\n<\/p>\n
A commercial <\/strong>real estate crash<\/strong><\/a> is looking more and more likely in 2023<\/strong>. Rising interest rates<\/strong>, compressed cap rates<\/strong>, and new inventory <\/strong>about to hit the market is making commercial real estate, and multifamily more specifically, look as unattractive as ever to a real estate investor. But with so much money still thrown at multifamily investments, are everyday investors going to get caught up in all the hysteria?<\/strong> Or is this merely an overhyped crash <\/strong>that won\u2019t come to fruition for years to come?<\/p>\n Scott Trench<\/strong>, CEO of BiggerPockets<\/strong> and host of the BiggerPockets Money Podcast<\/em><\/a>, has had suspicions about the multifamily space since mortgage rates began to spike. Now, he\u2019s on the show to explain why a crash could happen<\/strong>, who it will affect<\/strong>, and what investors can do<\/strong> to prepare themselves. This is NOT a time to take on the high-stakes deals that were so prominent in 2020 and 2021. Scott gives his recommendations on what both passive and active investors can do to keep their wealth if and when a crash finally hits.<\/p>\n But that\u2019s not all! We wouldn\u2019t be talking about multifamily without Andrew Cushman<\/strong> and Matt Faircloth<\/strong>, two large multifamily investors who have decades of experience in the space. Andrew and Matt take questions from two BiggerPockets mentees, Philip <\/strong>and Danny<\/strong>, a couple of California-based investors trying to scale their multifamily portfolios<\/strong>. If you want to get into multifamily the right way<\/strong> or dodge a lousy deal, stick around!<\/p>\n Scott: Andrew: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Scott: Dave: Andrew: Philip: Andrew: Philip: Andrew: Philip: Andrew: Matt: Philip: Matt: Philip: Matt: Philip: Matt: Philip: Andrew: Matt: Philip: Matt: Philip: Andrew: Matt: Danny: Matt: Danny: Matt: Danny: Matt: Danny: Matt: Danny: Matt: Andrew: Danny: Matt: Danny: Andrew: Matt: Andrew: Matt: Danny: Matt: Andrew: Matt: Andrew: Danny: \u00a0<\/p>\n<\/div>\n Help us reach new listeners on iTunes by leaving us a rating and review! It takes just 30 seconds and instructions can be found here<\/a>. Thanks! We really appreciate it!<\/p>\n Interested in learning more about today\u2019s sponsors or becoming a BiggerPockets partner yourself? Check out our\u00a0<\/em>sponsor page<\/em><\/a>!<\/em><\/p>\n Note By BiggerPockets:<\/b> These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.<\/p>\n
This is the BiggerPockets Podcast, show number 721.<\/p>\n
Keep in mind, bigger is mentally more daunting, but bigger is easier. It\u2019s the same amount of work to take down a 10-unit as it is to take down a 100-unit. So my philosophy is go as big as you comfortably can. When I mean comfortable is without putting you or your investors at financial risk, but just don\u2019t be scared by the fact that, \u201cWell, it\u2019s a 100 units. I\u2019ve never done that yet.\u201d If you\u2019ve taken down a 10, you\u2019ve taken down a 100. It\u2019s just the amount of the finances, and it actually gets easier the bigger you go.<\/p>\n
What\u2019s going on everybody? This is Scott Trench, temporary guest on the BiggerPockets Podcast here with the host, Dave Meyer. Sorry, I stole that from you, Dave.<\/p>\n
Oh, no. I don\u2019t know if I\u2019m the host or the guest. Whatever it is, we\u2019re here together, and we\u2019re taking over the show today.<\/p>\n
Well, thank you for having me on today, Dave. I appreciate it.<\/p>\n
Yeah, of course. You\u2019re very smooth at that intro. You\u2019re an old hand at this. We wanted to have you on because we\u2019ve had a couple of questions. You and I have actually had a lot of great conversations offline about this. You have some really interesting thoughts and, frankly, some concerns about the multifamily commercial space that we\u2019re going to talk about here for the first 20 minutes of the show.<\/p>\n
Yeah, I do. I think that the commercial multifamily has enjoyed a really phenomenal run in creating a tremendous amount of wealth over the past 10, 12 years as rents have really grown almost in accelerating fashion for the last decade as interest rates have come ticking down over that time and as cap rates have come down. That\u2019s created an incredible environment for wealth creation that I worry has run its course and is set to give a lot of that back in the next 12 to 18 months. I want to voice those concerns really and ring the alarm bell here so that investors are very, very wary of this asset class heading into 2023 in particular.<\/p>\n
All right, great. Well, this will be a great conversation. I\u2019m looking forward to it. I have a lot of questions for you. Just for everyone listening, we\u2019re going to talk to Scott for about 20 minutes. Then we\u2019re going to turn it over to Matt Faircloth and Andrew Cushman who are going to be answering some mentee and listener questions about the multifamily space. So we have a great show for you today. We\u2019re going to cover a lot about commercial and multifamily, so you\u2019ll definitely want to stick around for this. You have some thoughts about what\u2019s going on in the multifamily and commercial space, and we\u2019d love to hear what you\u2019re thinking.<\/p>\n
I think the first thing that\u2019s concerning me in the multifamily or commercial multifamily and commercial real estate space is that cap rates are lower than interest rates right now in a lot of this space. What that means is when I\u2019m buying a piece of commercial real estate, I\u2019m buying an income stream. If that\u2019s at a 5% cap rate, I might spend $10 million to buy a property that generates $500,000 a year in net operating income. Well, if my interest rate is 5.5% or 6.5%, like Freddie Mac 30-year fixed rate mortgages are averaging 6.42% as at the end of the year, that means that my debt is dilutive. I\u2019m actually going to get a better return by buying all cash or being on the lending side instead of the equity side unless I\u2019m really bullish on appreciation. In the case of commercial real estate, that means I\u2019m really bullish on rent growth or I, for some reason, believe I can reduce operating expenses. So this is a huge problem. This is not sustainable in my opinion. When the average of the market sees cap rates lower than interest rates, that means that the market is going all in on these assumptions for growth. And I don\u2019t understand that. I think it\u2019s a really risky and scary position.
