Rising interest rates, skyrocketing property prices, and slowing rents are causing banks to pull out. So sponsors are hitting-up crowdfunding/syndication investors, instead. Is it worth the risk to jump in?
(Usual disclaimer: I'm just an investor expressing my personal opinion and not a financial advisor, attorney or accountant. Consult your own financial professionals before making any financial decisions. Code of Ethics: We do not accept any money from any sponsor or platform for anything, including postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members.).
Recession on Their Minds
No one knows when the next recession will hit or how severe it will be. But one thing we do know is that it's not a matter of if but when. And these days, some people are looking around and wondering if it might be sooner rather than later.
The stock market has been in a correction since January. The cost of oil is rising rapidly (and oil price shocks are a major cause of past recessions). The possibility of significant tariffs loom on the horizon (which could be like a bullet-in-the-foot, reducing business profitability, GDP and employment). And the synchronized global growth that looked so promising at the beginning of the year is starting to unravel in the euro zone, China and elsewhere..
In the world of U.S. real estate, bankers have noticed 3 worrying trends that are making them turn away sponsors with higher leverage deals. (See National Real Estate Investor "Multifamily Investors Face a Cutback in Loan Size".)
Skyrocketing Prices Out of Whack with Rent
First, the cost of buying new properties is climbing quickly (or to put it another way, cap rates are going down). This isn't a new trend and has been going on for years. But there is one big difference now.
In the past, higher prices were financially justified by higher rents. For example, if an apartment makes more rent than it did yesterday, it makes sense to pay more for it today.
But, the new thing in 2018 is that in many parts of the country, multifamily rent increases have slowed down a lot. Many of the most popular markets (the gateway markets like New York, Los Angeles) are being hit the hardest and requiring owners to provide concessions to fill buildings, like free rent. One formerly red-hot market, Austin, Texas, even became the first larger market to experience year-on-year rental drops. (See National Real Estate Investor, "Multifamily Rent Growth Stalls in Top Markets".)
The result of these two trends is that in all of these markets, prices are now going up faster than the rent. So the danger of overpaying becomes much higher. And this increases the risk of not being able to make the mortgage payment, and blowing up, if there is a sudden downturn.
The third thing is that after six rate hikes by the Federal Reserve, interest rates are finally rising. The average loan is now 0.55 percentage points higher than it was just 6 months ago. (See National Real Estate Investor , "Multifamily Investors Face Cutback Loan Size".) That doesn't sound like a lot, and it wouldn't be if the price and rent fundamentals were stronger. But in the current situation where finances on many deals are sometimes under stress, it takes away a big chunk of the potential profits. And if rates continue to rise, it will get more and more difficult.
Bye-Bye Big Bank Loans
So banks have noticed these three things and have cut back their lending to reduce their risk.
Two or three years ago it was relatively easy to get a permanent loan from an agency lender that covered 75 percent to 80 percent of the value of an apartment property (75-80% LTV). Not anymore. Dustin Doolin, the managing director of real estate services firm JLL, says, “Today we can get to 65-70 percent—it’s hard to get to 80 percent with a 1.25x debt service coverage ratio given the cap rates where deals are trading.”
So, when a bank shoots down a sponsor, what can that sponsor do? They could raise more equity in the deal so that their LTV goes down to say, a conservative 65%. But this also reduces the return to investors. For very conservative investors, a lower return isn't actually a problem, and is the ideal solution to this issue. In practice, very few sponsors go down this route.
Part of the problem is intrinsic to their compensation. The dirty secret of real estate industry is that most sponsors get paid a lot better for taking more risk rather than less. So, many will prefer to keep their debt high at 75%-80% and turn to crowdfunding/syndication investors to fund what the bank turned down. There are more and more of these deals coming out every day.
Or, the sponsor may take 65%-70% from the bank, and get crowdfunding/syndication investors to make up the rest with something called mezzanine (or second lien) debt. On the surface, this may look like a great deal because it gives the investor a much higher return (maybe 5 to 10 percentage points higher than basic debt). And it can be great if things go well.
But the catch is that it has lower priority for getting paid back if things go wrong and the property has to be foreclosed on. If the property experiences a price drop, many times the mezzanine debt will get wiped out and investors lose everything. So the investor is taking much more capital stack risk for that return. Again, there are more and more these deals coming out.
And of course, investors usually have the option to invest in the equity portion of either of the above types of deals. Again, since there is more risk usually there is a higher return on these deals to entice investors to give them a try.
Do any of these make sense for an investor? In my opinion, it depends on the risk the investor is comfortable taking and their personal financial situation.
Usually, deals like the above come with a pitch about how safe it is because "apartments are recession-proof" and "apartments shrugged off the last downturn with just a tiny hiccup". Or they may admit that this might not be true for all apartments, but will tell a narrative about how their particular strategy… usually class B workforce housing...doesn't have to worry about this.
Does the data support the marketing?
How to Lose Money without Even Trying
If apartments are really recession-proof, there should be a ton of sponsors who have gone through at least one full real estate cycle. In reality, such sponsors are rarer than a purple cow. (See the very short list of Top Full-Cycle Sponsors for 2018). This is the first hint that perhaps the risk on some of these pitches may not be fully stated.
