{"id":145578,"date":"2022-11-15T09:42:47","date_gmt":"2022-11-15T16:42:47","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=145578"},"modified":"2023-08-09T10:19:42","modified_gmt":"2023-08-09T16:19:42","slug":"lines-just-crossed-investors-need-to-be-careful","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/lines-just-crossed-investors-need-to-be-careful","title":{"rendered":"Sounding The Alarm: Two Lines Just Crossed. Here&#8217;s Why Investors Need To Be Really Careful."},"content":{"rendered":"\n\n      <iframe loading=\"lazy\" frameborder=\"0\" height=\"200\" scrolling=\"no\" src=\"https:\/\/playlist.megaphone.fm?e=BIGPOC6128382417&#038;light=false\" width=\"100%\"><\/iframe>  \n\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">You\u2019ve heard about the blue pill and the red pill. But have you heard about the blue line and the green line?&nbsp;&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">You should. Because they recently crossed. Which could be disastrous for some real estate investors. And no, I\u2019m not talking about an <a href=\"https:\/\/www.investopedia.com\/articles\/basics\/06\/invertedyieldcurve.asp\" target=\"_blank\" rel=\"noreferrer noopener\">inverted yield curve<\/a>.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I recently wrote an&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.biggerpockets.com\/blog\/buyers-and-sellers-are-not-on-the-same-page\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">article<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;about the strange time we are in. There is a predictable disconnect between sellers and buyers, and I warned that it could worsen before it improves.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">When that article was published, BiggerPockets CEO, Scott Trench, made the following insightful comment:&nbsp;<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"512\" height=\"223\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/trenchcomment.png\" alt=\"scotttrenchcomment\" class=\"wp-image-145581\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/trenchcomment.png 512w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/trenchcomment-300x131.png 300w\" sizes=\"auto, (max-width: 512px) 100vw, 512px\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This was a great insight, and my hat\u2019s off to you, Scott (and I\u2019m certainly not buttering you up as the BiggerPockets boss. Certainly not).&nbsp;<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">We Are In The Negative Equity Zone<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Green Street is a premier data provider and analyst for the commercial real estate space in the U.S. and Europe. Green Street did a webinar in September called&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/events.greenstreet.com\/green-street\/Navigating-the-Upside-Down-in-Commercial-Real-Estate\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">\u201cNavigating the \u2018Upside Down\u2019 in Commercial Real Estate<\/span><\/a><span data-preserver-spaces=\"true\">.\u201d If you\u2019ve seen&nbsp;<\/span><em><span data-preserver-spaces=\"true\">Stranger Things,<\/span><\/em><span data-preserver-spaces=\"true\">&nbsp;you know this is a strange time indeed.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In this webinar, they made a lot of comments about the current strange environment. Similar to what I said in my article in August. The following graph jumped out at me:&nbsp;<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"512\" height=\"348\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/lower-leveraged-returns.png\" alt=\"lower leveraged returns\" class=\"wp-image-145580\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/lower-leveraged-returns.png 512w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/lower-leveraged-returns-300x204.png 300w\" sizes=\"auto, (max-width: 512px) 100vw, 512px\" \/><figcaption class=\"wp-element-caption\"><em>&#8220;Lower Levered Returns&#8221; &#8211; <a href=\"https:\/\/www.greenstreet.com\/\" target=\"_blank\" rel=\"noreferrer noopener\">Green Street<\/a><\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">First, the graph on the left shows a significant decline in the projected levered returns. Commercial real estate investors should expect lower returns if currently investing in conventional commercial real estate. Popular investments like multifamily are especially at risk.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I\u2019ve been&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.biggerpockets.com\/blog\/why-are-so-many-overpaying-multifamily\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">sounding an alarm bell on this topic for years<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;(even though I wrote a book called&nbsp;<\/span><em><span data-preserver-spaces=\"true\">The Perfect Investment<\/span><\/em><span data-preserver-spaces=\"true\">&nbsp;about multifamily investing in 2016). Multifamily investing is not perfect if you must overpay to get there! It\u2019s just a fact of life.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">When interest rates go up, investors should expect lower ROIs unless purchase <a href=\"https:\/\/www.biggerpockets.com\/blog\/cap-rate-real-estate\" target=\"_blank\" rel=\"noreferrer noopener\">cap rates<\/a> expand accordingly. That\u2019s the situation we are in for syndicators and investors who are paying \u201cfull price\u201d for multifamily and many other commercial assets. Be sure you don\u2019t do this, especially right now. Why?&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I recently heard a multifamily syndicator lament that he had been outbid on a $20 million+ apartment deal in the Midwest. He said the winner outbid him by approximately $2 million and acquired this asset at a 3% cap rate! He said there was not that much value-add available. I can\u2019t imagine how that will end up for their investors. It\u2019s hard to imagine how that will end well.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Look at the second graph. As I warned and Scott Trench clarified a few months ago, we are in a strange time where interest rates have gone up dramatically, but cap rates have yet to follow, at least not much.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The blue line (interest rate) should never meet or exceed the green line (cap rate). For the most part, the cap rate should always exceed the interest rate by what I will refer to as a \u201crisk premium.