The Current MF Market and Potential Repercussions of a Correction

Multi-Family and Apartment Investing
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The Current MF Market and Potential Repercussions of a Correction

Jason V.
Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes

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!

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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
9y

@Jason V. your cautious mind will serve you well.  You are right to be concerned but you can prepare for the worst ahead of time to mitigate some of your downside risk.

It starts with the acquisition underwriting.  It's too risky to underwrite to perfection, yet people do it all the time (oftentimes to their own demise).  In my opinion, at some point during the investment cycle of any property purchased now, there will be an adverse market cycle.  You want to make sure that your underwriting is conservative enough such that you can ride through the adverse cycle and sell at the next market cycle peak.

This means factoring in a higher than market vacancy rate.  And a conservative collection loss.  And for move-in concessions even if those aren't currently being offered.  Because in a downturn all of these things will be part of your daily vocabulary.

Your capital structure should reflect the reality of your business plan.  In other words, you don't want a five year loan if the plan is to hold for 20 years.  Nor do you want a 10 year loan with yield maintenance if your plan is to sell in three years.  But you also don't want a 3-year loan because your maturity could be ill-timed if your three year exit plan is thwarted by an adverse cycle.  And in all cases, you don't want to over-leverage.  This is the biggest risk factor and yet people do it all the time. 

How do you avoid being over-leveraged? Value-add is a must. Maybe you buy with 75% leverage but after improving the property and raising the income, the value goes up and by year 2 or 3 you are at 55% to 65% LTV. You can refinance and take cash out using the higher value, which will increase your risk because of the higher leverage, but decrease your risk if you have little to no capital in the deal. The risk is transferred to the lender to an extent, as long as the debt is non-recourse. And of course you're using non-recourse leverage, right? Well, easier said than done in smaller deals but for larger deals it's much more common. If the debt has to be recourse, you might want to re-think the cash-out refinance strategy.

As to your question about factoring reserves into the CoC and IRR, the answer is no. You can still invest those funds--either in interest bearing accounts, stocks, mutual funds...anything liquid, and earn a return. And one set of reserves can be used for multiple loans. In other words, if your lender requires 6 months PITI, you could have a lot of loans covered by the same amount, you don't have to have 6 months PITI for every loan (just the biggest one and the rest will be covered).

As to cap rate, yes you should expect them to rise.  You should be underwriting your exit to a higher cap rate than is market today.  But realize that interest rates and cap rates don't trend in parallel.  They are related, but more like third cousins. 

Speaking of market cap rate, you can't take the seller's income and divide it by the purchase price to arrive at a market cap rate. That is an over-simplification. Just calculating the cap rate from the asking price or purchase price requires that you adjust the property taxes for what they will be after you buy (called a tax-adjusted cap rate, which is more true than an unadjusted rate). And that's still not a market cap rate. That can only be ascertained by calculating the tax-adjusted cap rate of other properties that have sold in the submarket that are similarly situated and of the same class. The market cap forms the basis for your exit planning, it really has no other bearing on the price you should pay. Your strike price comes from underwriting to an IRR as you work backwards from your forecasted exit price and map out the annual income given your forecasts for rent growth and economic vacancy factors and layering on expense growth inflation and cost of debt.

And since the value is dictated by the income, investing in areas where rents are likely to rise the most gives the best hedge.  Believe it or not, rents can actually come down (gasp!) and that will cause a decline in property value for two reasons--the declining income and a decompressing cap rate (which will happen because the real estate is less desirable without the rent growth). 

This is why I buy value-add class B & C properties in growth markets.  You need both the value add and the strong job growth driving rents to successfully execute a multifamily strategy given where we are in the cycle today.

Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
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  • Bill S.Pro Member
    Moderator
    Rental Property Investor · Denver, CO · Member since 2013 · 4k+ posts · 2k+ votes
    9y

    @Jason V. great question. I have wondered that myself. Perhaps we can get some insite by tagging a few of the great apartment minds here on BP. Like @Ben Leybovich, @Joe Fairless, and @Brian Burke 

    3Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y

    @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!

    0Reply
  • David Thompson
    Investor · Austin, TX · Member since 2013 · 933 posts · 1k+ votes
    9y

    Jason,

    You e raise some good points.  I'll make a few comments.  

