All Forum Posts by: Jason V.

@Bill S. - Ben and Brian (and Serge) are the first guys I thought of when posting this question, but I didn't want to (or couldn't) tag them - thanks!

Good Morning BP!

Summary: How do smart investors hedge against market corrections in the commercial multi-family sector? And should required reserves for a property be factored in to calculations for CoC and/or IRR?

The whole thing:

As I get more and more comfortable with the SFR and Small MF properties I currently own, and the ones I'm working to acquire right now, I keep looking forward to what comes next. The logical (or maybe traditional) progression is to move onto larger and larger properties, which I've had my eyes open for. But as the market looks more and more like it's approaching the top, at the top, or starting to tip over (lots of indicators in a couple of leading markets, Phoenix, Houston, etc., but that's not the focus of this post) I find myself thinking about what it would look like to buy a commercial MF property right now, and especially what the next 5-7 years of living with it would look like. Primarily, I have concerns about the financing side of things, especially with how that relates to the property's valuation.

Say a deal lands in my lap tomorrow, and I have everything in place to pull the trigger on it. I pay $1 Million for the property, 75% bank financed, down payment and reserves out of pocket. Let's assume I'm smart and lucky enough to buy something with an opportunity to add value without a lot of out of pocket cash (reduce expenses and manage it better, for the sake of argument) and 12 months from now it's normalized and worth $1.3 Million. I re-fi, get all my cash back, and have a note for $1 Million (I rounded up for easy math) on a 5 year term and 25 year amortization at 5%.  Again, for the sake of argument (and because I've seen a lot of stuff selling at this price point) let's say I bought at a 6 Cap (which would be a steal in San Francisco or Denver!) 

Fast forward 5 years, and let's assume what a lot of folks are thinking might happen proves to be correct: there's been some inflation, lending rates are up, and despite my best efforts, I bought in a market that was hit by some sort of unexpected economic drop, so vacancy rates are up, rents are flat (or down) and Cap rates have gone up significantly in the area. 

Because I'm not a smart guy, or a savvy investor, I don't know how much cap rate traditionally swings in a particular market, but even if it only goes from 6% to 9% (which my research says was the industry average in the early 2000s) my property value drops ~33%, and now I'm looking at being upside down in a loan I need to refinance (because I'm at the end of my term.) So I'll have to put cash in to meet equity threshold, and if vacancy is up and rents are flat or down, I probably don't have a lot of cash - especially if this isn't my only property (because if I'm taking my cash from the first refi to the next property, it's probably all tied up.) And with rising rates, monthly debt service will also be increasing. 

I saw this happen on the residential scene during the 2008 correction (typically with people using interest-only mortgages or ARMs who were expecting the crazy appreciation to continue) but I guess I'm just starting to realize that this is the potential risk with commercial MF all the time.  

And yet I never hear anyone talk about this risk - why is that? All I ever hear is keep buying, and keep cashing out. I know there are a lot of folks a lot smarter than me investing in commercial MF properties, and who have done so successfully for a long time. What is typically done to hedge against market corrections with a single property? As the likelihood of this situation increases, are investors just raising the amount of their reserves? Reserves help to weather the storm, but at that point, aren't you just throwing good money after bad? 

I know we typically talk about Cash on Cash returns, total returns, IRR, etc. when it comes to real estate, but if you have a significant amount of money tied up as reserves for a property, that's money you don't have available to invest - yet I never see required reserve amounts factored in to the CoC or IRR calculations. Shouldn't it be, since it's money tied up by the investment, albeit indirectly?

Congratulations if you made it all the way to the end of this post, and thank you!

Great information - thanks guys!

Everything else aside, now is probably a solid time to exit. My crystal ball is just as hazy as everyone else's, but I think a lot of folks smarter than me are thinking we're near the top of the market. (Lots of indicators that certain markets are already starting to tip over too.)

Take your equity tax free while you can, and drop one more market you have to worry about while you're at it. 

Good luck!

One of the things I keep hearing regarding commercial loans is that lenders typically want your (the borrower) to have a net worth that exceeds the amount of the loan. Is this something that investors are getting a pass on for their first larger MF property? Or are they working around it in other ways?

If I were to "partner" with a higher net worth individual, who's only contribution would be bringing their net worth and signature to a deal, does that fly? If I'm not borrowing from them, or relying on them for anything else, what would be fair compensation? 

Thanks all!

Find really, really good deals and the buyers will find you. If you don't know any investors who are actually pulling the trigger, go to the Rochester BP meetup (last Wednesday of the month at Johnny's, if I remember correctly) and/or post them here on BP - lots and lots and lots of folks looking for deals in Rochester these days. 

On posts like this one, I find myself missing Bob Bowling.

I think the issue is that you understand the ratio to which Cap Rate applies, but maybe not how it is traditionally applied.

Cap rate is typically used to establish a present value for a stream of revenue within a set market: NOI of a MF property, in real estate. This is done because there can be so many differences from property to property in the MF world (24 units versus 32 units, tenant versus owner paid utilities, etc.) Cap rate is also determined by a market: identical properties in San Francisco and Rochester will sell for wildly different prices, and depending on who you ask, the "better" Cap rate might be 3% or 12%.

Cap rates are typically not applied to SFRs because the primary driver of value/cost for an SFR is not its NOI. If a typical Cap rate for Naples is 8%, and an SFR has an NOI of $3,600, is that house only worth $45,000?

A better way to discuss the criteria you're looking for in the SFR world is to say you're looking for "1% 'Rule'" properties in a certain area, or to tell people you're looking for a particular "Price-to-Rent" Ratio (which, oddly, is calculated using the annual rent, versus the 1% or 2% "Rule" which looks at monthly rent.)

I'm with David on this one: talking cap rates with SFRs is going to make people question your experience. But maybe that's just our markets, and it's typical elsewhere. 

In any event, good luck!

First at bat home run - great job guys! I bet the neighbors love you too!

One thing to keep in mind: all of the people saying that transferring the property to an LLC will violate the Due On Sale Clause are correct, and they are also correct that banks have little to no reason to execute that clause on notes that are current...for right now anyway.

However, if we start to see the inflation lots of people are predicting, and lending rates go up significantly as a result, you are absolutely going to see banks looking to recapitalize their money from 4% to 8% (or whatever prevailing rates will be.)

One man's opinion: the liability protection offered by an LLC is of limited worth to many investors (depending on assets and a lot of other things.) LLCs are also worthless unless maintained properly, which has some expense as well. Combine that with the risk of having the note called in the future and doubling your rate, or more, and how cheap excess liability policies are, and I plan on continuing to buy in my name, and keep them in my name.

Not a lawyer, etc., etc.

Good luck!

 Dear God....agents and their drama. 

I'm a big believer in aggressive offers: if your first offer doesn't generate some outrage, it was probably too high. (But I also invest in a rural area, and would rather not buy something than pay too much.) I honestly would have gone in on this one at $99.5k, or somewhere in that range (I don't know the numbers/property.) 

It needs serious renovations to get good tenants based on your description, and you're going to have to start off with at least one eviction costing you several months of rent and most likely damages. 

One thing to always keep in mind: as soon as you pull the trigger on a deal, one that's twice as good will immediately come along, and you won't have the cash for it anymore. Make sure you're never, ever settling for a deal just to do a deal.

Good luck!