What is happening with commercial real estate? Is now a good time to buy or will it get even better? How are the Fed rates going to play out? Ken McElroy, CEO and founder of MC Companies, shares his experience.
A lot of investors have bridge debt or value-add deals, we're seeing capital calls, you've been through 25 years of this, how are you looking at what's happening right now?
What happens in a normal balanced market is: there needs to be a little push-pull between buyer and seller and what happened is that the buyers in the last couple of years were at a massive disadvantage, they had to stretch for pricing and for terms, they were shortening their due diligence periods, etc. It was all coming and what this is doing is, it's an adjustment for the sellers and that gets lost in cash calls and all of that. But we needed the sellers and the brokers to adjust their expectations. What was happening was that people were stretching for deals and many of those deals are the ones that are in trouble, so the market was not in balance. It's unusually similar to what's happening with the single-family market and the same thing when you have 10, 20, or 30 people bidding on houses showing up and the prices are jumping, it's not a healthy market. It's healthy for a seller, not healthy for a buyer, that's why I say it's about time. The unfortunate part about that is, as it starts to unwind itself, there's pain for many people that have bought in, for all kinds of reasons. But as the tide goes out, and for those of us who are in the business for the long haul, it's actually better because prices are adjusting, cap rates are going up, interest rates are up, expenses are up, all those things are happening. It's just the pendulum swinging the other way and for somebody who's been at it 22 years now, it's a welcome time because we're still bidding on things but we're putting longer due diligence times on them, we're not doing nonrefundable day one, we're able to negotiate with sellers while we're in escrow, and that all goes away when you have a million dollars hard at day one. If you find a route for you to find problems inside of due diligence, then the sellers don't care, We need you to close anyway, you have a million dollars up, or half a million doors up, or 250k, or whatever it is. The playing field is starting to flatten again and it's going to be good for the industry if people can get through this short-term pain.
I have talked to one investor that has five capital calls going on, there's a lot of challenge, but it's really counterintuitive. A lot of times, it's the idea of being fearful when others are greedy and being greedy when others are fearful, as Warren Buffett would say. We were talking on a panel recently and somebody was talking about playing defense and offense at the same time. Defensively by taking care of what you have, as well as going after some of these new deals. Do you think, with the cap rate expansion, are we seeing some better deals now or are we not quite there yet?
We're not quite there. There's a lag effect with interest rates, with cap rates, with sellers and brokers and all of that. Playing defense and offense is a good analogy and I believe that you should be at all times. You should always be playing a little bit of offense, sometimes you're playing more offense, a lot of people right now are playing maybe a little more defense, but the worst thing that you can do is bury your head in the sand. If you're in this business for the long haul, I think that there needs to be a good balance there.
From our standpoint, what has gotten our investors to trust us over a long period of time is full transparency. We all know news can be a little slanted but it does stand to reason. If somebody's in that kind of trouble, how are they managing that? Have they been talking with their lenders? Have they talked to their investors? What are they doing on the management side because, for the last 22 years, the market has not gone up. I've seen it go up and go down multiple times. There are strategies for all of those things. There has been a tremendous amount of focus on influencers raising money online, I don't have a problem with that, however, if that's their only skill, then they have a problem and if the investors invested in those people, then that's an LP problem. When things like this happen, and it will happen again, you start to look at experience and wisdom, and how deep your bench is, your capital reserves, and all those things.
Somebody who has been in the business for a while is way ahead of these things and that's what's showing up now. A lot of these influencers don't know how to manage a property, they don't know how to manage a property management company so what's going to happen in the next year is all of these management companies are going to get fired, they're going to first blame the management company, then they're going to replace it one or two times, they're going to take it in house, and they're just kicking the can down the road, and maybe it works but if they don't know how to manage the manager, that puts them at a huge disadvantage. They don't know how to manage lenders and do loan modifications, and that's a problem. If their operating agreements aren't written correctly, they're not following the protocols of, whether their loans, or whether they're bringing in additional equity or preferred equity and squeezing people down, etc, because all of that is happening. I just wonder how much of that is happening that the LP's know about and that's all going to expose itself. It will turn itself into lawsuits and people will say, that's not what the business plan said and then the SEC will start digging into that. Those are all things that an online influencer, who knows how to raise money and brought somebody in, and they're partnering with others, doesn't get. Do I want all that to happen? Do I want all those people to be dragged through the mud? Of course not. It’s all going to depend on that transparency and how they're managing all this.
If you own multifamily between 2010 and 2021, just owning real estate really made you a genius because the rates were coming down and things were looking good. As rates have come up, we're seeing value add deals that are significantly lower value, where you do all these renovations and now the property is valued significantly less even after the renovations because of the debt. Somebody has to come in to buy the property. What do you think about the Fed with rates, especially coming to an election year?
I read the Fed minutes, and the reason I do it is there's a thing called the dot plot which is quite simply how is each Fed Chairman voted? Where do they think they're voting? I think that's a really interesting indicator. You find that most of them are grouped in some kind of average, you got a couple of high and lows, some say we need to raise rates, others say we need to lower rates, and you have everybody in the middle. I would dig into the dot plot, if you go back and look at what Powell, the Fed chair, he actually hasn't moved from his positions. The media takes what he said, they try to gas, and it comes out as a news article. But if you really take a look at it, sometimes people are just rewriting news articles and you have these journalists that, in my opinion, are not doing a very good job. They've said all along that they are trying to get inflation to two percent, they've never wavered off of that. Still, even though there have been all kinds of articles around that, if you look at them, they've never said we might consider something more than two. They talked about a neutral rate, that's different. I think that there is still a problem with inflation. Gas is at five, six dollars a gallon, rents are going up, albeit not as fast as they were, which is what the media is saying, but we're not seeing a decline in rent. House prices, mortgage payments, and food costs are going up.
You start to look at shelter as one of the biggest pieces. They've been trying to cave the real estate market, make no mistake about it, shelter, I think represents in the 40% range of the CPI. When you have a category like that, that represents that much of the CPI and it's still moving. I don't see rates going down. My crystal ball says that they're going to stay about where they are, they could potentially even go up a little bit, depending on those categories because again, going back to what the Fed is trying to do, they're trying to bring that inflation rate to two. It actually went up over the last two months, the CPI has gone the wrong way after 11 rate increases.
For all of you out there hanging on to thinking that the rates are going to go down, why do you think that because from everything I read and see it doesn't appear that the Fed would do that, and if they do, what are they going to go down to? Five? They punch all the way past 3, 4, 5, 6 and now they're approaching 7, so think how far they have to go. Even if they say, yes, we're going to reduce rates, they're going to do it at about a quarter point, half a point over time. Maybe if you're lucky, that could be a point in a year. Okay, great, now we're in the six. You have to put things in perspective, they're not going to go from 6- 7% rates or even 8 for single family, in some cases, and hard money is way over that. They're not going to jump down to 3 so all of your deals work, that's just not going to happen.