    1) Market - be in the strongest and most diversified markets (w/job and pop growth historically and future expected above natl averages).  Example: Dallas and many TX markets make sense.  Dallas has 28 submarkets, be in the top 5 as an example.

    2) Deal - must be value add Class B/C with conservative assumptions.  Don't fudge your numbers to fit.  Do a sensitivity analysis on rental rates, occupancy, interest rates and cap rates and make sure your model can stand up to swings and will you still be ok?  Re; cap rates for instance, a super strong market / submarket will damper cap rate expansion to some extent.  Just because interest rates go up its certainly not lock step that cap rates go up the same degree.  There's about 7 factors that influence cap rates.  That said, you definitely should project some basis point rise in cap rates into your exit plan regardless of market conditions / forecast as a good conservative move.  

    Stick with class type (B/C), not A, has much lower beta in a downturn. What you see in a lot of the data is A class that often gets overbuilt, over supplied and that is where developers will get hurt. So when you are reviewing national reports keep this in mind. Lenders are getting concerned in some cities with A class.  Class B/C value add hold up much better to downturns as this is the bread n butter tenant (think two earner income families - service type jobs making $30K each can swing a 2-3 bedroom for $1K/mo vs $2K/mo for Class A).  We saw this in Houston w/a partner who had 10 properties and weathered the downturn in that city when oil went from $100 barrel to $50 barrel.  Class A occupancy fell 15-20% in certain areas of the city while the occupancy at their properties was steady at around 92% and actually trended up slightly to 93% during that time. 

    3) Valuation model of commercial vs residential favors you in larger MF.  See the blog I wrote on this recently on why I like large apartments which talks about scale and valuation modeling advantages around forced appreciation.  Skilled syndicators are continuing to make money in this area.  You may want to play passively as a limited partner if you are accredited and earn/learn or help out a syndicator to gain experience to see how they are doing it.  Not saying its getting easier to find deals and competition is stiff, but opportunities are still there and we like the long trends here in renter demand for the specific niche we target.

    https://www.biggerpockets.com/blogs/9145/53820-why...

    8Reply
  • Chris K.
    Attorney · Nashville, TN · Member since 2015 · 1k+ posts · 1k+ votes
    9y

    Hi @Jason V.

    A few questions for you to clarify the scenario:

    1. What did you do with that $1 million you received when you re-financed?

    2. How did you initially plan to deal with that balloon in year 5? 

    0Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y
    Originally posted by @Chris K.:

    Hi @Jason V.

    A few questions for you to clarify the scenario:

    1. What did you do with that $1 million you received when you re-financed?

    2. How did you initially plan to deal with that balloon in year 5? 

    1. It wouldn't be $1 Million, it would be the difference between the loan balance before refinance and 75% of the new value of the property (assuming a 75% LTV based on the new stabilized price.) In this case, it would probably be around $245,000 cash out, or about what I would have put down on the property in the first place. Typically, that money is taken and used as a down payment for the next property. If done correctly (not necessarily like this example, which just made for easy math) the investor typically gets substantially more cash out at refinance than they put in intially, in addition to continuing to control the asset. Hence the popularity of commercial MF investing, as well as the BRRRR strategy (which is just what commercial investors have always been doing, but applied to SFRs.)

    2. Typically the loan is re-upped, often with the same lender, but not always. Many investors plan on refinancing on a somewhat regular schedule, based on the performance of the property, resetting the 20 or 25 year amortization period every time. The full term of the loan might never be reached in this case. You can get pretty deep on this topic, with some really intense math and theory about the optimal time to exit or refinance, that I can't even begin to follow. Some of the very smart people Bill S. mentioned could speak to these things, but I'm definitely not the person to ask. 

    0Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y

    @David Thompson - Thanks for your reply, that is some great information to have! 

    I've been trying to get a handle on market selection, but for me to be able to do it well, as a part-time investor who has a day job (and then some) feels kind of like picking individual stocks to me. The biggest, best RE firms in the country can't agree on markets, and sometimes get it really, really wrong - how can a guy like me get it right? (That's an honest question, not a snarky response, I promise.) 

    I'm definitely with you on the B/C properties, particularly value-add opportunities. The problem is, so is everyone else! I keep remembering what I heard a guest (Serge) say on a podcast: Multi-family is a very competitive sector, with very small profit margins. What makes you think you can do it better than the current experts in the field? Again, not being sarcastic - I have to find a way to be competitive with both local investors, and National level outfits. It's tough!

