The Real Risk you Might be Missing

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A common question I see on the forums relates to where we are in the real estate cycle and whether or not now is a good time to invest. You should absolutely keep looking to buy, but do it eyes wide open with a full understanding of ALL the risks. To me, the risk is not in an economic downturn per se; the risk is in the debt. Let me give you an example. Say you buy a pretty good multifamily deal at a 6.50% cap rate for $3.7 million. There are 50 units renting for $800/mo each and there is a 50% expense ratio, so your NOI is $240k. You've read all of the blogs about how smart it is to use as much leverage as possible so you can buy more deals at high returnsand you find an aggressive bank that gives you 80% LTV at 4.5% on a 30 year am schedule and the maturity is in 5 years. We can all agree that this is a common deal and a good real-world example.

Now let's say the economy/your market is just ho-hum. No major crash, but nothing exciting. We enter a stage of stagnant or slow growing rents. At the same time, the Fed or the bond vigilantes finally realize that the historically (insanely) low interest rates we're enjoying now must come to and end. So interest rates rise about 3.5% on average. While this may seem high, a rate around 8% is pretty run-of-the-mill by historic standards. Attached, I've copied in a quick and dirty, over-simplified analysis of what the deal may look like in 5 years. Assuming you can grind out 1% rental increases despite a weak economy and a down cycle, and hold the line on expenses, you've grown your NOI by $24k. You've also amortized your debt down from $2.9MM to $2.7MM. Cool, right? You should be fine...

But a new buyer, if we assume wants the same return/DSCR as you had, will only be able to pay around $3 million for the deal at 8% interest.

So now your loan is maturing, and the bank is hounding you like a jealous ex-girlfriend. They want their money back (and their sweater, and their Alanis Morissette CD) . You can sell and pay the bank back, taking a $400k loss (54%). Ouch!

Or, if you happen to have $270k lying around in a tight market where values are down, you can bring that to the table and get your LTV back to 80% to refinance, which would bring down your returns but keep you alive. Ouch again.

If you brought investors into the deal, get ready for some really uncomfortable conversations.

Imagine how much worse it would be if you had an IO loan and a second mortgage up to a higher LTV. You'd be wiped out entirely.

The moral of the story here is this: How you structure your deal matters. Leverage is great when used wisely, but it has the same magnifying effect on losses too. If you have high leverage and interest rates go up, it doesn't take some crazy, unimaginable crash for you to be in a really tough situation when your loan matures. 

Here are a few tips to think about when you're buying at this stage in the cycle:

- Moderate LTV - In the example attached, a 60% loan would be a lot easier to refi than the 80% and wouldn't require you to bring in new capital. You could refi and go on with your life, slightly lower cash flow but you're fine.

- Look for value-add deals that don't require market rent growth to see appreciation.

- Try to extend your loan maturity out as far as possible 10 year options are available, especially at lower LTVs.

- Amortization is your friend. We all love cash flow, but if you can avoid IO, do it. If you can get on a 25 or 20 year am schedule consider it.

There will be a time and a place to leverage to the hilt and hit some home runs. I;ll be the first in line to do it, but now is not the time.  Hit singles and doubles and avoid getting wiped out. 

Thanks for Reading. 

@Phil McAlister thanks for your food for thought. One key component I am always educating my investors on is the Freddie Mac Small Balance Loan. With rates rising (They Are!) any purchase at or above $1M on a stabilized asset should in most instances go through the Freddie Mac program.  10 year Fixed 30 Year AM is a great way to alleviate the concerns of a slow market. 

One very important note about that product is the ability to Assume the Debt. Lets say the market rates rise, and you have a 5 year exit strategy which is very typical. With another 5 years of a fixed rate that is assumable your property value will be higher than the competition based on the DSCR because the interest is fixed at 4.75% versus a property the Buyer would need to purchase at the market rate of 8%. Based on the example above.

There are more hoops, and it takes a little longer to close on the deal but 10 year fixed, Non-Recourse, Assumable are 3 factors that absolutely make this product a win win for the investor.

I also wanted to note that Bank of the West is providing a 10 Year fixed/ 30 Year Am on MFU for stabilized property. So if you don't want the hoops of Freddie you might get connected with a good connection of BoW.

@Phil McAlister excellent illustration of what can happen if the market shifts even a little, the dangers short term/long amort debt, and the relationship between cap rates and interest rates. 

Anyone investing in MF or syndicated deals should compare what you have laid out to the models in the PPM. More likely than not it won't have any answer to the situation or even address it. The assumptions are that entrance and exit cap rates are the same and loan terms won't change.

Though the buyer could not get as favorable LTV terms if rates hit 8%, but your point still stands.

@Keith J. - Man, the sex appeal really does rope people in! I'd rather make money than flash my projected IRR at parties! - I'm in Lombard, too. We should chat offline I'd be interested in hearing about what you're doing in real estate.

