news

Why You Must Raise Rents 33% to Break Even (Part I)

“How dare that guy say this!”   

I know that’s what many of you are thinking. 

Yeah, I feel sheepish about it, too. But as the author of a book on multifamily investing, and a commercial real estate fund manager, I want to raise a flag…yet again…about the danger of overpaying for stabilized assets in an overheated market. Or passively investing in deals like this. 

What am I talking about…and who does this apply to? 

This post reviews how potential cap rate decompression could lead to a significant drop in the value of your assets…and how to avoid or overcome this potential danger. 

This could apply to you if you are a passive investor in multifamily or any other commercial asset type that is valued by this formula: 

Value = Net Operating Income ÷ Cap Rate

This applies to apartments, self-storage, mobile home parks, RV parks, senior living, industrial, hotels, malls, retail, cell towers, and more. 

So why am I picking on multifamily? 

Partially because I had the “humility” to entitle my 2016 apartment investing book, The Perfect Investment, I feel responsible for ensuring investors know what they are getting into. The “perfect investment” isn’t perfect if you overpay to get it. 

Now that said, many apartment investors aren’t overpaying. Some are crushing it and making millions for their investors.  I’m visited one in Dallas last week who is doing just that. 

But I’m concerned when I see so many telltale signs of a potential bubble. And so many assumptions about rent growth, continued cap rate compression, and high LTV debt with aggressive assumptions about interest rates.  But that’s not all. 

I’m really concerned about syndicators/investors making risky bets on assets that great operators already run and have optimized/stabilized. Many of these will need to hope and pray for inflation with continued low-interest rates to survive. 

While I’m all for hope and prayer, this is not the best business strategy. Especially when you’re investing your hard-earned capital. 

Why on earth would you say I have to raise rents 33% to break even? 

It’s because of the possibility of cap rate decompression

That is the chance that cap rates could go higher. Which means asset prices go lower. And this issue is accentuated at low cap rates (high prices) more than at cap rates from days gone by. Here’s why…

The cap rate is the projected unleveraged rate of return for an asset like this in a location like this in a condition like this at a time like this. Since the cap rate is in the denominator of our value equation, asset values change in inverse proportion to the cap rate. 

When cap rates were 10%, a 1% move up or down resulted in a value change of 10% down or up. So, a decompression from a cap rate of 10% to 11% results in a 10% decrease in asset value. 

But cap rates haven’t been 10% for most assets for a while. In fact, current cap rates sometimes run in the 3% to 4% range. We’ve seen a lot of multifamily (and other deals) in the 3% range lately, in fact. 

So, what if your 3% cap rate goes up to 4%? What is the impact on the value? Let’s assume the net operating income is $500,000. At a 3% cap rate, the value of that asset is: 

$500,000 ÷ 3% = $16,666,667

You’ll have to spend $16.7 million to get a half-million annual cash flow. And with debt, mortgage payments will significantly cut the net cash flow to owners. 

With a 1% rise in cap rates from 3% to 4%, the asset value is: 

$500,000 ÷ 4% = $12,500,000

So, this is the math backing up the title of this post. A 25% drop in value from a generally uncontrollable metric (cap rate) must be offset with a higher rise in a generally controllable metric (net operating income). 

Taking the 4% cap rate equation and increasing the net operating income by 33.3% gets you back to a breakeven asset value:

1.333 * $500,000 ÷ 4% = $16,666,667

This is why you need to raise rents by a third to get back to the same value. Now this may be reasonably achievable with inflation over several years. But what if inflation doesn’t materialize as you predict? 

Worse yet, what if you find yourself in an economic downturn where occupancy drops, concessions rise, and rents are stagnant? If you don’t believe this could happen, I’m sorry to say that your opinion is at odds with all of investment history across every asset class. Read Howard Marks’s classic Mastering the Market Cycle if you doubt. Or listen to Brian Burke tell what happened in his worst deal in 2008. 

An important caveat

Caveat: Someone will argue that raising rents 33% will provide much more than a 33% increase in NOI since operating costs don’t go up by the same amount. Great point. You got me. 

But I will argue that you will likely experience significant inflation in your operating expenses (OPEX) and capital expenses (CAPEX) as well. And the increasing labor (and material) shortage will potentially raise your costs even more than expected as the labor market for maintenance and similar trades continues to shrink. 

But if you persist in this argument, I will grant you that perhaps you can cut this 33% figure down a good bit. Feel free to assume 18% if you wish. That is still a big problem in the short term. Especially if that short-term includes a refinance. 

Oh, and before breathing a sigh of relief at “only” 18%, realize this… cap rates could easily decompress by much more than 1%. What if they go up from 3% to 5%? Then you’re looking at double the problem I’m presenting here. 

Five potential impacts of decompressed cap rates 

I talked about this concept to a friend yesterday, and he said it was more academic than practical. Really? Let’s discuss five potential impacts of decompressing cap rates. 

1. Refinancing challenges from appraisal

Syndicators with a short hold time or short window until refinancing can get clobbered if cap rates rise. The appraisal is directly based on the cap rate, so a situation like that above, where the asset loses 25% in value, can cause potential challenges. 

2. Refinancing challenges from interest rate

Unfortunately, higher cap rates often go hand-in-hand with higher interest rates. So decompressed cap rates coupled with higher interest payments from new debt can be a double whammy. 

3. Capital calls – the need for fresh equity in a stale deal 

The result could be the need for a capital call from investors. A new equity injection. But investors may already be doubting the viability of this deal and may resist the offer to throw good money after bad. You could find yourself in deep water here. 

