How to Avoid Getting Pummeled at the Top of the Real Estate Cycle (2021 Update)

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The real estate market is red-hot right now, but if there’s anything the last few years have taught us, it’s that what goes up eventually comes down. I don’t know when or how the next recession will unfold, how severe it will be, or what will be impacted most—and neither do you. That is largely irrelevant. Whether a correction occurs in three months or three years, most investors would agree we’re currently near the top of the cycle.

That said, it would be a mistake to sit on your hands, hoping for some horrendous crash that allows you to swoop in and pick up properties at pennies on the dollar while the rest of us make money. There are ways that you can continue to grow your portfolio now while protecting yourself and your investors from a lot of the downside risk that will come with the next cycle.

Before I get into the details, let me quickly hit you the highlights of where we are in the cycle and why a correction is looming in the shadows like a TMZ reporter in Justin Bieber’s trash can. Then I’ll hit you with a little advice.

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The Federal Reserve

This guy is writing about the Federal Reserve?! Yawn. I get it. But understanding what the Fed has been doing is probably the most important factor to grasp if you want to know what is happening in real estate.

It would take an entire book to really get into the weeds on the Fed, but here is the short version.

Interest rates are like the one ring that controls them all when it comes to investing. When the Fed keeps interest rates artificially low, investors start to make bad decisions based on faulty information. They start taking on excess risk. Why? Because yields on traditionally “safe” assets are too low. The market is distorted. So they stretch themselves, and everyone shifts out on the risk curve, buying riskier assets and chasing yield. Speculating.

This is what caused the housing boom and bust. The other stuff everyone blames it on—greedy banks, no-doc liar loans, ratings agencies, hedge funds, etc.—were symptoms of the greater disease, which is free money sloshing around capital markets, desperate for a home.

Like me in college when it came to tequila, the wise overlords at the Fed have had a hard time learning any lessons from the past. For the better part of a decade, we’ve had basically 0% interest rates and QE out the wazoo. Holding treasuries won’t get you anywhere, so everyone has been pushed into yield-seeking speculation, chasing higher returns anywhere they can find it. That includes real estate.

Investors are indiscriminate in their choices today. They see little need to obtain much premium for investing in riskier assets. A 1980 value-add deal with eight-foot ceilings is trading very near the cap rate of a 1995 value-add deal with nine-foot ceilings. If you’re an active investor out there, I don’t have to tell you how crazy people are getting when bidding on deals. It’s ridiculous.

The good news is, even in a pretty severe downturn, solid multifamily properties tend to hold up well. It is usually not a catastrophic decline in income that will kill you—it’s overpayment and poor structuring. If your investment is underwritten and structured properly, you can make it out on the other side relatively unscathed, should the market turn.

Actionable advice

So, what should you do? I don’t know, I’m just a guy on the internet. But here’s what I would do.

If you are new to investing, keep your day job. Keep working, enjoy your stable income, and build up some valuable experience so you can get aggressive when there is blood in the streets. But maybe don’t jump in with both feet and risk everything.

Partner up and do a couple of deals structured as described below. If you try to buy a large deal from a reputable broker, you will overpay. Seriously. The only way they will ever award some new guy a deal in this market is if you pay way more than the next guy.

If you own a good amount of property now, consider selling some. I’m not saying panic and dump everything. Hold the high cash-flowing stable deals with long-term debt. Sell some of the more marginal stuff or deals that have debt maturing in a year or two. Take advantage of the low cap rates and position yourself to buy at better values. Be patient and keep some dry powder available. You can be a buyer and a seller at the same time.

If you are buying, understand that there are differences between underwriting and structuring a real estate deal. Doing both correctly is going to become important again.

Remember what I said earlier about investors being indiscriminate about asset selection? Most people at this stage in the game are simply underwriting deals to hit a given IRR or cash-on-cash return metric. Those pesky details that you read about in your real estate books like location, visibility, proximity to employment, entertainment, schools, hospitals, job creation, and new supply, haven’t mattered up to this point. It’s hard to say no to a deal when the model spits out the right IRR. The rising tide has lifted all boats, rent growth has been great, and no one can tell what’s a good deal or a bad one.

Good underwriting is going to start to matter again. Slapping 3% rent growth and 2% expense growth on a deal is not a conservative underwriting assumption. I have access to multiple national research platforms, and it is very rare to find a sub-market where 3% rent growth is projected over the long term.

Leverage & deal structuring

Structuring a deal relates to the mix between equity and debt and on what terms, as well as determining the appropriate level of reserves. This is where amateurs really risk getting their face ripped off. We’ll focus on the debt side of structuring for the purposes of this article.

