All Forum Posts by: Jonathan Twombly

@Zachary Bellinghausen  One issue that’s going to come back to bite a lot of sponsors (and their LPs) at this point in the cycle is their misunderstanding of exit cap rates. 

It’s Underwriting 101 to use a metric like 10 basis points per year over your entering cap rate to calculate your exit cap rate. So, if you buy at a 7 cap and hold for five years, you assume an exit at 7.5. 

What most people are missing is that this just a rule of thumb, and it’s meant to apply at the midpoint of the market cycle.

Right now, we have historically low cap rates, and people are mechanically applying this rule thinking that they are being conservative. So they are buying 1970s suburban garden apartments at 5 caps and thinking that, in five years, they can exit at a 5.5. 

This kind of product usually trades in the 7-9 % range, and they should be assuming their exits in that range, regardless of the rule of thumb. 

The difference is enormous. The exit cap has a huge impact on projections. 

One of my clients showed me a deal he was thinking of investing that was just like this. 1970s, suburban deal going in around 5.5 and projecting an exit at 6. They calculated some exit scenarios up to 6.75 to show a range.  However, I calculated over that, and over that exit cap, they were actually losing money on the exit. To be conservative they should have been assuming an exit around 8%, where these deals historically trade - and that was nearly 10 years ago, when they were 10 years newer. 

Brian, thanks for writing this, because people need to understand. 

In the last crisis, MFRE values fell about 32% from the peak. That would wipe out most if not all equity that purchased at the peak. 

However, because other real estate asset classes did even WORSE, MFRE was touted as being the most resilient in recessions.  

Over time, “least bad” morphed into “best” which then morphed into “safest” and even “does well in recessions”. 

Also, because of the foreclosure crisis, which won’t repeat itself for various reasons, MFRE did really well in the years following the recession - when it still felt terrible, so people think of it as the recession, but economic growth had resumed. People tend to conflate what happened after the recession with what happened during the recession, and the effect is again a misunderstanding that MFRE “does well” during recessions. 

If you are carrying any credit card debt or other consumer debt like car loans, paying that off is going to generate a better return.  Paying off credit card debt at 18% is like getting an 18% return.  You won't beat that with current real estate returns.

 Take advantage of the difficult time to study your chosen market, find target properties you’d buy if the price were right, and start saving. In other words, get prepared so you can pounce when the moment is right.  

4% is pretty typical for 100 units.  If you grow your portfolio in a given market, you might be able to negotiate down to 3%.  (You always have to pay the salaries and burdens for the onsite staff.)

I would not agree to a higher management fee for a rehab deal.  Most management contracts I've seen charge an oversight fee, which is a percentage of the cost of the work.  This is fair, since they will be site-managing your rehab project.  Locking yourself into a 6% management fee, which would continue after the rehab is done, is not a good idea.  The project oversight fee is one and done.

 This is article from Green Street Advisers is pertinent to your comment.  https://www.greenstreetadvisors.com/insights/blog/whats-ahead-for-u-s-apartments?utm_campaign=Market%20Currents&utm_source=hs_email&utm_medium=email&utm_content=71006850

Charles, my friend, you raise such an important point here, and I think it should be a separate blog post to get the attention it deserves. I don't think this point is raised nearly enough.

I can personally attest to the fact that running C-class apartments is difficult - and that is having purchased the property early in the cycle and swinging into a rising economy. That is with hiring a very large management company, which later had to be fired for incompetence.

Bad debt and evictions were a constant struggle, as were unexpected capital items and tenant-caused disasters like fires and people driving their cars into my buildings. (This happened more than once, so it's a thing.)

What I have discovered, the hard way, is that so many Americans are living close to the edge of survival that paying rent is a struggle. Investors are celebrating rent increases left and right but ignoring the fact that, while their tenants can "afford" the increased rents on a rent-to-income analysis, they cannot afford the rents on an income-to-expense analysis, when you include their cars, credit cards, etc.  People will default on their rent before they default on their car payments in many markets, because lack of a car means you cannot work, eat, socialize or anything.

Even when I brought in a better management company, the properties that struggled with these issues continued to struggle.  You can't get blood from stones.

Now, I remind you that these properties were purchased with the wind at my back.  And because of the insatiable greed for apartment properties these days, I was able to sell these properties at substantial profits that were not justified by the cash flow.