    And my comment on interest rates has more to do with the total investment outlook than just the lending side. If interest rates go up, rates on bonds and CDs are likely to go up as well as the other 'traditional' investment returns. This is going to draw investors away from RE, REITs, syndicated deals, etc. and lessen the demand for MF, especially large MF, significantly. I think this might be the biggest driver of change in the market, besides increased interest rates. (That's one amateur's perspective anyway - I could be 100% wrong.) 

    Maybe the best bet for me at this point is to try to work along side a syndicator, even though I have zero interest in syndicating a deal myself (just my personality) but the time is a tough commitment to me. 

    But just having this conversation is very helpful to me as I try to plan the next 5-7 years. Thanks David!

    3Reply
  • Chris K.
    Attorney · Nashville, TN · Member since 2015 · 1k+ posts · 1k+ votes
    9y
    Originally posted by @Jason V.:
    Originally posted by @Chris K.:

    Hi @Jason V.

    A few questions for you to clarify the scenario:

    1. What did you do with that $1 million you received when you re-financed?

    2. How did you initially plan to deal with that balloon in year 5? 

    1. It wouldn't be $1 Million, it would be the difference between the loan balance before refinance and 75% of the new value of the property (assuming a 75% LTV based on the new stabilized price.) In this case, it would probably be around $245,000 cash out, or about what I would have put down on the property in the first place. Typically, that money is taken and used as a down payment for the next property. If done correctly (not necessarily like this example, which just made for easy math) the investor typically gets substantially more cash out at refinance than they put in intially, in addition to continuing to control the asset. Hence the popularity of commercial MF investing, as well as the BRRRR strategy (which is just what commercial investors have always been doing, but applied to SFRs.)

    2. Typically the loan is re-upped, often with the same lender, but not always. Many investors plan on refinancing on a somewhat regular schedule, based on the performance of the property, resetting the 20 or 25 year amortization period every time. The full term of the loan might never be reached in this case. You can get pretty deep on this topic, with some really intense math and theory about the optimal time to exit or refinance, that I can't even begin to follow. Some of the very smart people Bill S. mentioned could speak to these things, but I'm definitely not the person to ask. 

     1. Sorry---what I meant was the $245k cash out that you mentioned. I think part of the answer to your question has to factor in what you do with that $245k cash. 

    2. This I think is the crucial question. Typically the loans that I see in the area has the note ballooning at anywhere between year 10 to 15. So let's say the note balloons at year 15. When I underwrite my properties, I look at what happens on year 5, 10, and 15 to see what my IRR is.

    Having a note that balloons on year 5 can get tricky for number of reasons. While other's may disagree, a traditional loan that balloons on year 5 means you would need to have multiple ways to deal with the balloon in case re-financing is not possible at that time for whatever reason. So the question is what were your initial plans if you couldn't refinance on year 5? 

    0Reply
  • Diane G.
    CA · Member since 2016 · 1k+ posts · 1k+ votes
    9y

    @Jason V.

    You asked some very valid questions, and those are exactly what i asked myself the last 2-3 months....And my conclusion is commercial is so much more risky, and now is a horrible time to get into it.... You could lose your shirt entirely!!!!!

    If there is one thing that I learned about RE is that you don't EVER want a balloon payment which is very common with commercial loans.....In bad times, if your property dropped in value, and you can't refinance it, you are heading right to foreclosure......

    1Reply
  • Diane G.
    CA · Member since 2016 · 1k+ posts · 1k+ votes
    9y

    @Jason V.

    Personally I would only take on a commercial at the beginning stage of a recovery, not the tail end....

    2Reply
  • Jeff B.
    Buy & Hold Owner · Redlands, CA · Member since 2015 · 5k+ posts · 2k+ votes
    9y
    Originally posted by @Diane G.:

    @Jason V.

    You asked some very valid questions, and those are exactly what i asked myself the last 2-3 months....And my conclusion is commercial is so much more risky, and now is a horrible time to get into it.... You could lose your shirt entirely!!!!!

    If there is one thing that I learned about RE is that you don't EVER want a balloon payment which is very common with commercial loans.....In bad times, if your property dropped in value, and you can't refinance it, you are heading right to foreclosure......