So let\u2019s go through what has to be true for this to work out for investors in the commercial space. One is rent growth has to go up. One way that could happen is supply and demand dynamics. On the supply side, we\u2019re going to have the most inventory coming online since the 1970s. Ivy Zelman estimates that there are going to be 1.6 million units coming online in the next 12 to 18 months in the backlog here. Builders will complete that inventory, and they will monetize it. It\u2019s possible that if things get really bad, they can stop construction, but then that just proves the point that there\u2019s a big risk in this space.
Then the other side of this\u2026 So I think that\u2019s a headwind to that rent growth assumption that the market\u2019s going all in on, lots of supply coming online, lots of construction. All you got to do is peek out the window here in Denver and you see the cranes more prolific than they ever have been. That\u2019s saying something because the city\u2019s been booming for a long time. Now, this will all be regional. Some cities will not see the supply coming online. Some cities will see tons of supply coming online and still have no trouble with absorption of those units.<\/p>\n
Well, just to reiterate, to emphasize that point, Scott, we are already seeing that rents, specifically in multifamily, are flattening and starting to decline in some areas. That\u2019s even before, what you\u2019re saying, this increase in supply comes online because I think that\u2019s sort of towards the middle of 2023 when that\u2019s intended to happen. So we\u2019re already seeing this before the supply glut even starts to impact that dynamic.<\/p>\n
Yeah, absolutely. I think a better bet is that rents stay flat or maybe even decline over the next 12 months in the multifamily space versus the implicit assumption when cap rates are lower than interest rates that they\u2019re going to explode.
On the demand side, I think we have a wild card here, and I don\u2019t really have any forecasts that I feel really confident in on demand. One of the big arguments for demand is that there are more people, household formation is accelerating. There\u2019s long-term trends supporting that. That\u2019s true, but there\u2019s a whole bunch of volatility from the whole COVID situation: lots of people moving out, getting divorced, breaking up. That creates household formation, in my opinion, artificially. It\u2019s a metric that can move and confuse economists. So I don\u2019t know how to predict household formation in 2023 one way or the other. I think the safest bet is to assume very little household formation. If there\u2019s a mild recession or interest rates keep rising, that\u2019s going to put pressure in the economy. It\u2019s going to result in less wage growth, and we might give back some of those rent increases. I think, if anything, there\u2019s reason to believe that rents, again, stay flat or decline year over year. Again, that\u2019s problematic.
So I worry that in 2023 we could see cap rates increase, which means multifamily asset valuations decline. So that same property that\u2019s generating $500,000 in net operating income goes from being worth $10 million at a 5.0% cap to 7.7% at a 6.5% cap. That\u2019s a 23% crash in the asset value of that property. If you\u2019re levered 70\/30, you used 70% debt, 30% equity, that\u2019s going to wipe out the vast majority of your equity. This is the problem that I see brewing in this space or that I worry could be brewing in the 2023 space.<\/p>\n
Do you see this across all multifamily assets? Are bigger syndications or smaller multi-families disproportionately going to be impacted by this?<\/p>\n
I think that this is a threat to commercial real estate assets across the board, which would include office space, retail, multifamily and other assets. I think that you\u2019re going to see more pressure on larger assets. You\u2019re going to see pressure on assets that are not financed with Freddie Mac loans at 30-year fixed rates. I think that folks will be disproportionately impacted. I also think you\u2019re going to see folks simply not selling in this period. If you\u2019re invested in a syndication, your syndicator\u2019s probably just not going to sell for the next year or two and hope that prices recover. My worry though is that if interest rates stay high, and they can even come down a little bit, I know you\u2019re thinking that mortgage rates are probable to come down next year, but as long as they just stay much higher than they were for the last couple of years, I think you\u2019re going to see cap rates reset at a higher level, maybe 6.5%, 7% on a nationwide basis, again, varying by region.<\/p>\n
Well, also ideally, most syndicators and operators will probably hold on. But given the nature of commercial lending, most of them don\u2019t have long-term fixed debt. Some of them might have balloon payments coming due or an adjustable rate mortgage that\u2019s adjusting in the next couple of years, and that could potentially force a sale or further negatively impact the cash flow of the properties.<\/p>\n
I think that\u2019s true, and I think that\u2019s a really big unknown in the space. I don\u2019t know anyone who has great data on averages in commercial multifamily real estate debt terms. What is the average weighted life of these debts? Is it five years? Is it 10 years? Is it 30 years? Is everyone getting fixed rate Freddie Mac loans on this and we\u2019re all set? My guess is there\u2019s a big spread in these areas and that different folks are going to get impacted very differently. My best guess is that there\u2019s going to be a process rather than an event for this cap rate reset. There\u2019s just going to be continual grinding pressure on operators of these assets over 12 to 18 months, but there could always be some sort of event issue where things come to a head at once.
