Two articles ago, I pontificated about the coming disaster for many real estate investors. I quoted Warren Buffett and Howard Marks. I played my “third decade in real estate” card. I tried to convince you that we are in a dangerous lag time that happens at the top of a bubble, like the front car in a roller coaster hangs in suspension on top of the first hill.
I pleaded with investors not to optimistically overpay for assets declining in value due to interest rate hikes and the potential cooling of rent growth.
Then I switched gears in the following article. I argued for reasons I might have been wrong. Or at least factors that could mitigate the severity of the likely downturn on real estate investors.
I argued that continuing rent inflation, quick economic response to interest rate hikes, the Fed not over-correcting, or ongoing supply and demand imbalances could rescue many real estate speculators.
But note that all of these are economic and market factors. These are out of the investor’s control and, therefore, not something we can count on in our investment strategies. If you count on the market and the economy to go your way, you are a speculator.
It’s okay to speculate if that’s your thing. But don’t kid yourself that you’re really an investor. And if you’re a syndicator taking other people’s money, please be honest with them.
Anyway, there are at least four strategies to invest wisely (rather than speculate) in any market or economic cycle. In keeping with the themes of this series, I’m focusing here on the current context at the time of writing: the rise in interest rates, the current lag in corresponding cap rate expansion (price drops), and the likelihood we are near the burst of a bubble.
1. Keep Low to Moderate Debt Levels
It probably goes without saying that those with no or moderate debt will be less affected by interest rate increases or economic downturns. Investors who depend on low-interest rates to make their numbers work may find themselves in trouble during a higher interest rate environment.
In the event of a drop in value, it’s possible that over-leveraged investors will experience a loss of equity or even negative equity, meaning the reduction in value will cancel out their gains and even their original cash outlay. As a syndicator, this could result in a capital call from already unhappy investors.
This can also hurt during refinancing. Economic troughs also kindle tight credit markets. Banks raise their lending standards, lower their loan-to-cost ratios, and generally become harder to borrow from. This can also lead to negative equity and the potential to lose an excellent cash-flowing asset.
Over-leveraging can turn a low-risk investment into risky speculation. Investors beware.
2. Use Fixed-Rate, Long-Term Debt
This goes hand-in-hand with the first strategy. We may be heading into a downturn. But that direction will eventually turn north again. Though timing will vary, it’s likely that investors with long-term, fixed-rate debt will ride the cycle through the trough and up the other side. And rent inflation will likely continue to raise revenues during this entire cycle, creating excellent cash flow and value for these investors.
It’s okay to utilize short-term, adjustable-rate debt. There’s certainly a place for it. But if you’re concerned about our position in the current economic cycle, carefully consider the structure of your debt.
3. Buy Off-Market When Possible, And Don’t Overpay
We discussed the importance of not overpaying in the prior article. With the massive number of investors competing for a finite number of deals over the last decade, it may be tempting to jump on any deal you can get as this market loosens.
With the market at a historical top, overpaying right now creates the highest risk at the worst possible time. Margins of safety are at perhaps an all-time low, and this is the time to be prudent. One way to do that is to buy off-market.
Real estate investors with a robust off-market acquisition strategy will find deals with lower buyer competition and likely at better prices.
There are a variety of ways to find off-market deals. Much depends on your asset class and team capabilities. My firm invests in recession-resistant commercial real estate with top operators. My favorite operator has a team of eight working full-time to contact off-market self-storage and mobile home park owners. This strategy has produced stunning results over many years.
One tactic to boost this effort is to carry significant cash reserves. Those who can buy for cash and refinance later may access deals and prices unavailable to many other investors.
Buying favorably priced off-market deals often coincides with my favorite wise investment strategy, which you can predictably count on in any market or economic cycle.
4. Invest In Intrinsic Value
Warren Buffett said, “Price is what you pay. Value is what you get.”
Top real estate investment strategists seek opportunities with significant untapped intrinsic value, just like those in the stock market or any investment do. This is value inherent in an acquired asset that a skillful operator can harvest.
These properties are often acquired from mom-and-pop operators in highly fragmented asset classes. Though the possibilities are extensive, we have found the best opportunities in asset classes like mobile home parks, self-storage, and RV parks. Our firm also selectively invests in certain multifamily, light industrial, and retail center opportunities with significant intrinsic value at acquisition.
Warren Buffett says that acquiring assets with a high margin of safety is the key to investing success. Tapping assets with high intrinsic value can create a sizable margin of safety, especially in times when buyers risk overpaying for underwhelming properties with questionable upside.
The debt service coverage and loan-to-value ratios are two meaningful and related margin of safety metrics. The debt service coverage ratio is the ratio of periodic debt payments to net operating income. Banks like to see a minimum DSCR of about 1.20, meaning a 20% margin of safety between debt service and net income. However, this is a small margin, and it can evaporate quickly if floating interest rates rise or if net income takes a hit.
Harvesting intrinsic value from assets should create increasing net income and a higher DSCR. This rising margin of safety results in much lower risk in tenuous economic environments. And this harvest produces meaningful gains in value, which can offset cap rate expansion resulting from interest rate hikes—a significant win for investors.
Many of the assets we invest in achieve DSCR levels well above 2.0, translating to a 100% margin of safety. Some even surpass 3.0, a 200% safety margin.
Higher margins of safety usually correspond with decreasing loan-to-value (LTV) ratios. This margin of safety matters most at the time of refinancing. The difference between the asset value and the loan balance is the investor’s equity. Lower LTVs result in higher equity and lower risk during economic contraction.
One of our operators starts with a modest LTC (loan-to-cost ratio, which is the LTV at acquisition) of about 65%. But harvesting value can result in a drop to their current average LTV of 35%. A very safe place for investors.
Avoiding risk is great. Mr. Buffett calls not losing money his first rule for successful investing. But the ultimate goal is to create true wealth. True wealth is assets that produce cash flow. I can’t think of a better way to avoid risk and create wealth than acquiring assets with latent value that a skilled operator can tap.
The Way Forward
I’ve penned multiple posts about the importance of buying assets with hidden intrinsic value. Our firm is obsessed with providing our investors with this strategy’s corresponding safety and profitability. Since this is my favorite of the four wise investment strategies, I will devote six future articles to case studies on harvesting intrinsic value in:
- Mobile Home Parks
- RV Parks
- Light Industrial
- Outdoor Shopping Centers (yes, even retail)
Here’s a preview of some of the case studies we’ll cover:
- A Texas self-storage facility acquired from feuding siblings for cash then appraised for 75% more in just three months.
- The Kentucky mobile home park was acquired and later sold during Covid’s worst months with a 347% IRR.
- A multifamily asset was acquired for $13 million and refinanced at a value north of $50 million in 19 months.
- A sunbelt RV park transformed into a profit machine projected to cash flow at over 25% annually.
Note that I won’t just be reviewing the case studies. I’ll apply the concepts of avoiding risk and creating value and wealth by implementing these value investment principles in your real estate investing strategy. I can’t wait to share these stories and principles with you!
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.