    So true for SFRs, but the MFU 5+ has multiple rents and the more doors, the more immune you become. Additionally, not all commercial loans have a balloon payment. There in No. Calif, you're into a tough market, but buying right, having good cash flow and NOI will make the refi a cake walk. MFUs don't decline due to neighborhood Comps; you have control over the property evaluations via the rents - - it's call Forced Appreciation.

    1Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y
    Originally posted by @Jeff B.:
    Originally posted by @Diane G.:

    @Jason V.

    You asked some very valid questions, and those are exactly what i asked myself the last 2-3 months....And my conclusion is commercial is so much more risky, and now is a horrible time to get into it.... You could lose your shirt entirely!!!!!

    If there is one thing that I learned about RE is that you don't EVER want a balloon payment which is very common with commercial loans.....In bad times, if your property dropped in value, and you can't refinance it, you are heading right to foreclosure......

    So true for SFRs, but the MFU 5+ has multiple rents and the more doors, the more immune you become. Additionally, not all commercial loans have a balloon payment. There in No. Calif, you're into a tough market, but buying right, having good cash flow and NOI will make the refi a cake walk. MFUs don't decline due to neighborhood Comps; you have control over the property evaluations via the rents - - it's call Forced Appreciation.

     Jeff - you're saying that having 5 multifamily units in a building will have lower vacancy than 5 SFRs? From what I've seen, that opinion goes against the grain.

    And if you buy multifamily you can just raise rents as much as you want whenever you want? I was under the impression the market drove rent prices, and in a potential down market like we're talking about, rents would be flat or go down. And of course the biggest factor in determining value of a MF property is cap rate, which is market driven as well. And if the Fed raises The Rate by half a percent, you can pretty much guarantee cap rates will rise significantly more than that, decreasing the value of properties drastically. 

    But I was under the impression pretty much all loans for commercial multifamily properties were 5 to 7 year terms, with much longer amortization periods, so it's good to know there's at least a chance for 20-30 year fixed rate term loans for commercial stuff. Thanks!

    1Reply
  • Marc C.
    Buy-and-Hold Rental Investor · Santa Fe, NM · Member since 2015 · 438 posts · 352 votes
    9y

    Actually posted about this a couple of months ago after the Trump Effect brought MF interest rates up .75%. 

    It's all about the cash returns. YES, it now costs more to borrow. So, if x% cap bought you x% CoC return 3 mos. ago, the same x% cap rate now brings you a lower cash return. How to avoid that? Pay a lower price or put less down. Since the latter isn't feasible in most deals, you need to pay less for properties today than you did on Nov. 7, 2016. How much less depends on your spreadsheet calculations.

    Cap rates DO go up. The Law of Averages is a law. Things revert to the mean in most cases. 

    How to avoid? You need to be using an EXIT cap in your calculations that is higher than your purchase cap. For example, I'm currently in an area with 7.2% average caps. Do I think they will be 7.2% in 5 years? 10 years? Nope. So, I plug in an 8.5% cap rate as my exit cap. Result? Little to no appreciation; possible decline in values. What to do? Buy at an 8.5% cap now, or do something to the building that will make it still be a 7.2% cap in 5 years. 

    As for loans: You are taking a big risk if you take out a loan with a 5 year call right now. Look for 10 year money so you can make it through the downturn. 

    Does that mean we should cower in fear and not buy commercial RE? No, that's not logical. Proper planning and budgeting is always key. Once again, it's all in what you pay when you buy. Play with all the possible scenarios and always choose a conservative approach.  And NEVER believe the broker's pro-forma. Ever. Never. 

    5Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y
    Originally posted by @Marc C.:

    Actually posted about this a couple of months ago after the Trump Effect brought MF interest rates up .75%. 

    It's all about the cash returns. YES, it now costs more to borrow. So, if x% cap bought you x% CoC return 3 mos. ago, the same x% cap rate now brings you a lower cash return. How to avoid that? Pay a lower price or put less down. Since the latter isn't feasible in most deals, you need to pay less for properties today than you did on Nov. 7, 2016. How much less depends on your spreadsheet calculations.

    Cap rates DO go up. The Law of Averages is a law. Things revert to the mean in most cases. 