What does the data say? The average apartment got hammered and lost 37.5%. And it took 7 long and painful years to recover.
(Some local markets did better and some did worse. I've seen more than one sponsor claim that their area did better, only to see the data contradict them. So I personally always double-check and don't take anything at face value.).
Why does this matter? Price drops are a problem because they usually make it impossible to exit. (This is especially true for value-added and opportunistic strategy investments which rely on price appreciation much more than core and core plus). So this often forces the investment to hold onto investor money longer than anticipated. For example, a 3 to 5 year value-added flip, might lock up the investor unexpectedly for 11 to 15 long years.
That's not all of the potential bad news though. During this time, the short-term debt that's financing the property has to be renewed to avoid going bust. This can be a double whammy and cause a really difficult problem.
First, in the last recession many banks completely froze their lending. So an investment relying on that would've been in big trouble.
Those deals that were fortunate enough to get financing, but which were burdened with high LTV loans, found a second problem. The loans they were offered were much smaller than they asked for, because the prices had dropped so much. So to avoid implosion, they had to go back to investors and ask them to pony up even more cash.
That was a really hard thing to ask in a recession. Most investors were under a lot of financial stress themselves, and were hoarding the little cash that they have. And also, sponsors were essentially asking to commit that precious cash for a decade or more...just to try to break even. That's a dicey situation for a fund to be in.
Silver Linings Playbook
All of the above is pretty bleak. But there is one potentially very large silver lining. Commercial real estate prices (including apartments) don't go down every recession. In the past six recessions, prices held steady or even went up slightly in three of them. So there's been a 50/50 chance.
So it's actually possible that the next recession will be fine, and price drops won't be a problem at all. Nobody knows what will happen until it does.
How to Strategize?
So if you're an aggressive investor, you might be fine with taking the risk with all these types of deals. If everything goes your way, you will be rewarded a lot better than someone who kept the money in cash.
For me, I'm a very conservative investor, so the risk is not worth it. I personally restrict myself to equity deals that have long-term debt (7 to 10 years). This reduces the chance of having to refinance during the wrong time. And I also limit myself to deals that have a maximum of 65% LTV, to best avoid a situation where the fund has to raise a bunch of money from investors to avoid losing everything. (And on my residential rentals which are owned directly, I go with no debt, to avoid all of these problems entirely).
What makes sense for you will depend on your risk tolerance and personal financial situation and goals.
What about income?
While the above are serious issues, there still some other things to worry about in these deals. Unlike prices that sometimes avoid drops, rents and occupancy always drop in EVERY recession. That can be a problem.
The average property rent dropped and took 3 years to recover. Vacancies were the same.
If a property is only barely profitable, or is in the midst of an expensive renovation, it might make it impossible to pay back the debt. If that happens, the investment goes bust.
So it's important for investors to always check the local statistics to look for worst-case scenarios, and then stress test the investment and see what happens. And for conservative investors, checking back one recession isn't enough. For most of the US, multifamily/apartment was hit much harder in the S&L crisis (sometimes called the "apartment recession") of the 90s. So checking further back, and/or adding extra to recession stress tests, is a wise thing to do.
"But Class B Will Be Just Fine! Right!?"
This pitch has gotten so popular, that I'm going to talk about it explicitly for a second. 10 or 15 times a week, I see a sponsor claim that their apartment deal is exceptionally recession proof because it is Class B or Class C. (Class A is newer/luxury housing. Class B is older/workforce housing. And class C is even older/"affordable housing"). They point out the (quite true) fact that it's too expensive to replace such housing, so there isn't a lot of supply. So, they claim, there will always be lots of demand from people wanting to rent, even in a recession. And this prevents them from going down.
But does the data support this? Here's a look at class B performance in one supposedly recession proof market: Dallas-Fort Worth.
An investor expecting a recession proof investment would've gotten a very rude surprise. As you can see, class B rents took a significant hit for 3 years, and did much worse than class A (which barely went negative at all). Class C did even worse. The narrative just wasn't true, here.
Here's a look at vacancies:
At least here, class B might have done slightly better than class A. But vacancies skyrocketed from 6% to over 9%. That's not recession proof. And class C got hammered the worst at an incredibly painful 12 to 13%.
This is why I always double check sponsor claims, by checking what the actual performance was in that city.
Full Steam Ahead?
If you're a more aggressive investor, you may have decided these types of deals are a good fit for you. If so, not every deal is created equal and some take more risk than others. So here are some questions to challenge the sponsor pro forma, to see if it's a good fit for you or not. (I call this process: "pro forma popping" )
Is the sponsor projecting ever-increasing rent in a straight line?
Since rent increases have already started to drop, try putting in a lower rental increase or maybe even a decrease at some point. Is there a big problem or could you live with the results?
Are they relying on price increase to hit projections?
If so, what happens if prices stay level or drop? Is there a huge problem or would you be fine with it?
If there is a downturn, and they can't refinance, what happens? Can they handle higher interest rates?
If they do not have long-term debt, what options do they have? And would you be fine if that happened?
I also recommend doing a recession stress test. This can be a good double check to make sure whether you really are fine with the worst case scenario or not.
And if you're not sure how to do any of the above, joining a good investor club, is a great way to learn how.