Archive for the ‘Debt’ Category
Today’s NY Times has an interesting comparison of 5% down FHA and conventional loans. (For more about the basics of FHA loans, read this.)
It turns out that the increased mortgage insurance premiums currently demanded by FHA make FHA loans a worse deal than 5% down conventional.
If you’re considering buying with little money down (always a risky move, by the way!), it’s worth reading this article and then asking your lender or loan broker some tough questions.
Was at a conference on syndication yesterday and came across an interesting idea: debt yield.
Debt yield is yet another test lenders use to determine whether or not they should make a loan on a 5+ unit deal.
The math looks like this: Divide the building’s NOI by the proposed loan amount. The resulting quotient is the “debt yield”.
- Say we’re buying a $1MM building
- Because it’s one of my deals, the NOI is $70k (if it were someone else’s, we could use $50k)
- We want to use a sensible purchase loan at 65% LTV, or $650k
- Bank calculates a debt yield of $70k / $650k = 10.8%
Attentive readers will recognize that this equation looks a lot like a cap rate, which compares the NOI to the price of the building. Except, because the equity isn’t taken into account, the debt yield on a given deal will invariably be higher than the cap rate (unless you’re asking for a 100% LTV purchase loan… in which case I’d like an introduction to your bank, please.).
The similarity to cap rate is intentional. What the bank is using the debt yield to understand is this: Assuming the borrow misses the fist debt payment and the bank needs to foreclose (wiping out the equity and trading its unpaid loan balance for ownership of the property), what kind of yield can the bank expect on its money?
Two problems occur to me in thinking about debt yield, one small and one big:
1. The small problem is that the equation does not take into account the time and expense involved in foreclosing. There’s probably a rule of thumb out there (varying by state, since foreclosures are different in each state), but I don’t know what it is, since I’ve never foreclosed on anyone before.
2. The larger problem is with the NOI part of the equation. In the event someone borrows and then misses an early debt payment, you have to assume something is royally messed-up at the property. In that scenario, it seems extraordinarily unlikely that the NOI upon completion of the foreclosure is going to look anything like the pro forma NOI against which the bank loaned. In real life, the NOI is 99.9% certain to be materially less than pro forma (since, if it was close, the lender wouldn’t have defaulted).
Based on the above, I’m pretty convinced debt yield tells you nothing that the DSCR and LTV tests don’t already tell you. But bankers have to have some analysis tools to use to talk themselves into and out of doing deals, so they might as well use this one…
One of the things that bothers me about today’s real estate market is the relative scarcity of sellers willing to carry back mortgages.
To understand why I think it’s weird, we first need to understand what seller carry back financing is.
Simply put, seller carry back financing is when the seller of a property provides the mortgage for the buyer to buy it. The way it works is that the buyer comes in with a downpayment, just like in a regular sale. But, instead of getting a loan from a bank for the rest of the purchase price, the buyer executes a note in favor of the seller. Then, over time, the buyer pays off the note.
Here’s an example:
- Buyer agrees to buy a property from Seller for $1MM
- Downpayment is $250k
- Seller agrees to carry back a note for the balance of the price, $750k, at 7% interest only, with a balloon repayment after five years
- At closing, Seller gets the $250k (less transfer taxes, escrow fees, and whatever he has to pay his broker)
- Buyer makes monthly mortgage payments of $750k x 7% = $52,500 / 12 = $4375 / month for five years
- At the end of five years, Buyer either re-finances the $750k loan with a bank loan or else sells property and pays off Seller’s note
- If, at any time Buyer fails to pay, Seller simply forecloses, takes back the property, and keeps Buyer’s $250k downpayment
It’s pretty easy to see why a buyer might like to get seller carry back financing. First, if it a seller might agree to a higher loan-to-value or a lower debt service coverage ratio than would a bank. Second, a seller probably doesn’t need to get the ridiculous amount of paperwork that a bank requires to do a loan. Third, a seller might be willing to loan to someone with bad credit or insufficient income, which a bank wouldn’t do.
All of the above makes seller carry back financing sound pretty risky. So, why do I think more sellers should do it?
Well, one important reason is that, because the seller can offer as much leverage as he wants, he can probably get a buyer to pay a higher price than the buyer would otherwise be willing to deliver.
But, perhaps even more important is the interest rate the seller can earn on the note. In our present, low interest rate environment, it’s pretty hard to get a safe 6-9% / year return. So, the question is, if you sell your property, what are you going to do with the money?