    How to avoid? You need to be using an EXIT cap in your calculations that is higher than your purchase cap. For example, I'm currently in an area with 7.2% average caps. Do I think they will be 7.2% in 5 years? 10 years? Nope. So, I plug in an 8.5% cap rate as my exit cap. Result? Little to no appreciation; possible decline in values. What to do? Buy at an 8.5% cap now, or do something to the building that will make it still be a 7.2% cap in 5 years. 

    As for loans: You are taking a big risk if you take out a loan with a 5 year call right now. Look for 10 year money so you can make it through the downturn. 

    Does that mean we should cower in fear and not buy commercial RE? No, that's not logical. Proper planning and budgeting is always key. Once again, it's all in what you pay when you buy. Play with all the possible scenarios and always choose a conservative approach.  And NEVER believe the broker's pro-forma. Ever. Never. 

     Great answer, thanks Marc!

    Practical question: it's easy enough to figure out what cap rate the seller is using to determine their price (if they don't state it outright.) Do you justify your offers by giving them the cap rate you're figuring on and why? The MF market is just crazy hot right now, with a lot of properties selling for "perfection" and maybe I'm just trying to talk myself out of putting the work in because I know the odds are pretty long right now. In any event, yours is a simple solution I hadn't thought of - thanks!

    0Reply
  • Mike Dymski
    Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
    9y

    Excellent feedback above.

    Most commercial investors will match their debt structure with their strategy and if the plan is to hold long term, they get a long term loan instead of a 5 year bullet.  10 year fixed rate, 30 year amortization is common and you can get hybrid products that convert to a variable rate after the fixed period and have no balloon.  I have a 25 year commercial loan (no balloon) that is fixed for 7 years.  The notion that commercial financing is so unfavorable relative to residential is false.  Fannie and Freddie took only minuscule losses during the recession on their multifamily products and their current offerings continue to have excellent terms.  They stress test the property numbers, specifically at the balloon point (if applicable), and will not lend if the property does not meet their underwriting criteria.  As others above have mentioned, we should stress test our numbers as well.

    Good post.

    3Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y
    Originally posted by @Mike Dymski:

    Excellent feedback above.

    Most commercial investors will match their debt structure with their strategy and if the plan is to hold long term, they get a long term loan instead of a 5 year bullet.  10 year fixed rate, 30 year amortization is common and you can get hybrid products that convert to a variable rate after the fixed period and have no balloon.  I have a 25 year commercial loan (no balloon) that is fixed for 7 years.  The notion that commercial financing is so unfavorable relative to residential is false.  Fannie and Freddie took only minuscule losses during the recession on their multifamily products and their current offerings continue to have excellent terms.  They stress test the property numbers, specifically at the balloon point (if applicable), and will not lend if the property does not meet their underwriting criteria.  As others above have mentioned, we should stress test our numbers as well.

    Good post.

     I think this might be one of the biggest things I take away from this post: get 20, 25, or 30 year financing with no balloon and leave some room for rates to go up after the initial fixed period. One of the biggest concerns I had was having to refinance after the initial 5 or 7 year term, and as others have noted, this might be a really tough time in the market. That particular aspect of MF investing was what concerned me the most. 

    It's also nice to be reminded that most/all commercial lenders are likely going to be conservative enough that if they lend to me, I'm probably in OK shape - I wasn't aware the crash was quite so isolated to SFRs from a foreclosure standpoint, but that's very reassuring. 

    Thanks Mike!

    3Reply
  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    9y

    @Jason V. your cautious mind will serve you well.  You are right to be concerned but you can prepare for the worst ahead of time to mitigate some of your downside risk.

    It starts with the acquisition underwriting.  It's too risky to underwrite to perfection, yet people do it all the time (oftentimes to their own demise).  In my opinion, at some point during the investment cycle of any property purchased now, there will be an adverse market cycle.  You want to make sure that your underwriting is conservative enough such that you can ride through the adverse cycle and sell at the next market cycle peak.

    This means factoring in a higher than market vacancy rate.  And a conservative collection loss.  And for move-in concessions even if those aren't currently being offered.  Because in a downturn all of these things will be part of your daily vocabulary.

