How to Avoid Getting Pummeled at the Top of the Real Estate Cycle

by | BiggerPockets.com

For my first article on BiggerPockets, I’d like to address what seems to be the most contentious issue in real estate right now: the coming crash.

Let me start by saying that 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 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 in to 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.

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. Lord of the Rings reference? Does this guy know how to party or what?!

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.



Related: 5 Reasons I’m Not Worried About the New Real Estate Market Correction

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 is overpaying and poorly structuring. If 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 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, new supply, etc. 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.

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 purposes of this article.

Related: An Analysis of Rental Market Trends: Here’s How Typical BiggerPockets Investors May Be Impacted in a Recession

Leverage

The worst advice I’ve ever heard is that it’s OK 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 $83.5k per unit, a 5.75% cap rate on a 5-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 the past 5 years has been tremendous and that will definitely continue for the foreseeable future no matter what forever and ever.

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.

Notice that in no scenario did we even contemplate rent declines or increases in vacancy. These are very reasonable downside assumptions that in no way contemplate some sort of apocalyptic event. 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:

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, and you are 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 certainly 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.

Conclusion

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 when all their friends are taking it in the shorts and your deal is in decent shape? You’re a hero. You might even get kissed on the mouth.

I fully expect that many of the deals being done over the past couple 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.

Do you agree with my take?

Weigh in with a comment!

About Author

Phil McAlister

Phil McAlister is a Chicago-area native and real estate investor. Working for a large national sponsor, Phil has been in charge of the underwriting, financial modeling, and valuation of over $3 billion in commercial real estate, including multifamily, medical office, self-storage, hospitality, and senior housing assets. Phil leads a team in evaluating commercial real estate deals nationwide and across multiple strategies including core, core-plus and value-add, with an occasional ground-up development sprinkled in. Phil is also involved in evaluating and negotiating multi-million dollar joint ventures with various strategic partners. In addition, Phil has been tasked with evaluating projects in Qualified Opportunity Zones, a new and exciting frontier in commercial real estate.

29 Comments

  1. Christopher Smith

    Very timely article. I’ve be wondering for a long while now how these folks willing to pay any price and finance every dollar with debt to do it are going to fair when we hit a bump in the road.

    They seem to be operating in a state of wiiful blindness. Utilizing my criteria (admittedly Buffett like conservative), I stopped buying directly in my locale due to pricing in 2013 (bay area), in all locales in 2016, and indirectly through REITS this year.

    I hung on as long as I could in each market sometimes marginally fudging my own standards to make a buy, but I think you need to live in never never land to justify heavily debt financed acquisitions at these levels. Can’t pretend that much.

    • Phil McAlister

      Thanks, Chris. Takes a lot of discipline to sit on the sidelines and stick to your guns! I hope I wasn’t too negative. Everyone’s strategy is different, but I still think it makes sense to invest here, just has to be eyes wide open, underwriting and structuring properly and accepting the corresponding returns.

    • Phil McAlister

      Thank you, Josh. You’re absolutely right. New investors especially are chomping at the bit to get a deal done. The last thing I want to see is people getting aggressive at the wrong time and souring on real estate. But again, I’m encouraging people to do deals, just be armed with the information that will prevent them from getting monkey-hammered!

    • Phil McAlister

      Thank you for the kind words. I feel like that’s the piece some people miss; it’s a broad based stretch for yield across everything from gov’t bonds to penny stocks.

      I’d be interested in hearing about what markets you’re currently looking in and if you’ve been able to make a deal work in that environment.

  2. Amy Pfaffman

    Thanks for this info! It looks like these scenarios are assuming that the debt has a balloon payment, which might force an investor to sell quickly. If there’s a 10-year amortization with no balloon payment, there’s nothing big and ugly looming in the future, so that would change the picture some.

    So far, I have debt on just the two most recent of my eight houses, but I make sure my cap rate is really good, so even in the worst-case scenario I’m cash positive. I’m still just three years into this scene, so we’ll see how it plays out over the years. So far, so good.

  3. Chad Lanting

    I appreciated the article. As a beginning investor with not even a first deal yet, its difficult to navigate between advice and articles saying to not stay on the sidelines forever (ie just get a deal and learn from it) versus strategies that advise buying deals well below market (difficult for newcomer in current market) and more importantly,those articles such as yours that wisely recommend taking note of where we likely are in the market cycle and not overpaying and over-leveraging to possibly set oneself up for failure. Thanks for the article.

