How to Invest in Commercial Real Estate

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Episode #052- Navigating Commercial Real Estate in the CURRENT ECONOMY!

by Criterion, Braden Cheek, Brian Duck
March 7th 2022

Today our hosts Braden Cheek & Brian Duck from The Criterion Fund and Joel Thompson from Precision Equity discuss how to navigate the ever-evolving landscape of Commercial Real Estate in today'... More

right now, you can watch the news cost of construction, cost of materials through the roof, through the roof. Well, okay, so then new houses are more expensive to buy and which, which makes it harder for apartments. People living in apartments to go buy their first house. Well, that's a that's a that's positive pressure pushing up apartments because they can get away with charging more for the apartment because they know, hey, your alternative is to go buy a house and those are getting really expensive. So all these factors are pushing up, uh well, the other thing that pushes it up is that with rising interest rates and rising costs, people aren't gonna wanna build, companies are going to want to build new apartments probably right now, right, because it's, it's a little riskier. So that means you'd have to be crazy to build new apartments right now would really crazy. Hey guys, and welcome back to how to invest in commercial real estate. We are a podcast, breaking down commercial real estate investing for the average person. And today we just wanted to take a look at just kind of some macro trends we're seeing in the market. Obviously we're always buying and selling and looking at our investments across the portfolio and seeing if it's a good time, you know, to buy or sell or hold or refinance and there's, there's a lot going on, you know, there's a, there's a lot happening and today we just wanted to dive in.

Sounds good. So I think a big thing that you need to focus on is everything is so expensive right everywhere you look, you know, crypto setting a new high, the stock market is on a massive run. I mean, it's hitting highs, I mean, you're gonna have some little dips every now and then. But generally speaking everything is just, I mean, so expensive. It's been crazy what prices are doing, we've been doing this, we've been investing in real estate since 2000 to 2003 and never in my investing career, we've seen anything like what we're seeing out in the market today. And, and for those that are listening, we're in Tulsa Oklahoma, we do by nationally, we have properties across several different states. So it's not just a localized deal, it's everywhere. And I think it's pretty much over all the asset classes. Yeah, particularly though multi family is just skyrocketing right now in MHC, just finished up, I believe it's in Orlando this year and that's a national multi family housing convention conference or convincing.

Yeah, That's really the big dog of, of multi family housing conferences, everybody's there. Um, everybody's got a new $500 million dollar fund that they got to get placed in the next six months. It's crazy. And do you think that's because for multi family, because in general, businesses has been really good and the economy has been really good for a long time. Interest rates are low. So there's lots of buyers or could it be because um, the economy has done so well for quite a few years that there's really low unemployment so people can afford to pay a little bit more when they're renting. I mean, is it some combination or have you, do you know what it is? I mean, what do you think? Okay, I mean, this is a show about our opinions, so I'm gonna give my opinion. You hit on a couple of them. I mean, in my lifetime we've never had a bull run, like we've had this long 2008 was tough to get through. But by 2010 we were starting to come out of it and then, you know, we were humming along 2015, and everyone thought, Oh, we're going to have a correction that we never did.

And so now we've got 12 years of complete unemployment going down uh you know, interest rates all time, low generationally low uh for that long. Uh You know, so you just the stock market near all time high. A lot of, a lot of positive stuff going, I think that's a lot of what's driving it. And then of course Covid. And so Covid, you know, think about the trump invited administrations, both of them pumped trillions of dollars into the US market trillions. That's thousands of billions. Well, even back quantitative easing. Obama did it too. So it's really, it's been over the last 10 years quantitative easing. Yeah. Yeah, literally printing money and dumping it into the economy and I'm not going to get into the politics if if that was the right or wrong decision, obviously it helped and we have this amazing economy, but all those trillions of dollars are circulating in the market changing hands. You know, it goes from one income column. Oh, I made, I made money, then they go spend that money and it ends up in another income column. And the faster the economy gets heated up, the more the same dollar accounts for income for multiple people.

And everybody feels richer and, and co terminus lee, they're lowering interest rates on the debt and they're making it easier to get in a lot of respects. Yeah, dad, they've kept it near zero now for a long, long time now. So what's unique about today is, we're gonna, we're gonna look at what we have is a super hot real estate market where prices are setting all time records. You got really low debt, which has been fueling a lot of that. But now we're going to see the Feds stepping in and starting to hike interest rates because they're gonna try to slow this thing down. So that's gonna be interesting to see, okay, we're at what has to be the peak of a cycle or close to it. And we've got monetary, uh pressure from the feds that are going to bring interest rates back up? So what does that mean? Should people get out of real estate? Should they sell all the real estate? Should they be buying more? That's what we can talk about today. Yeah, I think I want to go back real quick to what brian said earlier about why, you know, multi family maybe heating up. I think from the consumer standpoint, we watched them and we watched all of these people, you know, for the most part pay their rent during Covid.