\u201d In other words, the risk of investing in commercial real estate, or any real estate, is higher than investing at the risk-free rate (buying U.S. Treasuries). Therefore, it should significantly exceed the blue line (interest rate) here.&nbsp;&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">It\u2019s actually a little worse than that in this situation, however, because current commercial loans are priced with an additional premium reflecting the additional risk institutional investors see in the commercial space right now.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The following graph shows what I mean. Note the spread from 0.93% to 1.67%, an increase of almost 80%. It\u2019s just a fact that credit markets are tightening, and lenders want to get paid more than they did when \u201ceveryone was happy, and nothing could go wrong\u201d over the past decade.&nbsp;<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"512\" height=\"368\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/higher-debt-costs.png\" alt=\"higher debt costs\" class=\"wp-image-145579\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/higher-debt-costs.png 512w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/higher-debt-costs-300x216.png 300w\" sizes=\"auto, (max-width: 512px) 100vw, 512px\" \/><figcaption class=\"wp-element-caption\"><em>&#8220;Higher Debt Costs&#8221; &#8211; Green Street<\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">So, interest rates have shot up from 3% to 5%. Cap rates have not followed yet. Why?&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I think part of the reason is that there\u2019s been substantial training, coaching, and excitement in the syndication world over the last decade, especially in multifamily. All kinds of new players have thrown their hats in the ring. And many of them didn\u2019t experience the pain of the last several recessions, while many of the more experienced cohorts remember those quite well.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Many syndicators and their investors are so excited to finally get a chance at a deal! They proceed to pay full asking price or thereabouts for suddenly overpriced commercial real estate assets. Instead of bidding against 60 other well-funded players, as before, perhaps they\u2019re only duking it out with three or four others. After studying and courting investors and longing for a deal for years, they finally have their chance.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But the question is, who is getting the short end of the stick? It may not even be the syndicator because they often charge hefty acquisition fees, asset management fees, property management fees, and more.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong><span data-preserver-spaces=\"true\">Their investors could be victims. I\u2019m writing today so that you don\u2019t become one of them.&nbsp;<\/span><\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">These \u201cnewrus,\u201d as I call them (new gurus), sometimes tell investors, \u201cit\u2019s different this time.\u201d Unfortunately, they may believe that themselves.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But trees don\u2019t grow to the sky. And as economist Howard Stein wryly remarked, \u201cIf things can\u2019t go on forever, they will eventually stop.\u201d&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">As I often say, the tide has risen for everyone over the past decade. But as Warren Buffett often says, \u201cSomeday the tide will go out, and we will see who is swimming naked.\u201d&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">We might be coming into a time like this.<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Negative Leverage<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Many commercial real estate deals and their investors have entered an era of \u201cnegative leverage<\/span><em><span data-preserver-spaces=\"true\">.<\/span><\/em><span data-preserver-spaces=\"true\">\u201d Negative leverage is when an asset is acquired at a cap rate below the interest rate on the debt used to finance it. Our Wellings Capital Director of Investments, Troy Zsofka, explained this situation to me.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In this case, leverage is no longer accretive to the return profile and becomes a burden that puts downward pressure on equity returns (hence the term \u201cnegative leverage\u201d). Furthermore, increased debt service reduces the <a href=\"https:\/\/www.investopedia.com\/terms\/l\/loantovalue.asp\" target=\"_blank\" rel=\"noreferrer noopener\">LTV<\/a> at which lender-required Debt Debt Service Coverage Ratios (DSCRs) can be met, thereby requiring additional equity in the capital stack, further diluting investor returns.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">One may ask how, then, it could ever make sense to purchase properties using negative leverage.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In my experience, one way these sponsors get the investment to pencil is to assume continued rent growth. This growth will eventually result in a \u201cforward-looking cap rate,\u201d if you will, that is higher than the interest rate on the debt. In other words, they grow their NOI out of the problem.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But this is clearly a risky endeavor when downside potential is governed by market forces outside an operator\u2019s control.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Another way to justify negative leverage, as Scott Trench said, is with a heavy value-add deal that relies on expeditious execution so that the upside potential mitigates the negative leverage position.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Relying on execution to go exactly to plan to protect the downside is also a risky endeavor, especially for many less experienced syndicators, and it often doesn\u2019t make sense from a risk-adjusted return perspective.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">To the first point, I often see offerings that tout the market&#8217;s historical rent growth, highlighting that Phoenix or Austin, for example, have experienced 18%+ rent growth over the past two years. The inference is that this is somehow indicative of the future as if this growth rate will continue. This justifies using 8-10% rent growth in the pro forma underwriting assumptions and calling it conservative!