In my last post, I thought about the impending doom that would strike many people who had invested in real estate. I cited both Warren Buffett and Howard Marks. I used the “third decade in real estate” card as my ace. I endeavored to convince you that we are now in the risky lag period that occurs at the peak of a bubble, much in the same way that the front car of a roller coaster hangs suspended at the top of the first hill.
I advised investors not to be too enthusiastic and overpay for properties likely to depreciate due to interest rate rises and the potential slowing of rent growth. After that, in the next article, I went in a completely different direction. I defended my position by offering explanations for why I was wrong. Alternatively, real estate investors might benefit from variables that reduce the impact of the eventual market decline.
I believe that sustained rent inflation, a rapid economic reaction to interest rate rises, the Fed not overcorrecting, or continuous supply and demand imbalances might save many real estate investors. However, it is important to remember that each of them is a component of the economy or the market. These are not within the control of any investor, and we cannot depend on them to determine our returns. A person is considered a speculator if they make their living by risking the outcome of financial markets and the economy.
If speculating is something you like doing, you should feel free to do so. However, you shouldn’t fool yourself into thinking you’re an investor. If you are a syndicator accepting the money of other people, you owe it to them, to be honest with them.
Regardless of the market or economic cycle, you may invest properly (rather than speculating) by following at least four techniques. In accordance with the main principles of this series, I will concentrate my discussion on the circumstances that exist at the time of this writing. These circumstances include the increase in interest rates, the current lag in commensurate cap rate growth (price reductions), and the potential that a bubble is about to burst.
Maintain a low to moderate level of debt
Interest rate hikes and economic disasters will likely come as no surprise to people who have little or no debt. During periods of increasing interest rates, investors who base their financial decisions on historically low rates of return might find themselves in a difficult position.
When the value of an asset falls, it is conceivable for investors who have taken on too much debt to suffer a loss of equity or even negative equity. This happens when the fall in value washes away an investor’s profits and even the capital initially invested in the venture. If you’re a syndicator, this might make your already-displeased investors even more unhappy, leading to a capital call.
This could be problematic throughout the refinancing process as well. Credit markets tend to become more restrictive when economic conditions are poor. The lending requirements of banks become stricter, their loan-to-cost ratios go lower, and it generally becomes more difficult to obtain money from banks. This can potentially result in negative equity and the possibility of losing an asset that generates outstanding cash flow.
An investment with minimal risk may be transformed into a kind of dangerous speculation via the use of excessive leverage. Caution is advised to anybody considering investing.
Use Fixed-Rate, Long-Term Debt
The first approach should be used in combination with this one. There’s a chance that things are about to turn for the worse. However, that course will return to the north at some point in the future. Shareholders with long-term debt with fixed rates will likely ride out the cycle through the trough and up the other side, but the timing of this event is unpredictable. Inflationary pressures on rents are expected to keep profits high throughout the cycle, providing investors with a steady stream of income and a significant return on their money.
The use of short-term, variable-interest loans is acceptable. There is very definitely a place for something like that. However, if you are worried about where we are in the present economic cycle phase, you should consider the content of your debt.
To save money, it’s best to make purchases outside of the regular market.
In the last post, we highlighted the importance of not spending more than you should for anything. It’s tempting to take advantage of the relaxing conditions in the market by investing in each opportunity that presents itself, given the intense competition for a limited number of transactions among investors during the last decade.
Overpaying today carries the greatest risk when the marketplace is at its all-time high. Safety margins are possibly at their lowest point ever; therefore, now is the moment to exercise extreme caution. Buying something unavailable on the market is one approach to do this. Real estate investors should use a strong off-market buying approach to identify transactions with less buyer competition and presumably at cheaper pricing.
There are several multiple approaches one might use to find off-market bargains. A great deal is determined by the asset class you possess and the skills of your staff. My company invests in recession-proof commercial real estate by collaborating with leading operators. To get in touch with off-market property owners of mobile home parks and self-storage facilities, my preferred operator has eight staff members working full-time in this role. Over several years, this technique has achieved objectives that have been nothing more than extraordinary.
Keeping considerable financial reserves on hand is one strategy that may help improve this endeavor’s effectiveness. Those investors who can purchase assets with cash and then refinance them later may have access to offers and pricing that are accessible to the majority of other investors.
