Understanding and applying these three sentences can make you rich:
“In bad times, securities can often be bought at prices that undervalue their merits. And in good times, securities can be sold for more than they are worth. And yet, most people are motivated to buy enthusiastically when the cycle drives up prices and to sell panicked when prices fall. – Howard Marks (2013 Memo “Ditto”,
I’m excited to share some thoughts about fear and greed. But I’ll start by sharing a few comments on the current economy to set the stage.
Not long ago, I opened my computer to a shocking CRE email subject line:
“Prices have dropped to 2010 levels”
It was very attention-grabbing but wrong. The publication further added that the magnitude of decline in CRE values (not prices) was not seen since the Great Recession, which is still worrying. (note that title changed at some point since original publication.)
But it makes sense because we’ve seen property prices skyrocket due to low interest rates, skyrocketing attention from a whole new community of CRE investors, and irrational demand from many neuros (new gurus running syndication, mainly in multifamily). Has seen steady growth since a decade. arena).
The drop in value was indeed significant, registering 28% year-on-year.
“Yes! Is it not worrying? you can ask.
This is of great concern to many syndicators and investors. But we don’t find that surprising at all. And we see a potential opportunity on the horizon.
How did this sharp decline happen?
It is a simple matter of maths. This is based on disinflation in cap rates as a result of a series of 2022 interest rate hikes. As a reminder, here is the valuation formula for commercial real estate:
Price = Net Operating Income / Cap Rate
As you can see, and as most of you know, the price is directly proportional to the earnings (over which operators have some control) and the capitalization rate (market – over which operators have virtually no control) is inversely proportional to.
The interest rate directly affects the cap rate. While interest payments are not part of the net operating income (NOI) calculation, interest directly affects an investor’s net cash flow and, thus, the value the investor places on the asset. Other factors affecting the cap rate include the availability of credit and the desires of the buyer pool (i.e., competition to acquire these assets).
Currently, all these factors are trending to increase the cap rate, thereby reducing commercial real estate values.
But there’s another issue at play here: the cap rate’s recent starting point. In the “good old days” of 10% cap rates, a 1% to 11% increase (with no NOI change) would result in a decrease in asset value of about 10% (1% / 10% = 10%). (I say “about” because there is some subjectivity involved in actual value.)
not anymore.
In these recent days of 4% cap rates, a 1% increase could result in a value reduction of about 25% (1%/4%). With interest rates rising by a few points, it is not surprising that we have seen cap rates increase by more than 1%. And thus, it is entirely possible to see a property value decrease by 28% or more.
ten ideas for your consideration
Cap rates are going up. Commercial property values are falling. Here are 10 resulting ideas for your consideration.
- Cap rate moves typically lag interest rates and other economic factors, so we expect these price moves to continue. Further increase in interest rates will increase the fall.
- This average decline includes malls, hotels and other asset types, which may have adversely affected the average, so not all asset types and certainly not all individual properties are affected equally.
- Flat rents in 2023 will make matters worse for most as syndicators are desperate to proportionately increase NOI (the numerator) to offset rising cap rates (the denominator) to maintain their asset values.
- This environment is a matter of getting value-added assets from mom-and-pop vendors. We are investing with an operating partner to acquire a self-storage property in a location we are very excited about (market rent of $148 for a 10′ by 10′ unit) with current rates about 60% below market ($60 per unit). This asset is part of our Wellings Real Estate Income Fund.
- This environment is also the case for fixed rate loans. Many syndicators/investors in floating-rate loans are in a world of trouble at the moment. Many will lose their property to the bank or merchant buyer and watch their investors’ equity go up in smoke. Many are already cutting distributions to meet new reserve requirements mandated by their debt agreements.
- In possibly the worst times imaginable, multifamily syndicators are enduring not only rising loan costs and flat rents, but also dramatically higher operating expenses. Some of this is related to inflation, but for many, skyrocketing insurance costs and property taxes are hindering cash flow. Some Texas and Florida apartment operators have seen insurance double or triple.
- This environment is a matter of long-term stagnation. Syndicators who need loan refinancing or equity investors hoping to exit short orders may be forced to sell at a time inappropriate for discounting or refinancing loans with low LTVs and high rates. The latter could lead to distribution cuts (we’re seeing this weekly now), capital calls, or worse.
- This is a case of preferred equity. Warren Buffett invested an estimated $5 billion in Goldman Sachs in September 2008, when other investors were running around. His investors scored big. Following Warren’s example, my firm is now pursuing several preferred equity opportunities.
- This is the case for short-term, high-interest loans (wait…what?). Not as a borrower but as a lender. We have recently made substantial investments in private loans. This hedge provides us with cash flow for now and the flexibility to exit distressed (or other) equity deals when they occur. We believe this will happen in a year or less.
- Speaking of distress, this whole situation is not going to bother you. This is a normal aspect of the normal cycle. Those who anticipated this should be less swayed by the negatives and ready to take advantage of the positives (preferred equity opportunities and opportunities to acquire distressed assets).
conclusion
A lot of wealth is being destroyed in these times of fear and uncertainty. History tells us that a lot of wealth will also be created. Greed is often the enemy of wealth creation during good times. And in times like these fear is definitely the enemy of wealth creation.
This is what Warren Buffett, Howard Marks and other great investors taught us: Our ability to fight or flight, to avoid succumbing to fear and greed is the cornerstone of investing success.
As an entrepreneur over the past decades, I’ve tried to get the same thrill from investing that I got from starting a company. It didn’t go well. Investing should be like watching paint dry or watching grass grow. Thrill seekers need not apply.
I was in the woods in Alaska last summer and found myself constantly rehearsing what I would do if a nearby grizzly bear came after me. This was reasonable fear, that is, caution.
You will notice that I was not in this photo. I took it from behind the safety of the sliding door of our cabin.
But fear has no place in good investing.
Controlling your fear is probably the first step to successful investing in this environment. We must remember that not everything is scary, even if it may feel like it. Like good times, there are good deals and there are bad. Harnessing your fear will help you find good deals, some that are only available at times like these, and potentially generate significant money in the process.
My firm is now exercising the same level of “fear” caution as we did in good times. We do this for our investors, and we are very happy with the results we are getting.
Finally, it’s time to practice patience. I was deeply involved in residential real estate investing during the Great Recession. Although we usually refer to this as “2008,” remember that it was actually a long time from peak (mid-2007) to trough (early 2012).
We do not take any pleasure in the failure of other players. But we expect and are preparing to acquire distressed assets at prices that we could not even dream of in the past decade.
Do you?
Prepare for market changes
Revamp Your Investment Strategy – Not Only To Survive An Economic Downturn, But To Thrive! Take any downturn in stride and never panic about market swings again Recession-Proof Real Estate Investments,
Note by BigPockets: These are the views expressed by the author and do not necessarily represent the views of BiggerPockets.
