How to Invest in Commercial Real Estate

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Episode #071- RECESSION-PROOF Your Real Estate Career!

by Criterion, Braden Cheek, Brian Duck
August 1st 2022
00:00:00
Description

Today hosts Braden Cheek, Brian Duck and Joel Thompson from The Criterion Fund discuss the how to navigate the current current CRE landscape by seeing the opportunities behind rising interest rates... More

You know, when you're headed into a recession and interest rates are going up and you want to sell a seller may consider a 5% reduction. I don't know what his basis is. But if he's about to get a $2 million Okay, now I'm gonna get a $1.7 million get that, that, that money in his pocket. Welcome back! What is happening, man. Okay, so this week's episode of how to invest in commercial real estate, it comes at a good time. So the Fed is meeting again at the end of july next week, next week. And what are they gonna do? You know, everything is pointing to another three quarter point Reyes and interest rates, which is huge and they just did a three quarter point back in May. So that's a point and a half in two months. I thought it might be a full point right now. It's still, well, it still could be, could still be a full point When it went up 75 basis points last month.

It could easily do it again next month. Well, the next one is in september and they think there may be a half a point increase in september. So what we thought we'd do the show on today is that we're getting calls from investors saying, you know, what is the prognosis? What's the outlook? How is this affecting your, your acquisition strategy? Uh, we're getting questions from other people that are in the industry thinking, how are you guys navigating this? So today we thought we would take a few minutes to talk you guys through how the interest rates should affect your analysis of a deal. And, uh, can you still buy, can you still get returns in this market? Yes. So that brings us to a great starting point is we're typically higher leverage buyers. And what that means is when we go and buy a deal, we're borrowing 75-85% of that purchase price from some sort of bank from some sort of lending instrument where they put a rate on that some of my And when 80% of of the cost of funds, let's call it is coming from that bank.

And that rate is fluctuating like crazy right now, that affects your in cash flow immediately. That's one of the biggest things that is affecting your cash flow is the cost of your capital. So let's just, I mean, use a clean easy deal here. If we're buying a $5 million $4 million 1% more per year, that's an extra 40 grand that you're not gonna make on the same deal? Right. Yeah. And we've even got better than a general $5 million stone mountain Georgia. It was one of the last acquisitions for the criterion fund and it's called Stone Wood Village. And so we had a bunch of people invest in it and we want to kind of take that as a case study to show you how much the current interest rate increases affecting returns on the deals and what you should do about it. Yeah, This is a good example because we just closed on this on May 18. So we've owned it for a couple months now everything's going good. It kicked out his first distribution. But if we were by that same deal today, it looked really different. Yeah.

So let's take a look at it. Go ahead, go ahead. The deal we bought was we, we purchased it for six million. $457,000. It's a multi tenant retail center on a good corner. And in Stone Mountain Georgia 8.5 cap, about an 8.5 cap and the det we got on, it was prime plus a quarter. And at the time they had already raised prime like a half a point. And so prime was at 4%. And so our loan was at four and a quarter. Uh, and that was in May I think it was, it was it 80% lTV 81. So if my notes are right here. And, and Brandon, you gave them to me, the deal level returns were 12.61. Does that sound right? Deal level cash on cash with the four and a quarter percent interest rate on our purchase price was 12.61%. And so how we structure our Deies, there's uh, an 8% preferred return. And then there was some split, 70 30 to 70 30 70%. So you got the 1st 8% and then the 4.6% cash on cash left, 70% went to the investors.

The investors are getting somewhere between 11 10.5 11%. Okay. So all we did was, we went back and we said, okay, today, the best case, we think, uh, interest rate wise on that loan would have been 5.5. And you said you got a quote for a deal today at 5.5. So that's a today number. That's a today number. And, and Really look, prime right now is 475. But everybody knows that prime is gonna go up next week. So the best quote I could get on a deal today was was prime actually where we got prime plus a quarter before banks are having to get aggressive. We got prime today. Prime. I say today, prime as of next week is 5.5. And, and by the way guys, if you're underwriting commercial real estate property for acquisition and you don't know when prime and prime is moving or relatively by how much you need to get in the know because if you had a deal on contract and it just went non refundable and your rates not locked, you're in for a world of hurt. I mean, you can't take a three quarter point hit on, on your rate, uh, and not have your, your returns impacted as I'm gonna go over right here.

So, so this is a, this is one and a quarter hit, right? We were at four and a quarter. The best way I think we can do right now is 5.5 100 120. Yeah. And if you go back to some of the lower rates we got 3, 75 back earlier this year, that That would have been a 1.75% move in rates and you put 1.75 over three, Yeah, that's almost 50% move in your interest rates, 50% increase in the cost of your debt. And and that's not just for one year. Right? I mean, these are five year fixed rate interest, uh, loans, right? It's a.75 more expensive this year next year. The year after that year after that, the year after that. Until you can get the opportunity to refinance it. And depending on your pre payment penalty, you may be able to refinance it sooner. But still, that's a guaranteed high rate for a long time. Yeah. So on this deal, if we take the same purchase price 6.457 million and we just put in a higher debt, we go from four and a quarter to 5.5.