Leverage

The worst advice I’ve ever heard is that it’s okay to eat yellow snow. The second worst advice is that you should always maximize the amount of leverage you use in order to enhance returns and buy more deals with the same amount of equity.

It is true that leverage can magnify your returns. It also magnifies your losses. Misunderstanding how to use leverage and the associated risks is the quickest way to go broke in real estate.

Let me give you an example to illustrate the point. I threw together a simple model so we can toggle some basic assumptions. Let’s assume we’re buying 120 units at a little under $83,500 per unit, with a 5.75% cap rate on a five-year hold period.

Our “base” case will be 3% rent growth, 2% expense growth, and an exit cap 50 basis points (BPS) above the entry. This is what most would call conservative because rent growth over the past five years has been tremendous and that will likely continue for the foreseeable future.

Our “bad” scenario will have 2% rent growth, 2% expense growth, and a 75 BPS spread on the exit cap.

Lastly, our “worst” case will be 0% rent growth, but let’s assume you can also hold the line at 1% expense growth. We will assume here that our exit cap goes up 100 BPS from where we bought it.

When we originally ran these numbers, we didn’t contemplate rent declines or increases in vacancy. COVID-19 felt like a scenario from a post-apocalyptic movie—not our immediate future. But in many cities, rents have grown, despite the pandemic—and will likely continue to do so as the world stabilizes.

We will run scenarios based on 55% leverage at a 4.75% interest rate, and 80% leverage at a 5.25% interest rate. Here are the outputs from the model.

55% leverage

	Base	Bad	Worse
Cash-on-cash return	6.19%	5.65%	4.87%
Internal rate of return	11.83%	6.53%	-1.81%
Sale price	$11,192,531	$9,783,855	$8,098,048
Purchase price	$10,017,391	$10,017,391	$10,017,391
Initial equity	$4,507,826	$4,507,826	$4,507,826
Equity at sale	$6,151,376	$4,742,699	$3,056,893
Gain/loss	36.46%	5.21%	-32.19%
Equity % of value	54.96%	48.47%	37.75%

80% leverage

	Base	Bad	Worst
Cash-on-cash return	4.63%	3.42%	1.66%
Internal rate of return	17.07%	6.79%	-16.23%
Sale price	$11,192,531	$9,783,855	$8,098,048
Purchase price	$10,017,391	$10,017,391	$10,017,391
Initial equity	$2,003,478	$2,003,478	$2,003,478
Equity at sale	$3,807,751	$1,928,786	$713,268
Gain/loss	90.06%	-3.73%	-64.40%
Equity % of value	34.02%	19.71%	8.81%

What is the key takeaway here? At the lower leverage point, even under the worst-case scenario, you paid out an average of 4.87% cash on cash. You’re left with an equity position that would allow you to refinance the debt at a 62% loan-to-value (LTV) and continue to cash flow while you wait for the market to recover. Your base case IRR a little under 12% looks terrible next to the 17% IRR with higher leverage, but your downside is much more limited. Your risk-adjusted returns here given the potential downside are looking a lot like I do: pretty attractive if you’ve had a few beers and are looking from the right angle. You could do worse.

In the higher leverage scenario, you could quickly find yourself in a situation where you have no options. Even under the “bad” scenario, your equity position is now below 20% and there’s a debt maturity looming. The bank is hounding you like a jealous ex-girlfriend. They want their money back—and their Alanis Morrisette CD. You’ve just become a motivated seller. All your options are terrible. Try to call more capital into the deal so you can refi? Sell into a weak market and give your investors less than they put in? You just got your face ripped off.

Understand the risk—and mitigate it

In short, the way to invest successfully at this stage in the cycle is to understand the downside risk and take steps to mitigate it. That means being well-capitalized and moderately leveraged.

I understand that going with lower leverage isn’t sexy. You probably have investors that will laugh you out of the room and go with the guy offering the 17% IRR. But if you can sell the message correctly and get people to understand the concept of risk-adjusted returns, imagine how many happy investors you’ll have down the line.

I fully expect that many of the deals that were done over the past couple of years will not deliver the returns that were projected. As debt comes due, the under-capitalized and over-leveraged sponsors and IRR chasers who stretched their underwriting to meet the pricing expectations of the seller are going to find themselves in a tough spot. As Warren Buffet said, “You never know who’s swimming naked until the tide goes out.” Over the next three to five years, we’re going to find out.

Until then, keep grinding. And realize that lower, safer projected returns have their place in the real estate investing landscape.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.