Investors may adhere to the wisdom of Warren Buffett here: 

To be sure, you and I may not view this issue as “a chronically leaking boat.” But it doesn’t much matter what we think. This is the investors’ hard-earned capital, and their opinion will rule in this situation. 

Besides, let’s be honest, every deal doesn’t go as well as planned. And if (when) you have other problems like achieving occupancy targets, rent goals, and income projections, this refinancing/capital call issue may look like the last straw in an investor’s evaluation. 

4. Lower IRRs

I‘m not a huge fan of internal rates of returns for most deals. These IRRs are usually misunderstood and can be manipulated. The drive for IRRs often results in short-term thinking, which is not usually the path to building long-term wealth. 

Nevertheless, if you, as a syndicator, project IRRs at a certain level, cap rate decompression and its ugly twin, higher interest rates, can result in significantly lower IRRs. Why? Four potential reasons include: 

  1. The inability to refinance out lazy equity as a preliminary return to investors
  2. Lower cash flow as the result of higher interest rates (with floating rates on the original debt or higher rates on additional debt) 
  3. Lower valuations if selling in the short term
  4. The inability to sell at all in the short term. This delay can significantly lower IRRs. 

5. Impact on future deals – in the eyes of investors

Mr. or Ms. Syndicator, do you plan to be in this for the long haul? I hope you do. Because the most significant wealth is usually built by those who choose a lane and stay in it for a very long time. 

If you take on risky deals with risky debt and suffer the consequences in points 1 through 4 above, I can assure you this will mar your track record. And it will hinder or even cripple your opportunities to raise more capital in future years. 

And to you, Mr. or Ms. Passive Investor, I recommend you carefully evaluate deals with this lens. To assure you’re not getting into a deal with these risks. And to ensure your syndicator doesn’t have a history and tendency to play with this brand of fire. 

Do you really know how to evaluate these risks? If you’re unsure, you may want to invest with a group with the collective knowledge to analyze these operators and deals. And you might want to pick up Brian Burke’s outstanding BP book, The Hands-Off Investor

Storing Up Profits 3d 1 1

Self-storage can be a profit center!

Are you tired of overpaying for single and multifamily properties in an overheated market? Investing in self-storage is an overlooked alternative that can accelerate your income and compound your wealth.

Three ways to avert this potential disaster

1. Safe debt

One way to avoid this issue is to invest with relatively safe debt. What is “safe” debt? It can be low LTV debt. It can be fixed rates with a long time horizon. Hopefully, it is both. 

There are a few good reasons, especially with new construction, where 80% LTV, floating rate, 3-year term debt makes sense for a developer. 

But let’s face it… while real estate developers are some of America’s wealthiest entrepreneurs… some of them end up in the poorhouse. After being millionaires in their thirties or forties, some of them spend their retirement as Walmart greeters. (There is nothing wrong with being a Walmart greeter. But it’s not the way most of us dream of retiring.) 

So, what if you acquire an asset with a low cap rate that decompresses in year two? If you have to refinance, especially at a higher interest rate, you could be in big trouble in year three. But if you have low interest rate debt with a long term (like 10 or 12 years), you may be just fine. Sure, you may not be able to refinance to pull out equity as soon as you hoped, but the benefit of long-term holds at low interest rates can cover a multitude of sins. Especially in an inflationary environment

2. Assets with intrinsic value

This graphic shows the estimated ownership of large (50+ unit) apartments vs. self-storage and mobile home parks. This is important because the seller of a real estate asset often plays a role in determining the upside potential for the buyer, a professional operator. 

Independent operators own about three-quarters of America’s 53,000 self-storage assets, and about two out of every three of those only own one facility. This often means there is upside potential when acquiring the asset

Mobile home parks are even more weighted to mom-and-pop owners. Up to 90% of America’s 44,000 parks fall into this category

Trust me when I say there is often a lot of meat on the bones on mom-and-pop deals like this. Check out this article on finding deals with intrinsic value. 

You can find mom-and-pops in any asset class, but as you can see, they are probably easier to find outside of the multifamily realm. 

Acquiring and improving a mom-and-pop deal can create significant value for investors. And more importantly, for risk mitigation’s sake, this can help you grow an increasing margin of safety between your monthly income and your debt service. This is referred to as the Debt Service Coverage Ratio, and it is one of the essential concepts in real estate investing. 

3. Don’t invest in real estate

A third way to avoid this potential disaster is to avoid real estate investing altogether. You may want to avoid the stock market and other equities as well. These paths will certainly avoid the risks and perils of investing in real estate. 

Your options include collecting interest from a bank or money market account (current yields = 0.5% to 0.7%). You could also invest in the U.S. government. You can get long-term rates of over 2% today. 

There are many other debt instruments that could yield higher rates. Some municipal bonds yield 2% to 3%, and there are debt funds with higher risk and higher returns.  

You could invest in precious metals or cryptocurrency, but I believe these “investments” are more like speculations or insurance policies than investments. Yet I think it’s wise to have some of this insurance in any economy.  

You could even bury cash in a hole in the ground. But an esteemed ancient Jewish rabbi offered strict warnings against this practice in investing and life. 

Final thoughts

Every investment has a risk and return correlation. And some of the risks involved in these low-risk investments are hidden from plain sight. We’ll discuss this next time in part two of this post. Hint: the ravages of inflation could cause you to lose money with every low returning debt payment. 

So, what do you think? Do you see and agree with the logic and the math here? Or is the author like the boy who cried wolf? 

Source
Why You Must Raise Rents 33% to Break Even (Part I) is written by Paul Moore for www.biggerpockets.com

Related Articles

Leave a Reply

Your email address will not be published.

Back to top button