It is no secret that rising interest rates are causing massive pain for the US Economy. The Federal Reserve is on a mission to curb inflation and is willing to put the economy into a severe recession to achieve its goal. They want to architect a “soft landing” but are pushing rates “fast and furious .” I struggle to see how they accomplish that with the ferocity and speed of rate hikes. The primary issue is that rate hikes today take roughly 6-12 months to manifest themselves in the economy. We are now just beginning to see the impact of the Federal Reserve rate increases starting in the Spring of 2022.
I want to touch on a few basic concepts. First, the mortgage refinancing business has shrunk dramatically. Second, many mortgage originators have laid off people in residential and commercial markets. Third, investors only consider refinancing under immense pressure from matured loans or personal distress. Fourth, higher interest rates make it increasingly challenging to meet Debt Service Coverage Ratio (DSCR).
As far as new purchases are concerned, in the residential space, affordability has dropped dramatically. People are facing 2X higher payments than a year ago with the current interest rates for the same loan amount. This new paradigm has already driven residential real estate prices down in many markets by 10-25%. We are entering a generally slow buying season in many regions, “the Winter season,” when prices soften and combine that with further expected rate hikes. The future reflects a “bearish” mindset as the way forward for now.
Rising interest rates in the commercial real estate space have caused transaction volume to fall because the bid and the ask spread widened substantially. Many buyers are looking for better pricing, while many sellers are still “stuck in the past,” expecting prices of 6 months ago per se. Some sellers are compromising already. Many are trying to hold out, waiting for better times to sell. The significant drivers of better deals for buyers will likely come from the pressure on sellers to exit due to maturing bridge loans or other distressed conditions. Some sellers will not capitulate on healthy projects and instead try to ride out “the storm .”Nonetheless, the general expectation is that “better deals” for buyers come later when the pressure on sellers becomes heavier. The argument for waiting is substantial; no question about it.
However, are there still good opportunities to invest now? Why would someone want to invest now instead of waiting until 2023?
Yes, of course, there are good opportunities now. First, substantial value-add deals contain massive rent growth upside driven by comprehensive renovation work and “forced appreciation” opportunities. These deals’ performance depends heavily on executing the value-add plan, and a lot less on getting a better purchase price on the AS IS basis. For example, let’s take a value-add multifamily investment at $125,000/door and a planned investment of $25,000/door and target sale at $200,000/door in 4 years. Of course, it would be better to wait for the asset to get distressed and try to buy it for $115,000/door, but knowing how much discount you can get & when you get the discount is complex.
Another thing to remember is that rent inflation continues to be well above the historical average. Rising interest rates hurt the affordability of buying. As a result, many potential buyers wind up having to rent. So, the demand for rental properties is increasing due to the “substitution effect .” Rent inflation is likely to counterbalance the rising cost of financing driven by rate hikes. In the short run, higher interest rates outpace rent growth, no question about it. The speed of rate increases has significantly outpaced rent inflation. However, in the long run, persistent inflation will likely drive rents higher and catch up to the higher costs of elevated interest rates. If, on the other hand, the inflation subsides, the FED will likely take the foot off the gas pedal, stay neutral for a while, and reverse the direction when the economic recession they have induced has become very severe.
Many investors believe this inflation cycle will eventually subside, and we will return to the usual 2-3% annual inflation target range. I happen to be one of them. The underlying causes of this inflationary environment are decreasing. The US Government’s massive spending spree is over. Covid supply chain issues are getting better and better. Unemployment remains still too low, and that supports wage inflation. However, we will likely see announcements of significant corporate lay-offs in the upcoming months, heavily driven by the “demand destruction” of the higher interest rates.
Inflation will start coming down sooner or later.
Another critical reason to invest now, in late 2022, is that the tax benefits of bonus depreciation in real estate are still 100%. Next year, bonus depreciation phases out to 80%. Tax planning is an integral part of the investment decision for many folks. You certainly don’t want to have the “tax tail wag the wealth dog .” However, a solid multi-year value-add project investment in 2022 with outstanding tax benefits is worth serious consideration despite the potential “better deals” on the horizon.
Furthermore, it is challenging to try to “time the market.” Interest rates are still rising. Economists and Investors are speculating on what the FED peak rate is going to be. And when will the FED start easing again? That would be a great sign to get back into the investing business. However, once it is clear that the rates are coming down again, it might already be too late to look for bargains. Also, it is unclear how much real distress we will see turning into great deals for the buyers.
The better strategy, in my view, is to buy now and later, effectively using the “dollar cost averaging” technique. I am not talking about purchasing market-performing deals. I am referring to strong fundamental value-add deal investing. These assets’ performance depends on the execution of the value-add work as the primary driver of success. Also, investing with the best operators makes all the difference in the world. We put the “Who” ahead of the “What .” The “Who” you are investing with is more important than the “What” you are investing in. We always start with the great operator and decide on their investment deals using our proprietary financial investment modeling.
The deal structure matters a lot. For example, are you investing in the deal’s Preferred or Common Equity? If you are looking for downside protection, better safety, lower risk position reflecting current market conditions, then you might consider the Preferred Equity. This position lowers the risk and gives you enough confidence to invest in this market.
What’s fascinating is that the challenging market conditions to raise capital in this rising interest rate environment motivate deal sponsors and operators to offer investors better terms vs. what they used to under the normal market state. We don’t have to go far into the past to explain this. Let me use the example of the recent deal we have closed called Michigan 2.
The operator on this deal was willing to compromise and offer phenomenal Preferred Equity terms of 16% Preferred return, 8% paid current, and the rest on the capital event, and additional back-end upside to get investors’ IRR target to ~ 18%. Under normal market conditions, this deal would have sold at a 12% Preferred return rate and an overall IRR target of ~ 15-16% to Preferred Equity investors. A challenging capital-raising environment creates better opportunities for capital investors to secure better terms from the operators.
We have secured similar terms on the upcoming deals, Oak Park and Stephenson House, with the same operator, coming up in Mid-late November. So, if you have missed the Michigan 2 deal and are still looking to invest in the Preferred Equity, please reach out and ask to be on the waiting list for this deal. PPM should become available in the next two weeks or so. This unique deal will have about 1/2 of the available Preferred Equity units vs. Michigan 2 and will go very fast. So, please take action to express your general interest in advance. Then, you will have the opportunity to review the PPM and change your mind.
In summary, I hope you can see the benefits of investing now and investing later. Of course, it is challenging to time the market and find a perfect deal. The best part of working with us is that our investors can piggyback off the elements we use to increase our clients’ wealth:
- Long-term planning avoids near-term fluctuations
- Use Top Operators
- Focus on Value-Add Deals to provide strong returns
- Disciplined Diversification
- Healthy Risk-adjusted returns
My team and I focus on the above pillars of our investment strategy to provide our clients with returns to increase their wealth and allow them to sleep better at night, knowing that we have their best interests at heart.
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