How not to act in a rising interest rate environment

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.

Don’t buy apartment buildings if…

1. You don’t like confrontation. Inevitably, you are going to have tenants who screw things up and need to leave your building. No one is going to care about it as much as you do, so you’re the one with whom the buck is going to stop. If you can’t stick up for yourself / your family, don’t buy a building.

2. You can’t tolerate risk. Apartment buildings are little businesses. No matter how much you plan / prepare / etc., there is still risk to owning them. Earthquakes happen. Fires happen. Market prices and rents swing. Working with a good agent and being smart about what you buy and how you buy it can mitigate risk to a large extent, but it can’t remove risk entirely. This is a big boy / big girl game.

3. You hate negotiating. In business, I’ve found, everything is a negotiation, whether you realize it or not. When you own a building / business, you’re going to be employing all kinds of people and companies. Many of them will try to take advantage of you. You don’t have to “win” every negotiation (often, you’re willing to happily pay a price the other side is happy to accept), but you need to be aware that you are, indeed, negotiating. And you have to not despise the process.

4. You’re disorganized. There is an unbelievable amount of paperwork that accompanies owning buildings. There are a million different regulatory agencies, tax authorities, insurance companies, banks, managers, etc., all of whom want documentation, bills paid on time and in full, etc. If you’re the kind of person who avoids opening mail, either make sure you hire someone to do it (that’s what I do) or stay out of the business.

5. You don’t like numbers. This isn’t a video game. There isn’t a big “You Win” or “You Lose” screen that pops up. The business is about patiently husbanding your capital, placing it, watching it grow, limiting your expenses, mitigating your risk, etc. All of this involves thinking about numbers. If you don’t like numbers, do something else.

6. You don’t like to learn. I’m still learning a lot, every single day, roughly five years into doing this for a living. If you want to do a good job with buying and owning apartment buildings, you have to keep your ears open for new ideas, your eyes open for new neighborhoods or changes to existing neighborhoods, and your mind open to thinking about existing assets / threats / opportunities in new ways. If you’re closed off and hate new ideas, don’t start buying buildings.

FHA loan limits

Have recently had a lot of buyers interested in using FHA loans. We’ve discussed why this is a difficult time to get these loans done before. But, obviously, being able to buy an apartment building with 5% down is pretty appealing. So I thought I’d post a quick FHA refresher.

FHA is a program for first time home buyers. Because the government considers 2-4 unit properties “residential”, as opposed to commercial, they qualify as well. Because of the incredible leverage you get from FHA (basically, put down 5% of the purchase price and borrow 95%), FHA can be incredibly attractive. But, obviously, the more leverage you use, the more risk you’re taking on, since leverage magnifies outcomes.

With that caveat, here are the maximum loan sizes for FHA loans in Southern California:

  • Single family home: $729,750
  • Duplex: $934,200
  • Triplex: $1,129,250
  • Fourplex: $1,403,400

Remember, this isn’t even the maximum price you can pay; it’s the maximum loan size. To get the maximum amount you can pay, just divide each of the above numbers by .95. So the maximum prices you can pay for FHA deals in Southern California are:

  • Single family: $768,158
  • Duplex: $983,368
  • Triplex: $1,188,684
  • Fourplex: $1,477,263

As you can see, the maximum loan limits are very high. There are few, if any, deals west of La Brea that you couldn’t do FHA, in theory. The problem, of course, is getting sellers and brokers to believe you can close. But that’s a topic for another day.

How security deposits are handled in a sale

Have had this question a few times in the past few weeks so I figured I’d answer it for everyone: How are security deposits handled in a sale?

First, owner typically do not maintain a separate account for security deposits. When a tenant moves into the building, he gives the landlord a check for the deposit and the landlord notes the amount on the lease and, often, a separate security deposit receipt. The landlord then deposits the check in his general operating account. The tenant’s assurance that he will receive his deposit back when he moves out is that, if the landlord unlawfully withholds the deposit, the tenant can sue and win triple damages.

But, if the money is simply deposited by the owner of the building, what happens when someone buys the building from the owner? Does the old owner have to write a check to the new one to transfer the deposits?

Fortunately, the answer is “no”. Escrow handles the transfer, in the form of a debit to the seller and credit to the buyer. During the escrow period, the escrow officer reviews the rent roll (and, if the buyer’s agent is smart, the estoppels) and calculates the total amount of security deposits. Then, the escrow officer simply reduces the price the buyer will pay for the property by the same amount. So the seller keeps the deposits, but the buyer gets an equivalent price reduction.

One wrinkle to keep in mind is that tenants in Los Angeles are notionally entitled to earn interest on their security deposits. Calculating the interest and paying it out is an unbelievable pain in the ass and, because interest rates have been so low for so long, the amounts of money involved are ridiculously small. So, most landlords and tenants ignore the law.

It’s worth mentioning here, though, because, in the event that there are long-term tenants in a building, the interest owed on their deposits can actually end up being a meaningful amount of money. Escrow is supposed to calculate the interest owed and add it to the deposit credit the buyer receives, but most escrow officers are too lazy to do this. This is another case of caveat buyer (or, if you’re properly represented, caveat agent).

Why a quiet marketing period makes sense

When it comes down to it, most brokers who sell residential properties don’t know a lot about marketing income property. (One easy way you can tell is that most of them don’t include information that is absolutely critical to an income property investor – like the rents! – in their MLS listings.)

But why does it matter if a broker doesn’t know a lot about income properties? After all, don’t all brokers just post a listing on the MLS and wait for offers to roll in? After all, isn’t marketing a property as widely as possible the best thing you can do to maximize price?

I don’t believe so, and here’s why:

  • As a buyer, when you offer on a property on the MLS and have your offer accepted, you know you’re the winning bidder in an auction;
  • This means, by definition, that your bid was higher than everyone else’s;
  • This means that, once you’re in escrow, you might be able to chip the price (by raising all kinds of issues about the physical condition of the property, etc.), because there’s probably some room between your (highest) bid and the next one down.

So, if you’re listing your property on the MLS, you are almost definitely going to see the buyer try to chip you in escrow. Contrast this with an offer that comes through a “quiet”, off-market marketing period.

With a “quiet” marketing period, the listing broker puts out the word that the property may be available if a buyer is willing to pay the full price. He puts it out to his own buyer list and also to select agents he knows have serious buyers ready to make a deal.

Assuming the broker does his job well, several strong offers should come in. Then, the broker can run a quick “best and final” counter process to clean up the contract terms and maximize price before finally accepting an offer and opening escrow.

Consider the situation this buyer is in: He has a deal that has not been widely exposed. If he tries to chip price, he knows the seller can always cancel and take the property to market, where someone else will certainly buy it. Because the threat of cancelation is credible, he’s much, much less likely to try to chip price. Mission accomplished.

And, the best part is, if, for whatever reason, an acceptable offer does not emerge during the “quiet” marketing period, the seller can always just go ahead and put the property on the MLS, anyway.

So, if the above is clearly the best strategy for marketing properties, why don’t all brokers do it? The ones who don’t just don’t have sufficient contacts among the relevant market participants (buyers and brokers) to effectively get the word out. And those are the brokers you don’t want selling your property in the first place.