one over the other? Or is it the flexibility to change the time horizon based on market conditions that enables you to handle market risk?

Thanks again. Great discussion!

Does that mean only comps are used? Or are there other analytical tools commonly used?

For instance, building one more 100+ property in an area with 20 similar existing properties would put little downward pressure on rents, assuming a reasonable population increase. But in an area with only one existing property, the effective doubling of the number of doors would put a greater pressure on rents to go down. Such an impact ought to be considered when the comps are analyzed, correct?

Additionally, if the area has few competing properties, there may not be any that are truly comparable (e.g., building a new A property when surrounding it are only older B- properties). In this case, it's arguable whether the comps are legitimate, and then to what extent a conservative underwriter would discount comps to negate the differences.

A friend of mine built homes years ago for $75 / sq ft, live in them for 2 years, then sell them for $150/ sq ft. I can see a similar possible gain in building a larger MF property and selling it shortly after it's built (or at least doing a cash-out refi). The challenge is forecasting what rents the developer would be able to charge in an area with limited real comps.

Thank you!

The uncle of a friend lived to his mid 90s. After several years of success in sales, he bought an apartment complex in the midwest and managed it for many years. He eventually retired to San Diego and lived very comfortably off the cash flow from the property, with a good property manager running it. This is a long-term play, and I'm wondering if via syndication, such an opportunity may be available. That's the genesis of my question.

Based on the responses, it sounds like some long-term plays may be out there, but the market cycle currently favors shorter-term plays.

Your last point is probably the driver. That's particularly good to know.

That's interesting. I'll keep my eyes open. I think the longest plan to hold I've seen so far has been 5 years (with some contingencies for a couple more years, based on market conditions).

I like the 3-5 or even 7 year return horizon, but I'd like to diversify into longer plays as well. Any tips on how to find operators with an interest in longer-term plays?

Thank you. 

To your first point: Why does the IRR (generally) decrease with increased duration?

To your second point: I can see a 5-7 year maintenance cycle driving the frequency of reinvesting in the property. Yet there are companies that own and manage large properties over the longer term. How do they stay profitable over the cycle? Are they absorbing profit variation year to year, with some very lean (or even negative) years in which they invest in major repairs balanced by very profitable years?

Thanks!

Thank you all for the responses. Very informative.