Why not get a chunk of money now (the buyer’s downpayment) and invest the balance in what is effectively a bond paying 6-9% for, say, five years? That’s better than you’ll do anywhere else. And, in the unlikely event the buyer defaults on the loan, you take the property back, keep his downpayment, and sell it again!
A lot of people are wondering whether it’s already too late in the cycle to buy.
After all, prices have bounced back up off the floor of 2009-10. For context: I sold a bunch of totally renovated buildings in 2011-12 for 10-10.5x the rents. I would get 11x all day right now, and possibly more. (Ouch!)
So, is it too late?
Syd Leibovitch, the president of Rodeo Realty, doesn’t think so. His prediction is that prices will double from the lows… implying there’s plenty of room to run.
Now, I love Syd. He’s a sweet guy and he’s brokered more deals than I probably ever will. (In fact, before I set up the brokerage part of Adaptive, I considered signing on at Rodeo… before remembering that I don’t play well with others!) But I always get a little nervous when I hear brokers predicting price increases. It’s a little too potentially self-serving.
But let me give you another data point: I’ve bought five apartment buildings over the past 3-4 months for our funds, several more for fee-for-service clients, and am making offers for myself now.
Why am I so bullish on the market?
First, let me acknowledge that I don’t have a crystal ball. Anyone who tells you they are certain which direction prices are going to go is a fraud. There’s just no way to know.
Here’s what I do know:
- I don’t pay high prices. The buildings we have bought were all cheap on either a price per square foot or GRM basis, or both. I can’t predict the future, but I know if I buy for less than replacement cost and/or at a price which allows me to lock in a good return from the cashflow (with increases to come), then I don’t really care that much about where the market goes…
- …because I don’t use a lot of leverage. If you don’t over-lever, then there’s no way you’re ever going to be forced to sell. If you’re never going to be forced to sell, then you can always wait out bad markets.
- Rents are rising. There is a lot of demand for quality apartments in good areas. We put a 2 bed / 1 bath in Echo Park on the market for $1850 and had 40 inquires within 24 hours. I think this demand is likely to increase as the economy improves and jobs come back. More demand in supply-constrained in-fill markets (like Los Angeles, generally, and Echo Park, specifically) leads to rapidly rising rents.
- There is a long-term trend away from the suburbs and towards city centers. Long commutes are among the largest contributors to unhappiness. Cities have culture, entertainment, exchange of ideas and, most importantly, good jobs. Over time, I just can’t imagine prices in the 2nd largest city in America not increasing faster than inflation, because living in the middle of a vibrant city is a good life decision for most people.
- Interest rates are incredibly low. Sure, they’re not as low as they were six months ago, but they’re really low by historical standards. If you lock in a 4.5% loan for 30 years right now, I can’t see how you will look back and wish you hadn’t done it.
So, there you have it… a slightly scattered, but fairly emphatic defense of buying now. If you buy my logic and want to get serious about buying a good apartment building, get in touch.
Market prices are up across the entire city. Where you could once buy stuff for 10x GRM, almost everything is now 12x+.
If you’re looking at deals now, it’s important not to get caught up in thinking about buildings relative to each other. At any time, I can tell you what the best thing to buy is in any of the neighborhoods I like. But just because something is a better deal than the other stuff out there doesn’t necessarily make it a good deal.
Now, there are still some genuinely good deals out there. For example, there are stabilized apartment plays at 11x where there is upside because the zoning allows for denser development in the future. And there are non-rent control buildings where the rent have room to move, allowing you to get closer to 10-11x by doing a little management work.
And, if you get one of these reasonable deals and you finance it with reasonable leverage for as long a fixed period as possible, you’re going to do very well.
But there is no magic that transforms a rent control building bought for 14x the rents into a good play. Unless you have (1) a plan to increase rents / reduce costs, and (2) the capital and experience to pull it off, you should probably not buy any rent control building at that multiple, because there is not going to be any real cashflow for years and you’re exposed to re-finance risk in the event rates continue to move (hint: they will).
On the other hand, you don’t necessarily have to pay attention to cashflow if you don’t want. You could just decide to bet on prices increasing. You can figure: I’ll buy at 13x now and hope some fool down the road is willing to buy at 15x two years from now.
But just understand that, if you’re doing that, you’re a speculator. And speculating right now hoping for multiples to increase, when we know interest rates are also increasing, seems like an extremely risky play to me.
Today, we’re going to focus on strategies that make sense in an environment where:
- The economy is improving; and
- Interest rates are rising
Let’s take these conditions apart, see how they affect the apartment business, and then see what strategies make sense.
