Today I'll be sharing with you my personal opinion, based on what I see and what I know about real estate investing on how you could potentially lose up to 50% of the value of your property in one downturn. Maybe we could lose more, maybe we could lose less than 50%. Please note that if you can afford to keep your property during the downturn, none of this matters, this applies if you won’t be able to afford your mortgage payment, taxes, etc and therefore you’d have to sell the property. But I want to share with you some things that I see and that are not being talked about. I called this theory the quadruple whammy.
And before I go into these numbers, I want to share with you a few other things that I have seen and heard people talk about that are completely out of whack with reality. I was recently attending a commercial real estate event and I caught up with a friend of mine that does a lot of investments in multi-family properties. And the first thing that he said was that in the multi-family market, in a particular city in Texas, there is so much competition for these properties that the sellers are requesting the deposits to be non-refundable.
From the get go, this means that if something is wrong with the property, if the apartment units are not great, if the roof needs to be replaced, or if something is incredibly wrong with the property, you're going to lose your entire deposit. Now, I clarified with him, "What if the financials are wrong?" Meaning what if the seller said that they're making, let's say a million dollars per year when they're actually making $500,000 per year in that operating income. That's the only time that the buyer is going to get their deposit back. If anything else is wrong with the property and you don't want to purchase it anymore, the deposit is completely non-refundable. And this tells me that there is too much competition and people are just potentially making offers on properties that might not work out.
Another thing that I learned separately from another investor is that a lot of operators are underwriting these deals with the best case scenario in mind. For example, when they are looking at rent increases, they're taking into consideration a rent increase of 5% per year when in reality the average rent increase has been, let's say, 4%. And in the last downturn, rent increases stayed at either 0% or were negative. This is a very important number if you are a passive investor investing with an operator that is not doing the right job on underwriting the deal.
People are also accounting for basically no vacancy. For example, they're accounting for a 10% vacancy at the worst case scenario when, in the last downturn, there was 15, 20, or even 25% in some properties. And this can also kill that deal because you need to pay your mortgage, you need to pay property taxes and you need to pay your investors if you are doing a syndication.
One more point that I learned (and I did not do the financial calculation to confirm) is that if the cap rates increase, you must have an additional 20% increase in your net operating income per 1% increase in the cap rate. Let's say that you bought a property at a 5% cap and now properties are selling at a 6% cap. You need to compensate for that 1% increase because your property value has decreased. You're going to need an additional 20% increase on your NOI. This is a significant number. Especially during a downturn.
Last but not least, I am observing what actions that highly sophisticated investors are taking. I'm not looking for people that have been doing this for the last five or eight years, mainly because they have never been through a downturn. Most of the highly experienced investors are selling properties. And I heard that some of them do not care about paying the taxes since they're not purchasing another property and they're not doing the 1031 exchange. They know that we make money when we buy, not when we sell. When things do change, they're going to have a lot of cash to buy properties at a steep discount.
This brings me to today's topic that I want to share with you in detail. Why, according to my calculations (and I have passed this by a few investors, so we're just going to generalize on these numbers) you can potentially lose 50% of the value of your property in one downturn. Let's take an example of a commercial retail property that you purchased for 10 million dollars at a 5% cap rate. This means that that property is currently making $500,000 in NOI. Let's say, for example, that this property has 25,000 square feet, this brings us to $400 per square foot on the purchase price, which is very reasonable in some places in California, and other states. You have now have a 10 million dollar property making $500,000 NOI.
1. In this great economy, the rents are higher. Let's say you were getting $20 per square foot per year across the board on all of your 25,000 sf of property.
2. Your property is completely leased, since we are in a great economy.
3. The interest rates are low. When property prices are rising, that means that interest rates are decreasing and more people can buy more property. When interest rates are higher, you do not qualify for as big of a loan as when interest rates are low because you have a specific dollar amount to pay every month. Let's say that when interest rates are at 6%, your interest only mortgage payment on a three million dollar loan is $180,000 per year. When interest rates are at 5%, your interest only payment on a three million dollar loan is $150,000 per year. That's a $30,000 difference, which means that you need to have an increase on your net operating income of $30,000 per year in order to make that additional 1% payment. In a downturn, this can be a bit challenging: if rent is going down, if you have increased vacancy, etc.
