Recognizing what a ‘good deal’ looks like is a crucial skill, especially right now. Gone are the days where every deal will over-perform projections.
It is equally important to know what a bad or overly risky deal looks like. Most of these points relate to things that operators did in the last few years without consequence. Further, some of these tactics were actually encouraged, as they allowed for higher leverage and returns prior to 2023.
Here are 5 of the things that have some deals in hot water, and what to look for in deals today.
It is equally important to know what a bad or overly risky deal looks like. Most of these points relate to things that operators did in the last few years without consequence. Further, some of these tactics were actually encouraged, as they allowed for higher leverage and returns prior to 2023.
Here are 5 of the things that have some deals in hot water, and what to look for in deals today.
- Debt
Interest rates have just gone through their fastest increase in nearly 40 years. This doesn’t impact any existing fixed-rate agency loans, but it does have a huge impact on loans originated today, and any existing loans that have floating rate debt.
A common loan prior to 2022 was a bridge loan, which is designed to bridge the gap between the acquisition and the longer term, fixed rate debt. Bridge loans are great because they will offer loans based upon what the asset will become, whereas agency loans won’t always lend on value-add properties that require a lot of work. Bridge loans also have lower up-front fees and typically no pre-payment penalty, which have made them a very popular tool for anyone buying multifamily properties in the last few years.
The problem is that bridge loans come with a floating interest rate and a short term, usually 3-5 years or less. There is a balloon payment at the end of that term.
So here is what happened. Many operators bought at a 3% interest rate and are now paying interest at 8%. Their deals no longer cash flow, and instead are requiring new capital inflows to prevent default.
Refinancing is not possible because no agency will lend to a deal that doesn’t cash flow (more on this below). A sale is challenging because it will be done at a lower evaluation, potentially wiping out investor equity.
So here is what happened. Many operators bought at a 3% interest rate and are now paying interest at 8%. Their deals no longer cash flow, and instead are requiring new capital inflows to prevent default.
Refinancing is not possible because no agency will lend to a deal that doesn’t cash flow (more on this below). A sale is challenging because it will be done at a lower evaluation, potentially wiping out investor equity.
How to NOT Screw Up Debt Right Now: Used fixed-rate debt or underwrite for the maximum interest rate cap on floating rate debt.
- DSCR (Debt Service to Coverage Ratio)
DSCR is one of the best metrics to evaluate if you’re going to be able to pay your debt service or even refinance out to a new loan. The calculation includes dividing the properties Net Operating Income by the debt service (interest if interest only, or interest plus principal).
If your DSCR is a 1X, then that means you have exactly enough income to satisfy your debts. Most lenders want to see a DSCR of at least 1.2X, which means that there is some cushion in case income drops, expenses rise, or debt becomes more expensive.
Properties with bridge loans have seen their debt cost rise, and their DSCR dip below 1.2X. That’s a problem because it is very hard to secure a new loan without exceeding this metric.
How to NOT screw up DSCR right now: build in buffer on income, expenses, and debt, and pass on deals where the DSCR comes close to 1.2-1.3X or less.
- Aggressive Underwriting & Not Holding Reserves
As recent as a year ago, a red-hot market forced some operators to be quite aggressive in their underwriting and offers. Consequently, there are people that overpaid for deals that were too aggressive in rental income growth projections, didn’t adequately factor in inflation’s impact on expenses, and didn’t secure substantial reserves in case the business plan went awry.
Now, their cash flow has been cut due to increased debt cost and expenses, their reserves are rapidly dwindling.
A refinance is out of the question due to the DSCR being below 1.2X. The only other option is a forced sale. One of the best ways to consistently make money in real estate is to never be a forced seller, and one of the best ways to lose money is to… you guessed it.
A refinance is out of the question due to the DSCR being below 1.2X. The only other option is a forced sale. One of the best ways to consistently make money in real estate is to never be a forced seller, and one of the best ways to lose money is to… you guessed it.
How to NOT Screw up underwriting & reserves Right Now: Underwrite 0% rent growth, high vacancy, and rising expenses. Plan for substantial reserves to support debt service until a refinance or sale.
- Paying Too Much At Purchase
Buying with a lot of built-in equity is a fantastic hedge against risk.
It doesn’t matter if all other items in the business plan go wrong, as long as you can sell the asset you bought today at a favorable markup to what you bought it for.
However, not being able to sell today for more than you paid means that you risk losing investor capital if you exit prematurely. Unfortunately many operators may have done this in 2021, and their options are now to either hold, raise more capital through a capital call, or sell and potential return less capital to investors than they raised.
It doesn’t matter if all other items in the business plan go wrong, as long as you can sell the asset you bought today at a favorable markup to what you bought it for.
However, not being able to sell today for more than you paid means that you risk losing investor capital if you exit prematurely. Unfortunately many operators may have done this in 2021, and their options are now to either hold, raise more capital through a capital call, or sell and potential return less capital to investors than they raised.
How to NOT screw up purchases right now: Only close deals at a purchase price of 10-20%+ below market rate. This allows for some ‘buffer in case there are unforeseen challenges that may be out of the operator’s control (like the Fed).
- Short Time Horizons
The last point has to do with time horizons. In real estate, you want to buy low and sell high. Duh.
What many don’t understand is that the single biggest factor in pricing has to do with market cycles, interest rates, and macroeconomic trends. Cheap debt matters a whole lot more than the washers and dryers that were added to the units.
The problem is that the market cannot be accurately predicted. Therefore, it is important that your deal is held for as long as is needed to ride out any downturn.
What many don’t understand is that the single biggest factor in pricing has to do with market cycles, interest rates, and macroeconomic trends. Cheap debt matters a whole lot more than the washers and dryers that were added to the units.
The problem is that the market cannot be accurately predicted. Therefore, it is important that your deal is held for as long as is needed to ride out any downturn.
How to NOT screw up Time Horizons Right Now: Plan to hold the asset for 5 years or more (up to 10), even if you plan to sell sooner than that if market conditions are favorable.