    Your capital structure should reflect the reality of your business plan.  In other words, you don't want a five year loan if the plan is to hold for 20 years.  Nor do you want a 10 year loan with yield maintenance if your plan is to sell in three years.  But you also don't want a 3-year loan because your maturity could be ill-timed if your three year exit plan is thwarted by an adverse cycle.  And in all cases, you don't want to over-leverage.  This is the biggest risk factor and yet people do it all the time. 

    How do you avoid being over-leveraged? Value-add is a must. Maybe you buy with 75% leverage but after improving the property and raising the income, the value goes up and by year 2 or 3 you are at 55% to 65% LTV. You can refinance and take cash out using the higher value, which will increase your risk because of the higher leverage, but decrease your risk if you have little to no capital in the deal. The risk is transferred to the lender to an extent, as long as the debt is non-recourse. And of course you're using non-recourse leverage, right? Well, easier said than done in smaller deals but for larger deals it's much more common. If the debt has to be recourse, you might want to re-think the cash-out refinance strategy.

    As to your question about factoring reserves into the CoC and IRR, the answer is no. You can still invest those funds--either in interest bearing accounts, stocks, mutual funds...anything liquid, and earn a return. And one set of reserves can be used for multiple loans. In other words, if your lender requires 6 months PITI, you could have a lot of loans covered by the same amount, you don't have to have 6 months PITI for every loan (just the biggest one and the rest will be covered).

    As to cap rate, yes you should expect them to rise.  You should be underwriting your exit to a higher cap rate than is market today.  But realize that interest rates and cap rates don't trend in parallel.  They are related, but more like third cousins. 

    Speaking of market cap rate, you can't take the seller's income and divide it by the purchase price to arrive at a market cap rate. That is an over-simplification. Just calculating the cap rate from the asking price or purchase price requires that you adjust the property taxes for what they will be after you buy (called a tax-adjusted cap rate, which is more true than an unadjusted rate). And that's still not a market cap rate. That can only be ascertained by calculating the tax-adjusted cap rate of other properties that have sold in the submarket that are similarly situated and of the same class. The market cap forms the basis for your exit planning, it really has no other bearing on the price you should pay. Your strike price comes from underwriting to an IRR as you work backwards from your forecasted exit price and map out the annual income given your forecasts for rent growth and economic vacancy factors and layering on expense growth inflation and cost of debt.

    And since the value is dictated by the income, investing in areas where rents are likely to rise the most gives the best hedge.  Believe it or not, rents can actually come down (gasp!) and that will cause a decline in property value for two reasons--the declining income and a decompressing cap rate (which will happen because the real estate is less desirable without the rent growth). 

    This is why I buy value-add class B & C properties in growth markets.  You need both the value add and the strong job growth driving rents to successfully execute a multifamily strategy given where we are in the cycle today.

    Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
    11Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y

    @Brian Burke - Thanks so much for taking the time to respond to this post! Among all the other great information, you walked me through a couple of points I've really been struggling with in considering the jump to commercial MF properties.

    I would love to be able to get non-recourse loans, but from the research I've done (talking to some commercial mortgage brokers and listening to a couple of guests that are brokers on podcasts) it's likely I'll have to work my way up into that size property, which I really don't have a problem with. In my current situation, a $500,000 note isn't something that would terrify me to have to give a personal guarantee on, and would also give me some of the requisite experience to move up into the next, larger property, and so on. I believe my other option would be to partner on a deal with someone who does have the experience to do a deal large enough to get non-recourse loans, correct?

    Buy Value-Add B & C in Growth Markets...sounds so simple when you put it like that :-) But seriously, I've been trying to figure out the market analysis piece for a while, and I still feel like I'm picking stocks (maybe not that bad, but still.) I know what I think are the key indicators, and I think I have reliable sources of information, but I'd love if you could share some of what you look for when identifying growth markets. 

    I'm going to force myself to walk away from the computer now: I could easily burn up your whole day picking your brain if you let me, but I'll try to be respectful. Thanks again for your input Brian, I really appreciate it!

    0Reply
  • Jeff Dulla
    Lender · Western Springs, IL · Member since 2015 · 472 posts · 245 votes
    9y

    Thanks @Jason V. @Brian Burke @David Thompson - this has been one of the more insightful posts I have read in a while. Sincerely, thank you.

    2Reply
  • Mike Dymski
    Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
    9y

    Jason, I will leave it to Brian to cover the market analysis because that's right in his wheelhouse and what he spends a lot of his energy on.