4. And that brings us full circle. When interest rates are low, you can buy more property. More people are buying properties and naturally cap rates compress, they get smaller and smaller. So that's what brings us to the 5% cap rate that you bought this property for.
Quadruple Whammy Gone Wrong - Economic Downturn
Let's say something pops in the economy. Here is what is going to happen to all these four bullet points that I just described.
1. Your rents are going to go down. Instead of leasing for $20 per square foot per year, let's say that about 25% of the property is now renting at $16 per square foot per year because some leases are going to be long term. Therefore, 75% of your tenants are still going to be on the $20 per square foot per year lease. Now, we dropped to $16 per square foot per year just because people cannot afford the $20, and your neighbors are also charging $16/sf so you cannot charge more. The total net operating income on that property is now $475,000. Again, this is if you are 100% leased.
2. Vacancies are higher. You are going to get some vacancies in that property, and is going to take longer to get them filled. Let's be conservative and have a 15% vacancy rate at that $475,000 that you are now making because you're charging a little bit less rent. You're now making $403,000 in NOI. Now that your property just lost almost $100,000 in that operating income, unfortunately everyone is selling, because nobody can afford their mortgage, because they bought at a super high price, and they don't have enough rent income to pay for the mortgage.
3. Interest rates are up, and buyers can afford less "property".
4. Cap rates are higher because it's a buyer's market. Let's say that from a 5% cap rate, the market is now selling properties at an 8% cap rate. So that $403,000 net operating income divided by an 8% cap brings the value of your property to $5,037,500. You just lost five million dollars of property value. Let's just let that sink in for a bit.
- We have a 15% vacancy rate because everyone has a higher vacancy during a downturn.
- We have rents for a small part of the property that has decreased from $20 per square foot to $16 per square foot. So rents decrease, let's say 20 percent for a small part of the property
- Cap rates are higher.
- Another thing that makes the cap rate go up is that interest rates go up. As soon as the government starts increasing interest rates, which will inevitably happen, buyers can qualify for a smaller dollar amount because their mortgage is going to be more expensive because interest rates are higher.
At that point, everyone is looking for a deal because they simply cannot afford as much property as they could before. Not only are interest rates higher, but people can buy less property, and less people can buy property.
What's the other side of the coin?
Another important side of this coin is the potential lost income of not making an investment. Let's say that you found a great deal back in 2016 that was bringing you 20% cash on cash return. At a $1,000,000 cash investment, you'd have lost $600,000 so far in three years (we're currently in 2019) if you had not made the investment at that time.
What is the conclusion of this conversation? I just want you to be aware. I want to congratulate you for learning as much as you can. Now is a great time to learn and gather as many skills as possible, as much knowledge as you can, because when something does happen, you are going to be an intelligent investor. You're going to be able to do the right due diligence. You're hopefully going to buy really good properties at a really good price. There's a lot of people say you'll make money when you buy, not when you sell.
And one more thing that I want to leave you guys with that's worth repeating: you should follow the very successful investors. They all say that you need to buy when nobody's buying, and you need to sell when nobody is selling. A lot of loans out there are 3-5 year terms and they are not going to be able to refinance these loans when they come due. They are not going to be able to refinance because the interest rates will be higher, their vacancy is going to be higher, the cap rates are going to be higher. So they are going to have to sell and potentially lose that property.
When the banks own the properties, then go get a great deal. Banks do have a certain timeframe to get rid of these properties, and that is another reason why you should buy at the right time. I hope that you have learned something from post. I have been talking with quite a few sophisticated investors about my theory of quadruple whammy gone wrong and they all agree with me. However, they all also say that nobody is talking about this. You just need to put all the pieces of the puzzle together. It's not that complicated. But unfortunately, common sense is not common.