@Matt Popilek - 10 year agency debt at moderate leverage is a fantastic option! Terrible idea for the gov't to offer but hey if it's available to me I'll take it! At the institutional level, most of our deals are 10 year, 5 IO, 55% LTV, 30 year AM. They also have a green program, where their stupid rates get even stoopider if you put in low flow toilets, shower heads, etc.:)

@Bill F. Great point. Very important to understand that the IRR is very dependent on the deal structure and the exit assumptions. IRR drops in a hurry with very modest tweaks to the exit. Sensitivities/Stress testing is a must. And yes, you could argue the next buyer would get less favorable terms, and even might demand better returns/cap rate in that sort of environment, but I wanted to keep it simple and show that even without a catastrophe, leverage can cause catastrophic losses.

@Phil McAlister  

I couldn't agree more. To get a remotely usable IRR, you have to model out so many assumptions to generate free cash flow numbers that one slight tweak can yield crazy swings to your final metrics.

Funny you should mention stress testing, that's what I'm doing right now for exit cap rates, refi LTV and refi interest rates.

What If Analysis is such an awesome tool in excel.

Originally posted by @Bill F. :

@Phil McAlister  

I couldn't agree more. To get a remotely usable IRR, you have to model out so many assumptions to generate free cash flow numbers that one slight tweak can yield crazy swings to your final metrics.

Funny you should mention stress testing, that's what I'm doing right now for exit cap rates, refi LTV and refi interest rates.

What If Analysis is such an awesome tool in excel.

Sponsors will provide IRR and rent sensitivity tables. Seeing the returns under stressed scenarios helps me pull the trigger (or not).

Value add is a must in this market to mitigate risk (and it's been a must for me for 15 years anyway).

@Mike Dymski I didn't mean to imply that it's not done, that's certainly not the case, but more to point out that it matters what scenarios are used in the stress test and how they are combined. 

To me personally having a stress test that only involves raising exit cap rate by 25 basis points with income going flat to me isn't much of a test. 

I want to know what will happen if the asset can't be sold in Yr 5 as planned and it has to be held for 30 more months, financed at 300 points above the origination rate and is finally sold at a rate 250 points over the entrance cap rate all while experiencing  a 10% decrease in occupancy. What does this do to the return and more importantly what does the free cash flow look like?

No free cash flow is fine, but if it goes negative, then you are dipping into working capital/CapEx. That opens the door to the death spiral of deferred maintenance, which pushed the cap rate up, shrinks the pool of buyers and the asset sits on the market longer. It accumulates more deferred maintenance and the dance starts again.

You look at far more deals than I do, but the few I've seen tend to stress test individual variables, which, at least to me, ignores reality. All these factors are inter related so if vacancy doubles, the odds that a 85% LTV 30 yr amortized product will be available is low.

I also look both ways before crossing a one way street, so maybe I'm overly pessimistic.

@Phil McAlister Great points, it's important in this stage to have longer term financing in place. Even if the rate adjusts, you'd rather have lower returns than a balloon payment. 

@Matt Popilek agree with you completely. The 10 year product is assumable and imagine how attractive that loan will be in the scenario Phil laid out? 

@Phil McAlister

You make a good point here. I've read quite a bit of material that encourages using as much leverage as possible and this effectively illustrates how that can lead to financial ruin; especially at this point in the market cycle. As a new real estate investor who is anxious to buy more property this was good for me to read so thank you!

Great post @Phil McAlister . I have a related question. My portfolio loans can be called due anytime(My banker says they will never call the loan if my payments are in time, but that's not the way on paper). Say there is recession and my geographic area is not doing good in terms of Market, my bank will be less likely to call my loan if LTV is 65% vs 85%, right? I might be asking the obvious, but wondering if more experienced folks like you can throw more light on this other than the obvious.

@Krishna Chava Good question. A lot of bank loan documents actually read that way and people don't realize it. It is also true that the banks typically honor the stated maturity commitment and really have no interest in calling your loan. If you're worried about it, the best thing you could do is try to get that language modified upfront when you initiate a loan, but since that ship has sailed you you're only other real option would be to refinance the loans with that language removed, if they'd allow it. 

That being said, we could only speculate as to whether or not they would actually do it, as every bank and every situation is different. It is very expensive and a hassle for a bank to call a loan, and they would really only do it as a last resort. Even if it is underwater, they are better off collecting your payments as long as you're making them than foreclosing. 

Lastly, you are absolutely right that generally the less risky the loan, the less you'd have to worry about it getting called. The bank will only do that if the think it's the best shot they have of recovering their money. LTV is only one factor the bank will look at; they'll also be considering DSCR, condition of the asset, market conditions, etc. in making that decision. They are in the business of making money, so if they've got a moderately leveraged, performing loan there is really no reason to call it before it matures. Maybe in a recessionary environment, if it is an 85% LTV and the bank thinks things are only going to get worse, maybe they call it now thinking they need to sell it and recoup their funds before the LTV gets to 100% or worse. Even then, they would probably work closely with you to see if you could pledge more collateral, pay the loan down some, etc.