The deal level cash on cash goes from 12.61 to 10.35. So it's basically a 20% reduction in your cash on cash. Given the debt number, it's a lot. But I'll say it wasn't as much as I I initially thought it was gonna be, uh, you know, 10.35 if you're paying an eight pref really, the sponsor's taking a majority of that that hit, the investors are still going to get close to 10 Years, going from 11 to like 10 9, 9.8, 10. And so the investors are taking a huge part of that hit. The sponsor is if we keep everything the same. Um, But you know, 20% hit to your cash on cash, changes the deal. And, and people have to be aware of that doesn't mean you can't buy stuff. It just means you need to need to know what's happening there with your cash on cash. And you may need to try to to re trade the sellers or try to get the sellers to move. And so we did that math for you as well today, where we said, Okay, you know what if we we want our 12.61 uh deal level cash on cash and we have a five and a quarter or a 5.5 rate.

What do we have to do to that purchase price? And in this case we have to get the seller to drop their purchase price to 66.125 million or a reduction of like 330,000. So what did you that goes from? We bought at an 8.5 cap down to what about an eight uh or up to a nine cap. What do you have to? Yeah I'd have to do that math. I don't know if I want to do it right here. Uh But yeah, you'd have to get the seller to adjust the cap rate up. The purchase price would have to come down and 330,000 on a $6 million deal is a big re trait. It's 5% approximately. But you know when you're headed into a recession and interest rates are going up and you wanna sell a seller may consider a 5% reduction. I don't know what his basis is. But if he's about to get a $2 million check And he's like, Okay now I'm gonna get a $1.7 million dollar check. But if I don't take this and I wait another two months rates are gonna go up even further. Or if we go into recession, it's gonna depress pricing, he may think that's a great opportunity to get rid of that property, get that, that that money in his pocket.

So, uh, is there any downside say? So, we went through the example and, and we say, okay, the investors only went from 11 to 10% cash on cash or so, um, what's the downside to me? Um, possible downside is you you said that a lot of these loans are for five or for five years, what if interest rates keep rising for the next five years and and five years comes along and now you're you you have to refinance and and you have a higher rate, I mean, that's that's possible downside, right. I mean, I don't think people think five years from now the rates are gonna be higher than they are now. I think they think they're gonna peak and then come back down. But I guess that's that's a possibility, right? We have that risk on all of our deals all the time. You know, in fact, you could argue that the rates that we did a year ago at 375, 3.5 and four, that we were essentially at a higher risk because those are 55 year rates. But if you if you were paying attention at all, you would have thought, okay, at the end of five years, the chances of it being higher than 375 is pretty high.

Uh So here, like I think I was mentioning this to you earlier, what's interesting is as interest rates go up up and up, I think there's less downside, less interest rate risk in five years because you know, okay, if it does go up, how much more is it going to go up then it's already gone up, You're not starting at 375, you're starting at 5.5. And so there's a little less risk on the backside if you can make deals work at higher interest rates and you have the added benefit if come down in the future, you can refinance and increase cash flow without doing anything besides getting a new loan. That's interesting point. Actually less risk if you bought a property four years ago and your five years is up 12 months from now. You're, you could be in real trouble right four years ago, you might be sitting on a 3% loan and you're looking at a 6% loan or something here and the next year or something. And yeah, I mean looking at that specific example back in 2018, 19, you know, you were seeing high fours, low fives, you know, mid to high fours and and there was still plenty of deals getting done.

The problem is when debt gets so cheap, the sellers expectation of the sale price goes so high and right now we're just dealing with the time needed to to kind of get them off that high anchoring point, I think. And then to your point, since we're talking about the cost of capital and you say there might be, you know, less risk going into a high interest rate rising environment. Uh an investor like yourself may be willing to take a little less on their money today looking for tomorrow's upside. So that may average out your cost of capital problem with the rising cost of debt. Right? Yeah. Let let let let me give you kind of an extreme example if we wanted to look at that because I I heard that the peak not peak the low of interest rates, the low point of interest rates, people were getting 2.5% let's say on a hud loan maybe or something, maybe a floating rate, 2.5%. Well, uh to me that's that's the ultimate risk because there's nowhere to go but up your for your interest rates. And so those people could be wiped out if it goes from 2.5 to 5, you just doubled your cost of capital.

And so what's gonna be interesting to me is as rates go up really high, the higher the rates get, if you can get deals done and they make sense at a high interest rate, especially compared to the last 10 years, let's say, let's say rates got to six or seven, Uh you know and and everybody thinks this is the kind of the highest they're gonna get inflation is kind of coming back under control. Then you have massive upside because if rates ever worked their way down which I believe they will uh you'll be able to refinance and cut your cost of capital in half. Very specific example going back four or five years ago. I mean how many deals did you do in 2018 and 19 that you refinanced and In 2021 or or 2020 when rates started to go Down right there. Yeah there's one example on a big deal we had where we had a rate of $475 on $15 million $15 million $300,000 a year for you and we fixed it for five years.