    I will add though that if you are looking for a small MF property, you don't have to land in one of the national emerging markets that will be on the radar of many larger syndicators. I live on the I-85 corridor between Atlanta and Raleigh and many of the cities in-between would not be considered emerging but they have had modest steady growth for decades. Good climate, close to beaches and mountains, friendly people, and business-friendly governments. There are likely pockets of these places all over the country. Huge rent increases over time are not likely nor are huge decreases. For example, property values in my market declined around 5% (maybe 10%) during the recession and my rents actually went up a little. And if you buy a value add, you may not be as concerned with big rent increased down the road because you already achieved the big ticket gain in your expected IRR with the forced appreciation. Many of these properties can be purchased far below replacement cost, which also mitigates risk.

    You are wise to question financing risk and are asking all the right questions.  One of the primary causes of MF failure during any recession is an improper debt structure and the related lack of capital to properly maintain the property.  If you are a podcast guy, check out Old Capital Lending.  They just did a five minute "ask Mike Monday" podcast on avoiding foreclosure.  One of their team members is a BP member and they also have free white papers on apartment lending and other topics.

    When you get past the financing and market analysis, let's discuss property management.  IMO, that is the toughest aspect (and maybe largest risk) of small MF because the property management industry does not have a model that services that space in the market.  It's a bigger deal than it sounds like it would be.

    @Jeff Dulla my goal is to improve my replies so that I make it to your thank you list.  Kidding aside, it's great hearing from these professionals...a lot more targeted than any book or seminar.

    5Reply
  • Jeff Dulla
    Lender · Western Springs, IL · Member since 2015 · 472 posts · 245 votes
    9y

    @Mike Dymski Haha, sorry about that. I was still in a haze chasing my 1.5 year old around. It is true, men cannot properly multitask. 

    I took away something from all of your responses and do appreciate the knowledge. 

    1Reply
  • Ian WalshBusiness Member
    Lender · Philadelphia, PA · Member since 2016 · 2k+ posts · 1k+ votes
    9y

    This is a real concern on people's radar.  Nice thought on this write up.  

    0Reply
  • Jeff B.
    Buy & Hold Owner · Redlands, CA · Member since 2015 · 5k+ posts · 2k+ votes
    9y
    Originally posted by @Jason V.:
    Originally posted by @Jeff B.:
    Originally posted by @Diane G.:

    @Jason V.


    •  Jeff - you're saying that having 5 multifamily units in a building will have lower vacancy than 5 SFRs? From what I've seen, that opinion goes against the grain.

    no, just A vacancy is not as devastating as it is with a SFR - - there are still other rents coming in :)

    • And if you buy multifamily you can just raise rents as much as you want whenever you want? I was under the impression the market drove rent prices, and in a potential down market like we're talking about, rents would be flat or go down. 

    Yes, the market has great impact on rents.  When people loose their homes, where do they go - especially when they have children and can't go back to mom+dad?  They rent.

    • And of course the biggest factor in determining value of a MF property is cap rate, which is market driven as well. And if the Fed raises The Rate by half a percent, you can pretty much guarantee cap rates will rise significantly more than that, decreasing the value of properties drastically. 

    BP is obsessed with CapRates, but from 19yrs of B&H, I can attest that the caprate that was generated when I purchase NEVER controlled anything during my ownership. As I raised rents upon move-outs, my NOI went up, generating a new CR - - so the CR, being a derived, non-fixed number, was driven by my rental policy, not the Fed, not the community and not my loan. The math reads NOI / PurchasePrice -> CapRate. I change the NOI and get a better CR. Prices (for new purchases) fall with a constant NOI; The CR raises, not falls.

    • But I was under the impression pretty much all loans for commercial multifamily properties were 5 to 7 year terms, with much longer amortization periods, so it's good to know there's at least a chance for 20-30 year fixed rate term loans for commercial stuff. Thanks!

     Yes, it pays  to shop around as there's lots of 'products' available: 5/10 (year due in ten), 5/15, 15 fixed, 20 fixed and I was blessed with a 30 arm adjusted biannually.

    1Reply
  • Jason V.
    OP
    Investor · Rochester, NY · Member since 2016 · 477 posts · 426 votes
    9y
    Originally posted by @Mike Dymski:

    Jason, I will leave it to Brian to cover the market analysis because that's right in his wheelhouse and what he spends a lot of his energy on.