If you haven't over leveraged the asset, and you've been able to add value, even if they did call the loan on you, you shouldn't have a big problem refinancing with another institution.

@Phil McAlister thanks for sharing your wisdom on this thread. I'm just getting started with MF investing and building out my credibility book as well as pro formas to give to investors. Should I be factoring in 8% interest rates say 5 years down the road in my projections for refinancing or selling? Also what numbers do you like to put for your stress testing pertaining to interest rates, vacancies, etc.?


@Stu Basham Interest rate stress testing on exit is tough because a lot of factors go into the value outside of the rate. Some smart guy or call will probably respond now with an easy way... 

Spend some time googling and on YouTube to learn how to do sensitivity tables in excel. In my models I always do at least 3 two-variable sensitivity tables for the acquisition and the exit. For the exit 1 table will be the exit NOI based on rent growth rates and vacancy rates. The next would be the Sale Price based on varying Exit NOI and varying Exit cap rates. And the last would be the IRR based on varying exit NOI and Cap Rates. You can also do equity multiples, average returns, and a host of other metrics. The exact range to set for the variables will depend on the deal, but make sure it generally captures worst case through best case. (Side note: worst case doesn't mean aliens show up and destroy the building with laser beams, keep it reasonable).

Unless your model calculates the exit price based directly on the prevailing interest rate, you can't directly run a sensitivity in excel that way, but you could manually build out some additional stress testing based on interest rates, if you make some assumptions the way I did in the original post (i.e. assume the rate causes the next buyer to lower his price by X for Y reason). 

Another way I've seen it done is by building out 5 or 6 columns of underwriting scenarios that start with a base case and then go to base case with 20% vacancy, then base with 20% vacancy and -5% rent growth, etc. etc. so people can grasp the risk in differently.

@Marco G My banker said that is the standard language (call any time) on all their portfolio loans. I didn't shop around much because I was getting a good rate and this was my first portfolio loan. I have done several other loans since then with same banker (>2mil total), but language remained same and I didn't think of questioning it. 

If I get to refinance these loans (unlikely, mine are fixed rate for 5-10 years), I will discuss making loans not callable and instead promise DSR above 1.3.

Good points. People need to be following the FED. Every once in a while look at the "dot plot" . Whatever your entry cap is --I would add in the cumulative rate increases projected into your "exit multiple " assumptions.  Most the buyers on this board have seen 9years of low rates+the yield curve is very flat. Buying a stable/no upside 6 cap at last years rates and selling in 4 years at future rates is going to leave a lot of levered ppl upside down 

Thank you for sharing this!  I don't think enough people use projections and sensitivity analysis in making informed decisions.  Let's hope information like this gets some traction before the next correction (whatever that may be).

+1 on the appreciation to @Phil McAlister and other posters for really illustrating this point and making me/us analyze our underwriting assumptions even more. A lot of things that seem obvious, aren't so obvious and the little nuances that have been pointed out are incredibly helpful. On to Google to figure out the best way to add multi-faceted stress tests to my  underwriting model.

Originally posted by @Krishna Chava :
Great post @Phil McAlister . I have a related question. My portfolio loans can be called due anytime (My banker says they will never call the loan if my payments are in time, but that's not the way on paper). Say there is recession and my geographic area is not doing good in terms of Market, my bank will be less likely to call my loan if LTV is 65% vs 85%, right? I might be asking the obvious, but wondering if more experienced folks like you can throw more light on this other than the obvious.

This matter was discussed on BiggerPockets 10 years ago as the Financial Crisis of 2008 was unfolding:

Can a Bank call the loan?

My takeaway is that when a bank is under stress and needs to raise capital quickly, it will do whatever it has to do to remain solvent ("desperate measures for desperate times"). Performing loans with a "due anytime at the discretion of the bank" clause are fair game.

It makes sense from the banker's point of view. You need to raise money quickly because there is no long term when you can't survive the short term. Are you going to sell your junk to raise cash? Or your gems? Responsible borrowers are punished in this scenario.

Most small investors do not have means to purchase a 50 unit and settle for sfh, duplexes, when the economy is good there are fewer job loss, when the unemployment rate rises, the assumption of getting steady rent becomes difficult to maintain. If the investor loses his job along with his tenants together he is not unable pay both properties. Often he tries to pay his mortgage to have a place to live. This is especially acute if the town where one invest has no diversification in employers.

@Phil McAlister great post. I wish more people would spend time on the potential downside of some of the investments being offered today. In so many investments I look at, everything must go right in order to achieve the projected return. They all use very high leverage and several years of Interest Only payments to make the numbers work. They all use 'light value-add rehabs' to bump the rents up $100/month.

The first few investments I looked at personally syndicating, I looked at with financing I knew I could get which was 20-year amortizing debt. Makes a big difference in cash flow... 

It all looks good on paper and will continue to work until it doesn't anymore. The thing that bothers me most is how many people are doing it now. It always give me the heebie jeebies when it suddenly becomes extremely popular to do something like buy crypto-currencies or flip houses.