But if I were to buy these properties today, at the inflated prices we see, and then experienced the exact same problems, I would probably have been looking at foreclosure.  Remember, those are operational problems in a strong economy.

Imagine what this will look like when vacancy isn't at all-time highs.  When turnover isn't at all-time lows. When people start losing jobs and delinquency, bad debt and vacancy really bite hard.  When, as Charles said, you and every other operator in the market are fighting for a shrinking tenant base and offering concessions and lowered rents to try to get people in the door?

And it may not require a bad economy for the competition for tenants to heat up.  Just today, Green Street Advisers is warning about a deadly combination that may hit some rental markets soon - accelerating supply and decreasing demand, as the Millennials age out of renting and the following generation is much smaller in number.

All of this militates for a very conservative approach to investing in apartments - exactly the opposite tack being taken by investors out there  "making" deals work.

If this property is 5% units or more, it will be a commercial mortgage.  Commercial mortgage standards will apply.  They will include such things as:

1.  Skin in the game.  You will need to put down 20-25% in equity on this deal.  The lender won't want this coming from another lender because:

2. Oftentimes in commercial deals lenders forbid other mortgages on the property.  Indeed, it's a breach of your loan covenants and can transform your non-recourse loan into a full-recourse loan.

3.  You will need a personal net worth equal to or greater than the amount of the loan, excluding the downpayment you put into the property.  You can combine with partners to meet the net worth requirements.

4.  You will need liquidity equal to 9 months debt service or 10% of the loan amount.  The lender wants to make sure it gets paid even if the property is not making enough money to pay the mortgage.

5.  You will need to meet the experience requirement of owning and managing other investment properties.  If you don't have this, you can bring on an experience partner or hire a professional management company, or both.

Before you invest a lot of time and energy into this, make sure that you meet these requirements or that you can partner with someone who does.

@Tyler Erickson The issue isn’t whether there are buyers when you want to sell. The issue is whether there are buyers when you have to sell.

Successful investors set themselves up so that they can sell when they want to, and not when they have to. 

Buying at the right part of the cycle and/or locking in long term debt increases your chances of exiting when it’s good to exit and not when it’s bad to exit. Doing both at the same time is even better. Needless to say, buying at the top of the market with short term debt and hoping the market will favor you when you must refinance increases your chances of disaster. And at the top of the market is when investors are often most tempted to do all the wrong things to increase returns to equity, such as too much leverage, short-term leverage, and massive and expensive rehab plans. 

For the purposes of this note being forced to refinance at a bad time is effectively the same as being forced to sell at a bad time. Indeed, the former often leads to the latter. 

Over the long run the world’s most successful investors are successful because they focus on minimizing downside risks rather than maximizing upside gains. 

Investors with good plans, bad plans, and no plans make money when markets are rising. It’s when markets are falling that the people who prepared for the downside survive and those who only think about the upside don’t make it to the next bull market. 

I know you asked Serge, but here is my advice. You are young and there is no rush. Time is your friend in real estate but you still need to buy in the right part of the cycle. 

My advice is wait until you start hearing horror stories on BP about people losing money, and about how terrible MF is, and how it’s rigged against the little guy. When you start hearing about foreclosures and blood in the streets. That will be the time to buy, and if you are patient enough to wait until then you will do very well. Save your pennies for that day. 

If you cannot wait for some reason then you must be extremely cautious. Learn how to underwrite deals and then scenario plan them to see how far down your vacancy can go before you cannot make your debt service payments. Plan for the absolute worst to happen a year or two into your hold period. Only if the deal still works under the worst case scenario should you even consider moving forward.  

Also, at this point in the cycle, you want to buy the best located properties, where people will always want to rent no matter how bad the economy is. Buying marginal properties in marginal markets, as so many people are doing right now, is a really bad idea. 

And a word on markets. There are a lot of markets that look cheap because they are marginal. Lots of people are investing in these places because they think they are finding bargains. But they are still overpaying and don’t even realize it because you should never compare markets laterally. Only compare them to themselves. These marginal markets will always be cheaper than the good markets and when a downturn hits and the good markets get cheaper, the marginal markets will get even cheaper and people who invested there at the top will lose money.