You know, it's a very stressful time on a lot of asset classes. You don't know what's going to happen, You don't know who's going to pay or what your income is gonna look like. Um and a lot of apartments had pretty good collections, you know, people paid their rent, people paid where they needed to live and the government was giving them tons of money. So you, I think you've got a lot of rent growth over the past couple of years. That that people may or may not have been underwriting for sure. That. And industrial has been going insane as well. I mean, you see people nabbing up indoor industrial, you know, primary jobs like crazy. And I think that also relates a lot back to Covid because you see that these primary manufacturing jobs that that stayed open during the economy because they were while the economy was shut down, let's say during Covid, they were so important that they paid their rent. You know, they were still operating, they were still manufacturing, they were still producing revenue. It's, it seemed like a safer asset class to invest in than, than some others because of the priority going on. You know, No question. Multi family has, has the least perceived risk in the future.

You know, people always need a place to live if there's, you know, shortage of units, um, people are always going to make that that house payment or the rent payment first. What struggled a little bit was retail through Covid because, you know, people are shut down, they're more afraid to go into business is people wanna pick up the drive through, they want to get it delivered to their house. So brick and mortar, retail has a higher perceived risk. Uh, and so a lot of the dollars are hitting multifamily. You mentioned industrial, I can't help but think that, that the main driver of that is a strong economy, but also cannabis because now we have literally a crop that everyone wants to grow indoors and it's profitable enough to do that. So you're absorbing indoor industrial space by the hundreds of thousands, millions of square feet across the country. And markets said it's now legal to grow. Uh, so that's been a huge driver. Yeah, I think it's legal in and almost half the States, if not more now. So that's, that's a lot of square footage and like you said, it was probably older, cheaper square footage anyway, that was just absorbed back into the market.

So that was great. But back to what you said earlier on interest rates, you know, with interest rates being this low, we've talked about a cap rate before and we use cap rates to evaluate what a property could be worth based on the income it produces. So when the debt is cheaper, we're typically borrowing, you know, 75-85% of the cost of that deal from a lender. And if they're charging us one or 2% less on $5 or $6 million $10 million dollars or $100 million you can see how that adds up really quick and you can make a lot of deals work because it puts the cash in your pocket because the lender is charging less. Right? So you can I mean you can see how that adds up. Okay, I can afford to buy a nicer asset because the loan from the bank is so much cheaper. You have positive leverage where you're borrowing or you have an asset that produces 8% and you're going to borrowing the money to buy that at at 4%. So what's gonna happen when the interest rates rise on that our people are there going to be less buyers because there are returns not as good or do do cap rates rise or fall? I mean you have any opinions on that as as interest rates rise.

Yeah. I think cap rates have always kind of historically been tied to the availability and the cost of debt and in some respect, people have to take that into consideration. Most people aren't out here paying all cash for this debt is evaluated. Um It typically puts pressure on the sales price and and multi family and industrial and some of these hotter asset classes that are so expensive. It's pushing cap rates down so your cash yield each year is going down and down and down. But when um you're trying to refinance that or get out of that in an interest rate market that is multiple points higher. It may not only not work but it may not even be able to service the debt of of the refi you may be selling for substantially less. Right? Yeah. So people are looking at evaluating multi family deals and today they say, well I can get a debt at 275 or three on a multi family cheap, super cheap, let's say years ago it was five. Okay, so now I can get it at 2.5, 33 and a quarter. Uh So that allows me to to bring that cap rate down and I can buy it at five or 5.5 cap somewhere you can go in lower and I can still ink out some positive leverage.

Well what's the point you're making is okay if I get a floating rate or if I get a five year fixed rate or even a 10, what happens at the end of that? Uh And so 10 years is a little bit better of a hedge because at least you pay down principal over 10 years. But a lot of these are interest only loans for 34 years, so you may not pay it down that much. And if the, if the rate goes from 3 to 3.5, not a huge deal, but if it goes from 3 to 5, that could be a problem. Now, how they're going to underwrite around that is rent growth. Uh And so it just becomes a little bit of a riskier game and a rising interest rate environment because you really do need rent growth to cover you in the event of higher interest rates in the future where before you know, or the last, let's say 10 years or so it's it's Like 2007. Since then rates have been down, they immediately during the recession lowered them, they may have started to tick up and then they brought them all the way back down. So you haven't had to worry about that, but I think it's time for people to start putting that into the equation.