1. An improving economy
With the economy improving, we should expect to see rents increase, because:
- As young people get jobs, the first thing they do is move out of their parents’ homes / the shared apartments they’ve been living in. This will increase demand;
- As employment increases in the construction trades, I expect we will see increased immigration (legal and otherwise) from Mexico. This will increase demand;
- Nothing was built between 2009-11, meaning that supply is pretty constrained.
Increasing demand and constrained supply should cause rents to continue to increase, which is great news, if you own apartment buildings. Except…
It’s not good news if you own rent controlled buildings with rents that are substantially below market. For those apartments, not only will you only be able to increase the rents by 3%, but, as the surrounding rents increase faster, your tenants will become increasingly entrenched (a $500 apartment where market is $650 is very different from a $500 apartment where market is $1500).
So, when you expect rents to climb, you want to either own non-rent controlled assets or else rent controlled assets where the tenants are at or near market (so that you get the normal amount of turnover and can therefore keep your rents rising as the market rises).
2. Rising interest rates
There are two problems with rising interest rates, from a landlord’s perspective.
A. Decreased cashflow
If you have a variable rate mortgage, increasing interest rates will have the immediate and painful effect on your cashflow. For example, if your net operating income is $100k / year and your debt service is $70k, you’re clearing $30k in free cash. If the debt service spikes to $85k, you’re only going to clear $15k.
The way to avoid this problem, of course, is to immediately refinance into some kind of fixed rate loan. If this is a 2-4 unit deal, you can get a 30 year fix. If it’s 5+, you’re looking at a maximum of 7 years (from a bank) or 10 years (through the Fannie Mae program).
B. Decreased value
This one you can’t protect against. When interest rates rise, prices fall (assuming constant net operating income). For example, with ultra-low rates, paying 13x the rents, while ridiculously pricey, is still semi-sane. With higher rates, it’s entirely nuts, because the cashflow falls to almost nothing.
As a buyer, if you know rates are increasing, you need to plan for the very real possibility that your property will decrease in value. Sounds bad, right?
It’s not really, as long as you aren’t going to be forced to sell any time soon. As long as you are happy to own the property for an indefinite period, you don’t care about valuations. After all, values are cyclical, going up and down. If you are happy to own forever, you can just wait to sell until the market is high.
So, the key is to finance the deal in such a way as to ensure that you will never be forced to sell. And that means keeping the price reasonable, the loan-to-value as low as possible (so, putting down more cash) and getting the longest fixed-rate loan you can get.
The best stuff to buy
Putting it all together, in this environment, you want:
- Non-rent controlled or rents at or near market;
- Bought for a reasonable price – say 11x (maybe up to 12x if 2-4 units);
- Relatively low leverage (say, 65-70% LTV);
- As long a fixed rate period as possible… meaning ideally 2-4 units (for a 30 year fix);
If you do a deal like this, you will enjoy increasing rents, mostly fixed costs (or, at least, costs that grow more slowly than the rents), and therefore increasing profit margins. And, since you will never be forced to sell, you can almost guarantee that you will not lose money on exit, even if interest rates continue to rise.
We’re living in a world of rising interest rates, which are already fundamentally changing the real estate market.
As discussed yesterday, as interest rates rise, prices should fall, all other things being equal. That’s because more expensive debt means reduced cashflow and lower returns at a given price.
But, all things are not equal. In general, assuming a normal economy, interest rates should only rise when things are improving. Why? Interest rates are effectively the price of borrowing money. When the economy is bad, and there is not much opportunity, no one wants to invest in new opportunities, so the demand for money is low and the price (the interest rate) falls.
On the other hand, when the economy is promising, everyone wants to borrow to expand their businesses, buy assets, fund consumption (cars, boats, etc.) So, demand for money increases and interest rates rise.
The fact that interest rates are going up isn’t necessarily such a terrible thing. It is, in fact, a strong signal that the economy is improving.
The trick for real estate investors is to figure out how to benefit from an improving economy without being hurt unduly by the rising rates.
Here’s an example of what not to do:
- Pay a high price (say, over 11x) for a rent controlled property with tenants at below market rents
- Use a 3- or 5-year fixed rate loan for a very large portion of the purchase price (say, 75%)
Why is that a bad play?
- You paid a high price, so your cashflow is pretty slim to begin with;
- Your tenants aren’t leaving, so you’re limited to increasing the rent by the city-mandated 3% / year, meaning that you’re not really benefitting that much from improvements in the economy;
- Interest rates go up in the interim, maybe to 6-7% (they were that high as recently as 2008);
- After 3 or 5 years, your rate comes unlocked and your debt payments increase, eating up most/all of your slim cashflow;
- When you go to refinance, depending upon how much multiples have dropped as a result of the increased interest rates, you may find that you lack the equity necessary to refinance and are therefore stuck with whatever rate your loan has adjusted to.