Yeah. So um so these are all things to think about, you know there yes, you need to be more cautious because rates are going up and sellers are not equally adjusting their price. But uh there still are deals to be had and once again I think you can if you can make deals work with the higher interest rate and still get the cash flow you need you could be set up for some upside in the future. Also like we talked about there are plenty of people that got rates at two and 3% uh 2.5 and 3.5% let's say to be to be more fair. And if they have notes do coming due in the next year as rates are pushing 5.5 6, they are going to be in a, in a bind and there could be opportunities to pick things up if if people go into foreclosure or go into Receivership, uh, could be opportunity there for us to pick up some deals. So they may walk away from whatever equity they have in that deal in, in exchange for the uh, not having the negative cash flow from the increased cost of interest. Is that what you're saying?

You never know, you never know anybody's specific situation. But some of these deals, I don't know where they are on, on their capital structure, but you know, they have to debt cover or they're not going to get loans. And so depending on where their cash flow is, uh, you know, if, if, if they were at 2.5 3% now, they got to go to five or 6% it may not work. And so if they highly leveraged, let's say 80 90% you know, two or three or four years ago. And now the only thing that makes sense is a 60% ltv. They may not be able to come up with the additional capital uh to pay off the note that's coming due so that, you know, we'll just have to see how it works out. So it seems like generally there should be way less competition in the market now for for a deal if, if it's out there right? You think so because you think that the there's thinner returns and so there's less competition. Is that what you're thinking or? Yeah, I think deals are just generally harder to get done. You know, I mean, we had lunch a letter the other day and they were saying, you know, they were starting to pump the brakes a little bit on, on multi family or whatever it was.

So, I mean, I think there's, I think there's just a general tightening and a period of time where people are saying, hey, what is this, what is this going to look like in december? I don't know, I'm kind of scared that I don't know what it looks like in december. Maybe we should hold off a little bit. Yeah, that's the unknown is the key is, is when there's uncertainty in the market, people don't have the clarity to move forward or move as quickly and so yeah, there will be less deals getting done because people are uncertain about debt terms, where the market's going, you know, are we headed into a recession our price is gonna fall. Uh do I really want to be buying at the peak of the market if prices are gonna fall. So there's all that going on now. There's still a ton of capital out there. So there will be deals getting done and a lot of 1031 exchange money is out there and at least for the next six months, all the deals that have sold the last six months, they don't have a choice if they don't want to pay a huge tax bill, they're gonna have to trade into something. What I see though is if interest rates keep going up, we'll still see deals for the next several months. But then I think it really slows down after that.

After a lot of this 1031 money works its way through the system. Um, It makes me wonder if, um, the sellers won't adjust their prices for a while because of all that 1031 money. It's gonna take a lot of cash deals where people don't care what the interest rate is, right? And so maybe the sellers don't have to adjust so much. We're selling deals right now right? Like you're, you're selling an apartment deal. We're selling some pad sites in Plaza West. We're selling a single tenant deal in Dallas and I haven't, I haven't dropped my price. Once we did, we did on our multi family portfolio hasn't closed yet, but we did give them a little bit of a discount given the size of the deal and the interest rate impact. But not, not not too much something, we both, we both felt the pain a little bit and that seemed to be a good middle ground like bob says that's how you know, you get a good deal, right? Yeah. Well, you know, that's a lot of information kind of unpack there. You can, you can do your research all of this. A lot of this is public information at least on the Fed when they meet with the probable rate increases the history of where prime has been.

Um But the great news is you don't have to be an expert in all of that, right? Because you can go to our website, the criterion fund dot com or precision equity and you can sign up for our investor list and then we have opportunities that work. We send them to you, you don't have to worry about what the interest rate is because we've kind of pre vetted it right, we bundle it in this nice little package, we send it to your email and then boom, we closed the deal. Yeah. And one of the things I want to challenge people to do is instead of saying, you know, it isn't gonna work, interest rates are going up recession is coming is start asking yourself, how do I win, how do I make a deal work? How do I get the numbers to work? Because there are opportunities that are out there in every single market, rising interest rate, market, recessionary market, you know, hot market, there's always a deal to be had. But if you don't believe that you're not gonna be out there looking and you're not gonna task your brain with trying to figure out what scenario can I make this work like in this situation, The new debts, this, how do I get the seller to give me $330,000 off that deal so I can get the same return for the investors that I had pre interest rate hike.

So as long as you're, you're trying to solve problems, you're gonna find an opportunity to buy in this market and in a market six months from now and a year from now, I agree with that. It's great advice. Well, if you guys don't have anything else, we'll see these guys next week. Yeah. Thanks guys, tune in next week.

Episode #071- RECESSION-PROOF Your Real Estate Career!
Episode #071- RECESSION-PROOF Your Real Estate Career!
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