  4. Delaney Ridgley

    I love this discussion but I have to ask: in a bad case or worse case scenario, why would you sell? Shouldn’t you just hold the property and keep cash flowing? We both agree that rent will never decrease (and will probably increase in a poor economy as more people look to rent instead of own). Unless expenses grow at a rate faster than rent to a point where expenses EXCEED rent (which shouldn’t happen unless you were very thin on cashflow to begin with), you should be able to cash flow positive, and it doesn’t make sense to sell. Am I missing something?

    Thanks for the post Phil!

  5. John Keiser

    Great article. I am a new investor anxious to get a deal done and learn from it. But, I understand we’re near the top of the market and I don’t want to get burned to start off my career. Guess I’ll just have to keep my finger on the pulse and run numbers on deals until something clicks just right.

    Glad I discovered BiggerPockets!

  6. Nick Kosko

    Great article and is inline with everything I’m seeing as well in my market. I got my rear handed to me after the last crash and learned quite a few valuable lessons. I’m a much more patient buyer as a result.

    Something to ponder, an even further comparison within your charts. Instead of putting down 4 million why not put down 2 million on 2 properties? If one is buying right then doesn’t that offer us the best long term financial position? Again, I’m assuming a smart buyer and the right properties.

  7. Vaughn K.

    As already mentioned the trick is being able to hold through the downturn.

    Many people who do “fancy” deals use short term financing with balloon payments after 5 years etc. People doing stuff like that now, or possibly in the last couple years, may well find themselves getting their faces ripped off in my estimation.

    However for the guys buying SFR with 30 year loans, or even commercial stuff with longer terms… They should mostly be fine, EVEN IF they’re highly leveraged. If you can talk somebody into a 20 or 25% down on an apartment building, and it is a 10-20 year term… Leverage away. It’s going to come back around. You may be buying towards the top of the market now, but you’ll come out in the black. Trying to time the market is tough, and not getting anything going on, no equity being built, for years while you wait for a market to turn… It doesn’t always work out.

    I’ve been waiting for the Seattle real estate market bubble to pop for years, because it has been beyond where fundamentals say it can be for years. It kept going up due to human irrationality. It FINALLY has gone down the last few months, so it may have finally happened… Or maybe this is a temporary blip and it will return to sharp growth next year, before finally popping for real in 2 years. I just can’t tell the future.

    If you invest in positive cash flow real estate, and have long term financing in place… I wouldn’t worry about it though.

    • Justin M.

      I live in a similar market (Denver) and have been waiting for the same thing to happen. I finally got tired of waiting and just closed on just my second SFR property (had some cash dying in the bank). The numbers worked and I was able to put down 25% on a 30yr, so my cash flow/equity should hold up in a down turn. I am still a bit worried however, and won’t be leveraging it or my other property (I don’t think), until the market shows signs of change.

      • Vaughn K.

        Sounds sensible. At a certain point not making any gains by staying out of the market can end up costing you more than potential losses. If you stay out for 4 years, you’ve lost all that equity building… Since you’re not forced to sell at the low, your only real “loss” is not buying it at a lower price after the dip… But if you’ve built as much equity as the difference between your purchase price and the new lower market value, you’re basically even.

        I’ve decided I’m moving from this mess of a city anyway. I’m going to move somewhere where real estate ISN’T over priced, and you positive cash flow. If you really don’t want to move, and don’t want to leave cash on the sidelines, there are almost always other places to invest that are close to where you live that have better math. That’s what I’d be doing if I didn’t want to move.

  8. Steve Smith

    This was an AMAZING thought provocing article. Thank you VERY much. I look mostly at syndications and doing some searching I have found that there has usually been a drop in rent rates and occupancy in the last two recessions, along with CAP rate changes (usually higher during recessions).

    For this reason I always ask the operator for a stress test using the two last recession numbers to see what would happen in the ‘possible’ worst case scenario. It is amazing how each MSA and sub market is different.

  9. Aaron Riemer

    Considering a situation like this:

    Purchase Price: 110,000
    Principle: 89,000
    Matures in 7 years.

    Rent: 1500 before mortgage and tax.

    If I sell now, I believe I can net enough on this property to pay off the other duplex I currently own with better cash flow. My thinking is that if I can sell in this climate and not be forced into buying another property that I will be in a better position as a buyer when the market turns. Thoughts?

    • Phil McAlister

      You’re in a pretty good spot. It depends on the specifics of your situation. The nice thing is you’ve got 7 years on the loan so your hand isn’t forced. If cash flow on that property is tight, I like the idea of getting a good price now and deleveraging your duplex. But here’s where I do a little CYA and tell you that you should talk with accountants, lawyers, financial advisors to determine what’s right for you 🙂

      If you sell and deleverage the other one, I’d take it a step further and after you pay off the mortgage, set up a line of credit against that building. That way you don’t pay for debt you don’t need, but you have dry powder to jump on the next good deal you find.

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