My preferred method of cautious investing, which can be depended on reliably regardless of the state of the market or the economic cycle, typically coincides with the purchase of advantageously priced off-market purchases.
Invest In Intrinsic Value
Those who are successful in the real estate investment strategy look for opportunities with considerable untapped inherent potential, just as those who are successful in the financial markets or any other kind of investment do. This refers to the value that already exists in an asset that has been bought and may be extracted by a competent operator.
In highly fragmented asset sectors, these real estate holdings are often purchased from smaller, family-owned businesses. Although the options are many, we have discovered that mobile home parks, self-storage facilities, and recreational vehicle parks provide the most promising outcomes. Additionally, our company makes strategic investments in certain multifamily, light industrial, and retail center prospects that have high intrinsic value at the time of purchase.
According to Warren Buffett, the key to successful investment is acquiring assets with a large safety margin. Taking advantage of assets with a high intrinsic worth may provide a substantial margin of safety, which is particularly useful when purchasers risk overpaying for underwhelming properties with uncertain potential upside.
Two important and related margin of safety measures are debt service coverage and loan-to-value ratios. Monthly interest and principal payments divided by operational profits represent the debt service coverage ratio. A minimum DSCR of around 1.20, which translates to a 20% margin of safety between net income and debt servicing, is preferred by financial institutions. However, this modest margin may rapidly evaporate if floating interest rates increase or net income falls.
If you can unlock the true worth of your assets, you’ll see rising net income and a better debt service coverage ratio. An increasing safety net makes it possible to take more calculated risks in unstable economic climates. In addition, this harvest results in significant increases in value, which can counteract the increase in cap rates that is caused by increases in interest rates; this is a huge victory for investors.
A significant number of the properties in which we invest have DSCR values that are far higher than 2.0, which translates to a margin of safety that is one hundred percent. Some go even higher than 3.0, representing a safety margin of 200 percent.
In most cases, an increase in the loan-to-value (LTV) ratio is accompanied by a decrease in the margin of safety. The most important time to consider this margin of safety is when you are refinancing your loan. The investor’s equity is equal to the difference between the asset’s value and the loan’s due amount. Lower LTVs result in increased equity and reduced risk when the economy is in a contractionary phase.
One of our operators starts with a relatively low LTC (loan-to-cost ratio, also known as the LTV upon purchase), which is around 65%. However, there is a possibility that doing so may result in a reduction in their existing average LTV, which is 35%. A location that offers a high level of protection for financial investments.
Avoiding risk is important Mr. Buffett considers avoiding losses to be the most important factor in a successful investment. But the ultimate objective is to produce true wealth. Real wealth consists of assets that provide a steady stream of income. Acquiring assets with unrealized potential worth that can be unlocked by competent management is, in my opinion, the best strategy for mitigating risk while increasing one’s wealth.
The Steps That Should Be Taken Next
Many articles I’ve written highlight the benefit of investing in things people don’t immediately appreciate. Our company is focused on the goal of providing our shareholders with the safety and profitability that are associated with this approach. Since I find this approach to investing to be the most appealing of the four sound methods, I want to dedicate the next six articles to exploring real-world examples of how to extract intrinsic value from:
- Light Industrial
- Mobile Home Parks
- Outdoor Shopping Centers (yes, even retail)
- RV Parks
The following is a preview of some of the research findings we will discuss:
- A self-storage facility in Texas was purchased for cash from disputing siblings, and then, in only three months, it was valued at 75% more than it was originally worth.
- Covid’s worst-performing months coincided with the purchase and subsequent sale of a mobile home park in Kentucky, yielding an IRR of 347%.
- After just 19 months, a multifamily asset that had originally been purchased for $13 million was refinanced at more than $50 million.
- A sunbelt RV park renovated into a money-making machine is expected to have an annual cash flow of more than 25 percent.
Please keep in mind that I won’t simply be going through the previous research. Your plan for investing in real estate will benefit from my implementing the ideas of minimizing risk while simultaneously increasing value and wealth. I will do this by putting these principles of value investing into practice. I can’t wait to tell you about these experiences and teach you these techniques using these guiding principles!