Two recent Wall Street journal articles highlighted two different multi-family investors that just got foreclosed on and lost their portfolios. One lost 3200 units and another lost 7000+ units.
Why did this happen?
They are the victims of an Emerging Cycle Mindset.
Emerging Market Mindset
The multi-family real estate space has been in an up cycle since 2010. In 2008 we had the Financial Collapse of the housing market and Leman Brothers. The market went sideways in 2009 and started to recover in 2010.
Anyone who first started buying multi-family properties from 2010 to 2022 only experienced upward momentum.
What Does This DoTo An Investor’s Mindset?
At first, if they learn how to invest in properties, they use a conservative cash flowing model to get into deals.
This works out well for them, not only do they get cash flow but that cash flow increases each year with the ability to raise rents in an up market. Some years the increase is significant, thousands of dollars.
The increase in cash flow increases the value of the property. When they either resell the property or refinance the property, they have made a lot of money. In many cases, millions of dollars.
This increases the investors’ confidence and they want to do more and more deals.
To get into more deals they start to vary a little bit from their conservative model but the results are still good. Then they start to deviate more from their model and the results are still good.
Next thing you know, the investor feels like they have the Midas touch. Every deal they do turns to gold.
This Is What Is Really Happening To Their Real Estate Portfolio
What’s really happening is the investor is making mistakes when he is buying his deals but because he is in a fast-appreciating market, the market is actually correcting his mistakes.
The increasing cash flow resulting in the increasing values covers up the poor fundamentals of the property.
This works well until the market changes and starts the downward side of the cycle… which always comes, that is why it is called a “market cycle.”
“At low tide, the naked man becomes exposed.”
I love that expression because it describes this scenario perfectly.
There are two other factors that happened at the end of this latest market run in 2020 – COVID and Bridge Loan financing dropping below conventional financing.
Let’s look at these one at a time.
2020 & COVID
Let me first say I thought the top of the market was the last presidential election in 2020. It was a natural transition. The average emerging side of a cycle is between eight to ten years. So, in 2018, my investment teams started to slow down our buying.
For two reasons, I felt we were close to the top of the cycle and there were not a lot of good deals available.
Deals were not penciled out using our conservative model that we like to call the “Trinity”; a cap rate of 7.75 +, a cash-on-cash return of 12+ and a debt coverage ratio of 1.6+.
A mentor once told me, “Dave, it’s better to get out early in a cycle than to get stuck on the downside.” He also told me, “I made most of my money because I got out too early.”
We had clients calling us here at RE Mentor and telling us our model no longer worked. That other teachers gave them other formulas that were working in the market.
We told them to be careful, stick to the “Trinity” and you will not get in trouble. Focus on your relationships and although there are not a lot of deals that will meet the “Trinity” near the top of an upcycle, good broker relationships will bring those deals to you.
Investing Trends During COVID
When COVID hit, I actually got excited. I thought there were a series of foreclosures by mediocre operators who never took the time to learn the key skill of asset management.
We started to scour the market for deals. We had dry powder ready but this didn’t materialize.
What I didn’t see happening was Office and Retail investors, who got decimated during COVID, enter into the multi-family space to go after available yield.
This compressed cap rates, resulting in increased multi-family values. Now there were more people in the market chasing these deals.
Investors were paying what I thought were crazy prices for properties and myself and many seasoned investors I know took advantage of this market and sold properties we thought we were going to hold as legacy properties but the amount of money someone was willing to pay changed our minds.
It was mind blowing!
Bridge Loan Financing
Now enter in Bridge Loan financing. This is used when you have a property that has a problem, usually low occupancy or in need of repairs, that will not qualify for conventional financing (Freddie Mac, Fannie Mae.)
Bridge Loan financing is short term, higher interest rates, higher closing costs, and usually needs to be paid back in full in two to four years.
For the first time that I can remember (and I’ve been investing since 1996,) Bridge Loans had a lower interest rate than the long-term conventional financing. It stayed like this for many many months.
Investors who could not qualify their deal with conventional financing turned to the short-term bridge financing. The lower interest rates of the Bridge Loan financing increased the deals cash flow and the investors that chose to use it were able to get into many more deals.
Bridge Loan Issues
These loans came with a big risk. They were due in a short time, two to four years, where would interest rates be at that time?
If they remained low, like they had for the last ten years, they would be OK. If they increased, they would have a problem.
The problem would be the cash flow of the property would not support the new higher interest rate. The result would be properties going back to the lender or other forms of ownership loss.
This is exactly what happened.
Inflation went up, to curb inflation the fed increased interest rates to curb demand.
The increased interest rates are causing my owners who chose Bridge Loan financing to refinance their properties at much higher rates causing a cash flow crunch in the property.
Crash Flow Crunch
This is what happens with a cash flow crunch.
- There is not enough cash flow to do all of the maintenance needed. Ownership gets behind on maintenance.
- Investors stop receiving distributions as any available cash is going into the maintenance and performance of the properties.
- Good tenants begin to leave because they won’t live in a place that doesn’t do property maintenance.
- Good tenants are being replaced by a lower tenant profile.
- To attract these new tenants, rents are lowered. These lower rents become market rate for this property because of the maintenance issues.
- Occupancy begins to slip.
- A cash call is given to the investors to infuse needed cash to keep the property running.
- Ownership realizes the problem will not be resolved and looks to sell. At the higher interest rates and at the properties current condition, the value of the property has significantly decreased.
- Ownership sells the property to avoid a foreclosure, there is no money to pay the investors and they lose all of their investment.
- If a buyer is not found, the property is foreclosed by the lender.
It’s a nasty cycle that I have seen played out in each of the four market cycles I have been a part of.
We saw a lot of crazy deals come across our desk in the last couple of years. They just didn’t make sense and we advised many people not to do the deal, even though they could close it.
Another way people got in trouble is they were doing value add deals with no cash flow up front but a lot of cash flow and value added in years two to four. This was all dependent on rent increases in the market.
In a down market, rents go down instead of up. All those deals are blowing up. And in the last few years, we were doing “one off deals” here and there.
How To Respond To This Market Cycle
I had a partner that kept telling me, “We have to do more deals, lots of people are doing deals, we need to be doing more deals.”
My response was, “We have to do the right deals. Take a break, rest up because when this market turns it’s going to be go time and for three to five years we’ll be running, sprinting to get into all the deals that will be available.”
I even had one person call me a “dinosaur” because the “Trinity” didn’t work and I wasn’t doing any deals.
I made my fair share of mistakes during my first market cycle all those years ago. They were painful. I like less deals and a better life.
Meet Vanessa Alfaro
One of our clients, Vanessa Alfaro, said to me recently at one of our events, “Dave, I go to all the multi-family education events. For the last three years you were the only one telling people not to buy using the crazy terms that were available. Everyone else was promoting how many deals their students were doing and now those people are in trouble. I guess experience really is the best guide.”
It’s a great time to be investing in multi-family properties, unfortunately because of the mistakes other people made but that is the nature of business.
It’s Vanessa run time, put on your sneakers and let’s gooooooooo!
Want to learn more? Check out our free Multi-Family Millions Workshop in a city near you.