    I will add though that if you are looking for a small MF property, you don't have to land in one of the national emerging markets that will be on the radar of many larger syndicators. I live on the I-85 corridor between Atlanta and Raleigh and many of the cities in-between would not be considered emerging but they have had modest steady growth for decades. Good climate, close to beaches and mountains, friendly people, and business-friendly governments. There are likely pockets of these places all over the country. Huge rent increases over time are not likely nor are huge decreases. For example, property values in my market declined around 5% (maybe 10%) during the recession and my rents actually went up a little. And if you buy a value add, you may not be as concerned with big rent increased down the road because you already achieved the big ticket gain in your expected IRR with the forced appreciation. Many of these properties can be purchased far below replacement cost, which also mitigates risk.

    You are wise to question financing risk and are asking all the right questions.  One of the primary causes of MF failure during any recession is an improper debt structure and the related lack of capital to properly maintain the property.  If you are a podcast guy, check out Old Capital Lending.  They just did a five minute "ask Mike Monday" podcast on avoiding foreclosure.  One of their team members is a BP member and they also have free white papers on apartment lending and other topics.

    When you get past the financing and market analysis, let's discuss property management.  IMO, that is the toughest aspect (and maybe largest risk) of small MF because the property management industry does not have a model that services that space in the market.  It's a bigger deal than it sounds like it would be.

    @Jeff Dulla my goal is to improve my replies so that I make it to your thank you list.  Kidding aside, it's great hearing from these professionals...a lot more targeted than any book or seminar.

     In the investing I do now, I've always been a believer in buying locally, for a lot of reasons - primarily because I have an advantage where I invest now that I wouldn't have in a new market. As my ideas about investing in commercial multifamily continue to mature, I think I going to keep looking locally for my first couple of deals, until I'm looking at a property that I would consider to be standalone (having full time management and staff, if I ever get to that level.)

    I'm meeting with a local PM company on Friday for lunch, just as a relationship builder and fact-finding opportunity. I currently manage all my own properties, and will likely continue to do so, but if I buy something 8-12+ units (what I see as my logical next step, beyond what I currently do, and plan to continue with) I plan on using 3rd party property management. 

    1Reply
  • Jeff B.
    Buy & Hold Owner · Redlands, CA · Member since 2015 · 5k+ posts · 2k+ votes
    9y
    Originally posted by @Jason V.:

     In the investing I do now, I've always been a believer in buying locally, for a lot of reasons - primarily because I have an advantage where I invest now that I wouldn't have in a new market. As my ideas about investing in commercial multifamily continue to mature, I think I going to keep looking locally for my first couple of deals, until I'm looking at a property that I would consider to be standalone (having full time management and staff, if I ever get to that level.)

    ... I currently manage all my own properties, and will likely continue to do so, but if I buy something 8-12+ units (what I see as my logical next step, beyond what I currently do, and plan to continue with) I plan on using 3rd party property management. 

     Bravo Jason.  Due to market timing for my 1031, my 6-plex was purchased 2hrs and 120 miles away - - and I still self-managed.  The trick is to get a trustworthy local team in place to do the heavy lifting.  I chose individuals as they had more skin in the game than some 'company' only managing their PnL, not mine :)

    1Reply
  • Gino BarbaroPro Member
    Rental Property Investor · St Augustine, FL · Member since 2014 · 2k+ posts · 1k+ votes
    9y

    @Jason V.

    It is getting more difficult to find deals that make sense. I think investors need to stay focused on the B to C type assets and have to stay diligent in their buying criteria. We all get in trouble when we force the deal. Many assets are going to be coming back on board because they were bought with 2-3 yr I/O and the deal barely worked. Once they come of I/O, they are dead.

    A lot of CMBS debt is coming due in the next 18 months. You need to stay patient in your market and continue to network with brokers.

    It's not what you buy, it's what you pay.
    It also comes down to a person's comfort level.  Multifamily offers benefits that other niches don't, but if an investor can not get over the limiting belief that he or she can do it, then it doesn't matter.

    Gino

    Podcast Guest on Show The “Conveyor Belt” System That’ll Build You a BIG Rental Portfolio Quickly
    1Reply
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