Can you usually get um an increase in rent um when inflation is taking over like it is now, can you kind of match that with increases in rent. I know a lot of times, of course the leases aren't coming up for two or three years so you don't know. But but any leases that are coming up do right now can you get an increase in in rent uh and say hey you know inflation is taken over? So you know your rent's gotta go up to. Yeah and I think you've seen that everywhere from from gasoline to milk at the grocery store right? If if you you six months ago and you're using it now there's no question it's more expensive. So I think your tenants are gonna be feeling that exact same thing. You know man this they're gonna know it's sort of expected probably and everything else is going up. I've seen it built into a ton of leases. I mean how many times have we seen commercial price index increases in in a lease. I mean you're not seeing that as much. There's probably a lot of C. P. I. Index written leases this year though. I can bet you that because Inflation is you know 789%.

The what in 2021 or now that's a ton. Yeah and multi family is a you're usually on a one year deal one year. And so You know as those but you're always having them roll every month you'll have a certain percentage maybe 10% 15% rolling uh and so you get a chance to adjust it but it's not an arbitrary oh as a landlord you know C. P. I. Is high. So I'm gonna raise the rent. It's really market driven and their analytics you can use but it's it's really just in that area a similar type apartment complex. What are they running for in the market? But with inflation and with costs going up and with demand high. Uh the rents will will drive they'll they'll come up. I think you're also seeing it in the um New construction single family market as well. The demand for a brand new construction house is insanely high. It almost seems like they can't build enough houses if you look at the houses built last year and and even the previous five years.

I mean there are hundreds of thousands less than in 2007, before the big crash. And there's no doubt there's a massive demand and it's easy to get debt for a new house. I mean it's it's still really easy. The debt is still super cheap. So I think there's a lot of people that are are stuck in an apartment so to speak because there's not a house. That's a good point. Let me think about that. So right now you can watch the news cost of construction cost of materials through the roof through the roof. Well okay so then new houses are more expensive to buy and which which makes it harder for apartments. People living in apartments to go buy their first house. Well that's a, that's a, that's positive pressure pushing up apartments because they can get away with charging more for the apartment because they know, hey, your alternative is to go buy a house and those are getting really expensive. So all these factors are pushing up uh prices. Well, the other thing that pushes it up is that with rising interest rates and rising costs, people aren't gonna wanna build, companies are gonna want to build new apartments probably right now, right, because it's, it's a little riskier, so that means you'd have to be crazy to build new apartments right now, Joel is in the middle of a ton of brand new class, a apartment development that I'm sure it will go great, but that was really funny, I'm not sure they're gonna go great, I'm not arrogant, this, these are my first developments, but we're trying to do it the right way and you know, I'm counting on rent growth, right?

I'm counting on on uh not only rent growth, but also demand, because like you say, a lot of people may not be starting a new developments and we, we are already in the middle of ours, so hopefully when I deliver it, there will be a high demand and we can get the rents that we need to cover our costs. Yeah, just something like that. I mean, I remember kind of looking at the model when we first started it and the rent growth, you've seen just in modeling since the first time you put a model together and hey, this is where we're gonna start this rent, we need, you know, maybe that's a buck 35 bucks, 40 bucks, 50 ft, you know, maybe that's a buck 65 now, the rent growth you've already perceived and just planning the apartment complex that you know, you didn't realize obviously because it's not there, but that helps bring some confidence knowing it's going in the right direction at least. So then what are people to do that are looking at getting into commercial real estate for me, what I would say is now is a good time to sell if you own assets that you have maximized value over the last 10 years, now's a great time to try to exit that, but why is that what you want to exit now?

Well, um, because I think right now we're seeing prices in a frenzy that are, that are, that are high, the demand, I haven't seen the demand higher now, it doesn't mean prices are gonna go up continue to go up. They probably will, but at some point you have to say this is a good time to sell could six months from now be a good time. Sure, but now is, But now is a good time if you have been holding the last 10 years but you have to think about what you're gonna do with the money, do you want to pay your taxes? Do you want to pay a big tax bill and just put the money in the bank and wait for an opportunity. Do you want to try to 10 31 exchange that? Well, if you're going to 10 31 exchange it now, you're gonna have to go buy a property at the top of the market. So that's tough. So there isn't a great answer for everybody. We're gonna look to sell strategic assets, but most of our assets, we're going to hold through, we're gonna continue to try to maximize value by increasing rents and we're gonna take that cash flow. And, and we're gonna just pay out to our investors. Like we, we said, we would now go ahead. It's also a great time to buy in that, in that same respect.

