The Current MF Market and Potential Repercussions of a Correction
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!