The above is pretty obvious to me, and yet I see poorly advised investors buying exactly this type of deal all the time.
Tomorrow, we’ll talk about some better strategies for investing in a rising interest rate environment.
Had breakfast with a really experienced broker this morning, a guy who I think of as kind of a mentor. He started in real estate in the early 1980s and has bought and sold an unbelievable number of properties in the Echo Park area since then.
I complained to him that the market feels pretty weird right now, with almost all sellers of apartment buildings asking for insane prices (GRMs of 13x, 14x and up – for more on this, see this post), given the change in interest rates over the past 1-2 months. (Note: The triplex I have on the market, 1142 N. Virgil, is priced appropriately for the interest rate environment, because my sellers are pros. And, as you would expect, we’ve seen plenty of action.)
Why should prices decrease when interest rates increase? There are a number of reasons, but here’s how I like to think about it:
- Properties are ultimately valued based on the cashflow they generate for their (prospective) buyers
- Higher interest rates mean higher debt payments, given the same loan size
- High debt payments mean less free cashflow left over for the buyer
- Less cashflow left over for the buyer implies a lower return on the downpayment she has invested
- Assuming the buyer is seeking a certain minimum percentage return, the only way to get there is to lower the price (and thereby reduce both the amount borrowed and the downpayment)
So, when interest rates go up, you should expect prices to go down.
My broker friend explained that this does happen, but usually only after a few months with very few transactions. This is because:
- Buyers immediately get the memo about higher interest rates (they hear it directly from their lenders), and therefore adjust what they are willing to pay;
- Sellers don’t get the same feedback (they typically aren’t speaking with any lenders), so they are much slower to adjust the amounts they are willing to accept;
- So, nothing happens until sellers get the memo (due to getting only low-ball offers or, indeed, no offers) and reduce their prices.
That’s what’s going on right now, and I expect it will continue for several months. Meanwhile, I’m probably going to be the guy low-balling sellers.
In our areas (Silver Lake / Echo Park / etc.), there are tons of small lot subdivision projects in the works.
So, the question for all of us apartment people, is: What will be the effect on rents in our neighborhoods from the coming wave of for-sale single family homes on tiny lots?
To answer that question, we need to be able to compare the monthly expense of renting to owning.
From speaking with a lot of developers of this kind of product, the pricing developers expect is generally in the $650k+ range for a 1500 sq ft home ($433 / sq ft). At 4.5% interest, the monthly payment required for a $520,000 mortgage (80% of $650k) is around $2,634. Property tax is around $680. Insurance is probably $150. And there are probably home owners’ association dues of $50. That’s a total of around $3,500 / month.
It’s important to remember that almost all of that is pre-tax money (since both mortgage interest and property tax are tax deductible) – so that $3500 is equivalent to paying something like $2000 in after tax money.
If you know our area at all, you know that renting a 1500 sq ft home in very good condition is likely to be $3,000+ / month in after-tax money (since rent is not tax deductible).
That means there’s roughly $1,000 / month in after tax savings if you buy. That’s $12,000 / year on your downpayment of $130k (20% of $650k), or 9%.
Bottom line: If you’re looking for a large place, you’re probably going to be better-off buying rather than renting, assuming you have the dough and the credit. So all of us in the apartment business need to be considering whether the rents we are getting on larger units are sustainable.
Had an amazing thing happen a few days ago: One of my agents was representing a buyer in a deal. When the buyer saw how much interest rates had moved in the last week or so, he changed his mind about the deal. In an effort to try to keep the deal together, my agent asked what it would take for the buyer to stay in. Buyer requested a $30k price reduction, prior to inspections.
Here’s where things got weird: When my agent called the listing agent to explain the situation, the listing agent explained that he had had two other deals blow up over the interest rate change and that he’d talk to the seller and see what he could do.
Pause for a moment to consider how crazy that is: What kind of seller agrees to a price decrease BEFORE the inspection, knowing full-well that the buyer may come back with a request for another reduction after getting back the inspection report?
The answer is: A realistic seller who actually wants to make a deal. When rates go from 4% to 4.5%, the numbers on the deal change for the buyer. If you’re a seller who wants to make a deal, you need to be willing to be somewhat flexible.
Rates can’t stay this low forever. We’re in for increasing interest rates for the foreseeable future. And everyone in our world needs to consider what that means for their deals.