Interest rates are still really cheap. You can find some great yield out there and, and, and retail and, you know, people are still buying multi family. They're obviously thinking they can make money. So, you know, there's, there's activity on both ends. Obviously we're still buying, we're out in the marketplace finding good deals. I'm still a buyer net net, I'm a buyer. Um, but you just have to, there are some risks associated with the stage of the market that we're in, that you just have to, you know, be thinking of, uh, but good deals are always going to be out there, someone's always going to need to sell for whatever reason, uh, there's always going to be something that an owner doesn't see with, with how to maximize this property that you might, could see. Um, so I think there's always opportunities to buy even through the cycle. You know, I think over the past Year or two we've seen so much cap rate compression, so so many values just go through the roof on, on our developments on, on Kiddie Academy's. You know, we're underwriting a cap rate, we hit 50 basis points lower on a single tenant restaurant deal.

We did, we're underrating cap rate, we got almost 200 basis points lower. So, you know, we're looking at these deals, you have to, you have to take that into account. Hey, you may be building something today, you may be buying something today, but 57, 10 years you need to be able to look in there and, and forecast and reasonably say, you know, hey, here's what I think I would do in that situation. You know, if interest rates are this, we can sell and it will still be okay if interest rates so that we can refinance and, and keep the asset, You know, you need to be looking looking forward and paying attention to these things. Yeah. And I think now's a great time to be really, really thorough with your underwriting and really position yourself. If I have to hold this asset, can I do it? Uh, if the market turns on me, am I going to be okay to hold this asset through the market cycle correction? And that's important because there are people that are, that are, they just got into multi family, let's say four years ago. It's done nothing but sky rocket to the moon and they think that they're the best investor ever. Every deal they've done is just, well, it just exceeds what I projected.

I am so good at this. Well maybe you're really good at it, but maybe you just happen to be in a window of several years where nobody lost money in multi family and that breeds a little bit of carelessness. Uh, because they're not gonna, you know, they're not going to be a stringent in their model. They're not gonna be appropriating the right risks. And some people are gonna get burned because of that, that situation. Yeah, there's a ceiling. There's the saying, I'd rather be lucky than good. But in real estate, I'd rather be good than lucky because you may hit a lucky deal. But if you have really shitty underwriting practices, it's gonna burn you. And, and like you said now is the time to be cautious. And so in underwriting right now, you'd recommend being a little more conservative. Maybe you put a little bit more Capex because you think that the costs are gonna go up. All I'm saying is, you can't keep underwriting cap rate compression, you know, for a lot of the time you could, you know, this is gonna be nicer. Hey, we may not increase The rent much, but the rent we have is going to be worth more or you know the guys who bought an apartment building for $50,000 a door on a six cap, you know, that was stupid when they bought it and they sold it on a five cap and did nothing to it.

You know that back in the day you used to have to work really hard for rent growth and multi family and it cost you a ton of money, it costs you refrigerators, remodels, new cabinets, painting. I mean it costs you so much to be able to say, hey, I am a good owner, I'm increasing, You know where you live and I need $20 more a month because that's where I'm gonna make my money and you would go in with this plan, this rehab and now you see people like Joel, they're just going into markets with insane rent growth, buying it, power washing it and putting it on the market a year later and making millions of dollars. Yeah, and I've been too conservative over the last few years, you know, because I, I really cut my teeth through the recession so I knew I knew how bad it could get and so I, I've been, I've missed out on a lot of deals where new guys have come in and just been buying up everything, not really worried about the risks and they're they're making a ton of money and I give them credit. Um So there's you can win at real estate a bunch of different ways. But yeah, we're being a little more careful I think, to wrap up and looking at how do they go about approaching deals is you need to underwrite uh increase in interest rates when you re fi um you know, before you may maybe you didn't have to do that.

But I I gotta believe the feds, we already know they're gonna hike in the march. They're probably gonna hike two or three times this year. So, uh If you're getting a ten-year fixed deal, okay, maybe that's a guessing game in year 11, what happens? But if you're at a five year, if you're getting a five year fixed, a three year fixed or floating rate, it's going up. So that's number one is make sure your accounting for that and and you have to account for in multiple ways, right? Because you don't have to just assume the interest rates going up. If you were to refinance it and keep the asset. But if the interest rate went up and you wanted to sell the assets, somebody would pay less for the asset because the debt they're getting was costing them more. You understand what I'm saying? Double it's a double hit, right, you don't, you're gonna be out of options if the interest rate rises too much. Either way sell or hold, it's affecting you and that's why I want to be able to hold assets through whatever market christian er is rising interest rate because eventually the market will heat up again. So as long as you're playing the game for the long run you're gonna be fine through some of these these market changes.

Well thanks for tuning in to how to invest in commercial real estate. If you've got an idea for our next episode, be sure to leave it down in the comment section below and um we'll see you next week with another episode. Alright, thanks guys.

Episode #052- Navigating Commercial Real Estate in the CURRENT ECONOMY!
Episode #052- Navigating Commercial Real Estate in the CURRENT ECONOMY!
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