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While no one holds a crystal ball, it is no secret that real estate investors are playing in the ninth inning. With a recession on the horizon, what do you do? Do you choose to stop buying so that brokers forget about you? Or, even worse, do you stop buying so investors find other syndicators to invest with? It’s a lose-lose situation, right? Well, not quite. Apply these principals to your underwriting and market analysis to give yourself the best opportunity to buy at the top of the market and survive, or even thrive, during a downturn.
Buy For Cashflow, Not Appreciation
It’s my view that back in 2011-2016, you could buy just about anything, make mistakes and still come out on top looking like a genius. If you’re wondering how that was possible, it’s called appreciation. Across the nation, rents continued to tick up year over year. This enabled operators to overpay, underperform and still look like geniuses. Since we are in the ninth inning of this current cycle, there is no room for error. If you overpay and underperform this late in the game, you can be sure to expect unhappy investors and a lost asset.
At the top is where cash flow becomes so important. Having an asset that throws off strong cash flow enables you to hold onto the asset, even when everyone else is forced to sell. Cash flow also enables you to continue to pay back investors throughout the life of the hold and replenish your capital expenditure budget if you need to hold longer than expected. Pair cash flow with the right debt and you are more likely to make it out on the other side of a downturn.
Unexpected Debt
The most common debt structures in multifamily apartments are bridge and agency. Placing the right debt on your deal is imperative. Again, it being late in the cycle, you are no longer able to take a two-year bridge loan with capital expenditure rolled in and expect to refinance out into long-term agency debt. If you plan to implement this debt strategy today, it is highly likely that this will be the last deal investors choose to do with you.
Instead, try finding deals that qualify for agency debt right out of the gate. These deals are typically stabilized above 90% occupancy prior to takeover. By using Fannie Mae or Freddie Mac, you may be able to secure longer-term fixed-rate debt. I would suggest using 10- to 12-year fixed-rate rate debt amortized over 30 years with a few years of interest only. This is standard and achievable with agency debt.
Have you found a deal that doesn’t qualify for agency debt? Explore bridge loans with extensions. One of the better options is to do a three-year bridge loan with two one-year extensions. I also heavily suggest buying a cap on it as well. This would enable you to underwrite with a worst-case scenario and stress test the deal to see if it still makes sense. The other highlight that many do not talk about with bridge loans is flexibility. Bridge loans do not have high pre-payment penalties or yield maintenance fees like agency debt does. Using these debt options will likely give you the best chance to weather the storm ahead.
Asset Class
At the end of the day, A-Class and D-Class suffer the most. History tells us that during a downturn, Class A offers more concessions and becomes stagnant, or drops, in rent prices. Class D is suffocated by bad debt, skips and turnover. The safer options are B/C-class assets. These are your typical hardworking, blue-collar residents who can continue to pay their rent during a downturn. Class-A renters who are unable to afford luxury living will move into B-B+ assets during tough times. This enables you to keep relatively high occupancy and continue to cash flow.
Capitalize Correctly
Buying a deal and being undercapitalized is like buying a gun but not being able to afford the ammo. Underwrite your deals with a rainy-day fund. It’s not an option, it’s a necessity. Whether you like to admit it or not, there will be issues with your asset and you need to have enough powder ready to fix it. Coming into a deal capitalized correctly will enable you to survive when something unexpected needs to be fixed. One of the easiest ways to add this into your underwriting is adding 20-30% to your capital expenditure budget. We have also held up our operating account as a secondary when acquiring a new asset.
A recession, or downturn, is coming. I don’t know exactly when, but I can tell you for certain that I believe it is. Although it can be scary, it can also be exciting. It can be healthy for the economy and provide opportunities ahead. Before you buy your next asset — and more importantly, put your investors’ capital at risk — take a look at these four areas and see if you have deviated.