Interest rates are up. Inflation is high – which means the cost of everything is increasing rapidly. Banks are failing. Rents are no longer increasing at 10+% per year, And it is getting tougher to qualify for a loan.

Given everything that is going on, it is hard to know what to do as a real estate investor.

That is one of the reasons I have been engaging with some of the smartest people I know, listening to their thoughts, and comparing them to my experience. The experts don’t always agree – and I wouldn’t expect them to. But their perspectives are really important when clarifying my thoughts and determining what actions I need to take.

One thing that everyone agrees on, however, is the importance of understanding the deal that you are investing in, the potential risks inherent in that deal, and the larger macro-economic picture that the deal is taking place in. When you understand that, you can determine whether the deal fits within your overall risk profile and is something you want to invest in.

A couple of weeks ago, I wrote about how to think about risk [1]. If you aren’t actively thinking about risk on your investments, hopefully this article will convince you why it is important to understand the risks you are taking with your portfolio. And all investments have some risk involved.

If we look at some of the recent high profile foreclosures, for example, the 3200 units owned by Applesway in Houston [2], you can see how the opportunity was a high risk / high potential reward deal. Unfortunately, it isn’t clear that all of the investors understood the risks they were taking.

It is impossible to know all of the details leading up to the foreclosure, but from what I can piece together, the deal was structured as a large-scale, value-add opportunity. This type of deal, which has been very popular in recent years, is very similar to a fix and flip or BRRR model [3], but done on a much larger scale. The approach is generally to get short term debt to purchase the property, fix the place up, increase rents, and then use the increased rents to get a new loan that allows the investors to be repaid. Because of the low cap rate at purchase, the property is typically cash flow negative – or at best neutral – for the first year or two while the renovations are going on.

Successfully completing a value-add requires several things to go as planned:

• The interest rates need to remain relatively constant while the renovations are ongoing. This is because the short term debt (also known as a bridge loan) is almost always obtained with a variable rate, so if interest rates rise, the costs will increase. Bridge debt is used because the standard commercial loans have a high prepayment penalty, and the strategy requires a refinance or sale of the property within 3-5 years (as soon as the rents stabilize after the renovations). So instead of paying a large prepayment penalty, most operators use variable rate debt and then plan to refinance.
• The rental rates must increase as projected. Both the value of the property and the ability of the property to cash flow depend heavily on the real rental income generated by the property. If the property manager is not able to generate the projected rents, the value of the property will not increase as expected. This can happen for a variety of reasons, including the renovations taking longer than expected (delaying the availability of renovated units), people not moving into the apartments (increased vacancy), or a softening of the rental market which places the target rents above what the market will support.
• The renovation costs must stay within budget. If the costs increase dramatically, the time required to complete the renovations may be extended, the quality of the work may decrease (e.g. using less expensive finishes), or the money available will be exhausted before the work completes leaving some units in a less desirable state. All of these impact the cash flow.
• The cap rates cannot change significantly between purchase and sale / refinance. Cap rates on multi-family properties have been at historical lows over the past few years as more people look to purchase these types of properties. However, if the cap rates increase, for example because people don’t want to purchase these properties anymore or they simply cannot afford them at those low cap rates, the value of the property will decrease accordingly. As the value of the property decreases, both the amount that can be refinanced and the equity available to investors decreases.
• The loan terms, such as the debt service coverage ratio, do not change. If the lending terms get more conservative, a cash-out refinance may not be possible since the property may not generate enough income to justify increasing the loan amount. If the cap rate changes enough, it is possible that cash may need to be added to the deal in order to move from bridge financing to a more stable loan.  

So what went wrong in this case?

Pretty much everything.

The sponsors took out a lot of debt, by some estimates 80% (which is very high for commercial property) in order to help finance their renovations. This debt was floating rate debt, held at a time when interest rates increased at the fastest rate in history. The renovations were not able to be completed according to the plan (I am unclear on why, by the supply chain issues and dramatic increase in costs are likely contributors). As a result, the rents were not able to be increased in line with the increased debt payments. The Houston Chronicle called the apartments rat and roach infested – not a byline that will get you top rents in a market and certainly not what the investors were expecting. The capital markets changed dramatically, making it both harder to qualify for a loan and reducing the size of a loan that can be obtained. Given the current rents and market conditions, it is highly unlikely the sponsors could obtain a standard, fixed-rate loan without putting in large amounts of new money.

Most importantly, they didn’t have, or at least employ, risk mitigation strategies fast enough. There are always ways to mitigate risks, but they come at a cost. These sponsors were not focused enough on ensuring the investors didn’t lose money. If they were, they would have taken steps to mitigate these risks, especially as they became more likely. For example, they could have taken out less leverage, used a rate cap on their loan to limit their exposure, etc..

“Rule #1: Never lose money. Rule #2: never forget Rule #1” – Warren Buffet

That said, none of the things that were done in this case fell far outside of the norms for multifamily investing in 2020/2021. Some of this looks reckless with the benefits of hindsight, but there are many other syndications in similar situations.

It is extremely unfortunate that the LPs lost their money as part of this investment since they could not have influenced the outcome. We can only hope that they understood the risks that they were taking when they made the decision to invest in these deals. As with all fix-and-flip strategies, eventually, someone is left behind when the markets shift. It is an unfortunate effect of the market cycles and the short-term perspectives being taken to generate high / fast returns.

I prefer to take a long term approach and ensure that the property will cash flow from the start. That allows me to hold the property indefinitely. While I am all for adding value to the property and increasing the cash flow as a result, I am not comfortable with strategies that require negative cash flow until something I do (which may or may not go to plan) happens.

I want the asymmetric risk of being able to get the big upside, while minimizing the risk that I will lose everything. Those deals are much, much harder to find – especially in a hot market. But they are worth waiting for.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

For additional reading:

1. https://mbc-rei.com/blog/how-i-think-about-and-manage-risk-in-real-estate-investing
2. https://www.rentalhousingbusiness.ca/houston-apartment-owner-loses-3200-units-to-foreclosure-as-multifamily-feels-the-heat/ – this also made the WSJ news, but since that is behind a paywall, I went with an open link
3. https://www.amazon.com/Buy-Rehab-Rent-Refinance-Repeat/dp/1947200089

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.