<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In my opinion, the fact that a market has experienced outsized rent growth in recent years is, if anything, indicative of the exact opposite\u2014it can be unsustainable. Rent growth typically stagnates to some extent for equilibrium to be reached.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Decreasing housing affordability is a headwind to continuing in-migration to a market, and continued demand growth should, therefore, not be relied upon to sustain outsized rent growth.<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">How can you fail in this environment? Let me count the ways\u2026<\/span><\/h3>\n\n\n\n<ul class=\"wp-block-list\">\n<li><span data-preserver-spaces=\"true\">Acquire a \u201cmarket rate\u201d (often brokered) deal with \u201ctypical\u201d leverage at the current interest rate.&nbsp;&nbsp;<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Make a bad situation worse by adding an extra layer of preferred equity to compensate for increased rates, lower allowable leverage, and falling return projections.&nbsp;<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Drag a bunch of unsuspecting passive investors into the mix, promising them a great opportunity to create income and grow their wealth. These are known as victims.&nbsp;<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Worst of all: be that unsuspecting victim.&nbsp;<\/span><\/li>\n<\/ul>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">How can you succeed in this environment?&nbsp;<\/span><\/h3>\n\n\n\n<ul class=\"wp-block-list\">\n<li><span data-preserver-spaces=\"true\">Acquire an off-market under-managed, underpriced deal with lots of predictable upside.<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Create that upside through your experienced team and well-honed process.&nbsp;<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Acquire the above through preferable loan terms (like owner-financed or assumable debt). Or acquire for cash and refinance someday. Or hold in cash.&nbsp;<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Invest with an experienced syndicator or fund manager who specializes in the above.&nbsp;<\/span><\/li>\n<\/ul>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">A Final Word About Banks<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Banks aren\u2019t stupid. As the largest investors in most commercial real estate deals, banks are obviously wary of making bad deals and losing money. Many of their junior staff weren\u2019t around for past downturns. Some are still eager to make loans, hit their quotas, etc.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But most banks have some seasoned professionals who have been around the block. Many of them are tightening the commercial lending noose as we speak. So watch for a significant decrease in lenders willing to make commercial loans in the coming days. It has already started.&nbsp;&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Conservative bankers often overreact to cover their risk. So it is possible that many of these bad deals won\u2019t even get to closing, which could protect some of you from a bad investment.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But please don\u2019t trust bankers to protect you from harm. Instead, do your own due diligence. Learn to be an intelligent investor and partner with others who have successfully weathered these storms in past decades. Pain + Years = Wisdom. At least in some cases.&nbsp;<\/span><\/p>\n\n\n\n<div id=\"hero-block_62ee867235a1c\" class=\"first:mt-0 hero-block py-4    has-background has-slate-300-background-color has-text-color has-slate-800-color\">\n    <div\n        class=\"gap-10 lg:gap-20 flex flex-wrap lg:flex-nowrap max-w-screen-xl mx-auto px-4 relative lg:items-center \">\n\n        <div class=\"relative z-30 lg:w-2\/3 \">\n            <main class=\"py-4\">\n                \n\n<p class=\"has-theme-slate-color has-text-color has-large-font-size wp-block-paragraph\" style=\"font-style:normal;font-weight:800\">Learn how to invest in self-storage!<\/p>\n\n\n\n<p class=\"my-3 md:my-5 lg:my-8 has-theme-slate-color has-text-color wp-block-paragraph\" style=\"font-size:16px\">Investing in\u00a0self-storage\u00a0is an often overlooked real estate strategy that can accelerate your income and compound your wealth with minimal active management.<\/p>\n\n\n\n<div id=button-custom-event-block_64138705d4d27 class='button-custom-event'>\n      <a href=\"https:\/\/store.biggerpockets.com\/products\/storing-up-profits?utm_source=blog&#038;utm_medium=marketing_block\" x-on:click=\"window.analytics.track(&#039;Blog Block | Publishing: Storing up Profits Book&#039;, {\n      referrer: &#039;https:\/\/www.biggerpockets.com\/blog\/lines-just-crossed-investors-need-to-be-careful&#039;,\n    });\" class=\" btn-shape inline-block no-underline has-background has-theme-blue-background-color has-text-color has-white-color\" target=\"_blank\">Get Yours Now<\/a>\n  <\/div>\n\n            <\/main>\n        <\/div>\n\n                <div class=\"lg:w-1\/3 first:mt-0 relative h-full lg:flex lg:items-center\">\n            <img decoding=\"async\" class=\"object-cover w-full relative z-20 my-0  rounded-md hidden lg:block\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2021\/11\/Storing-Up-Profits-3d.png\" alt=\"\" title=\"\">\n        <\/div>\n            <\/div>\n<\/div>","protected":false},"excerpt":{"rendered":"<p>You\u2019ve heard about the blue pill and the red pill. But have you heard about the blue line and the green line?&nbsp;&nbsp; You should. Because they recently crossed. Which could [&hellip;]<\/p>\n","protected":false},"author":214608,"featured_media":145586,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4433,7119],"tags":[],"class_list":["post-145578","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-opinion","category-biggerpockets-daily"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/145578","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/214608"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=145578"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/145578\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/145586"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=145578"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=145578"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=145578"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}