By the way, this is not news. Asset values in the space have come down 20% to 30% in many markets already. For some of those markets, it was like a light switch and some of it was over time. Brian Burke, I think, has some really good detail on this on a previous BP podcast. Then I also want to call out, you had Ben Miller on the On the Market Podcast, the CEO of Fundrise. He really has a good handle, I think, on the timing and credit issues that are coming up in the space, and how folks are leveraged and why lender A borrowed from lender B to finance property C, and everybody needs liquidity at once, that could create problems. I think that\u2019s really hard to predict. I think, again, that\u2019s a space where nobody has great data, and there\u2019s a big unknown here.<\/p>\n
It is really hard to find that information. If you want to check out that podcast Scott was talking about, it came out around Christmas on the On the Market feed. You can check that out. It\u2019s called the Great Deleveraging with Ben Miller. Scott, I think this is fascinating and appreciate your take. I\u2019m curious what you would recommend investors do. I guess there\u2019s two sides of that. As a operator, multifamily syndicator, what would you recommend they do? Then as people like me who invest passively in syndications of multifamily deals, what would your advice be?<\/p>\n
Well, I think if you\u2019re in a current syndication, you got to just kind of pray and hold. There\u2019s not really another option. You\u2019re a limited partner, and there\u2019s nothing to do. So it all comes down to what you can do going forward. I think that if you\u2019re considering investing in a syndication, make sure that it\u2019s a huge winner even in a no-rent growth environment. Throw out the syndicator\u2019s projections on market rent growth and say, if there\u2019s no rent growth, does this thing still make sense over the next couple of years for me? And does it make sense where, even if I have to sell the property with 150 basis point increase in cap rates in that market\u2026? That\u2019s a general rule of thumb. Each region will vary. You definitely can modify those assumptions by your region if you have one of those markets that has a lot of net migration with very little new construction.
Another one is, instead of getting on the equity side in a syndication, consider being on the debt side. There\u2019s preferred equity, which is really consistent with debt in terms of its return profile, although it\u2019s junior to the more senior debt at the top of the stack. Or you can just get into a debt fund. If the cap rate is 5% and the interest rates are 6.5%, why not just earn 6.5% interest rates or even higher with other debt funds? That\u2019s a lower-risk way to earn better cash flow for a period of time. When things change or if they change, you can always go back to being on the equity side or when you have confidence in rent growth. If you\u2019re going to go in on an equity deal, maybe consider finding somebody that is going to syndicate with no leverage at all. Again, if the property\u2019s going to produce a yield at a 5% cap rate, consider using no debt at all. That\u2019s actually going to increase your returns in a no or low-rent growth environment while being lower risk. So that\u2019s really attractive.
These are super bold opinions that I\u2019m trying to bring in here, but I really want to voice this concern because I feel like folks don\u2019t understand this and I feel like they\u2019re getting information\u2026 If you\u2019re getting all of your information from people who syndicate real estate deals, recognize that these syndicators, they\u2019re great people, they do a great job in a lot of cases, but this is their livelihood. It\u2019s hard to see perhaps some of the risks in this space if your livelihood depends on raising large amounts of capital, buying deals, and earning money through acquisition fees, management fees, and then having a spin at a carried interest on the [inaudible 00:13:51].<\/p>\n
That\u2019s great advice, Scott. Thank you. Do you see this potential downturn in commercial real estate? From what you\u2019re saying, it sounds like. I personally believe we\u2019ll see a modest downturn in residential real estate, but this commercial one has more downside according to your analysis. Do you see it spilling over into residential or any other parts of the real estate industry?<\/p>\n
This is not good news for real estate in a general sense. Look, I think that you have a really good handle on the residential market in particular. You have a good handle on all the markets. I don\u2019t think you spend quite as much time in the commercial space. I would say, by the way, you should take some of my opinions here with a grain of salt because I\u2019m an amateur aspiring journeyman in understanding the commercial real estate markets here. But in the residential space, I think we\u2019ve got a reasonable handle on that. There\u2019s a whole variety of outcomes. But, no, commercial real estate asset values declining will likely be hand in hand with residential real estate asset values declining. We already predict that. I think 3% to 10% declines are the ballpark that you\u2019ve been discussing for residential depending on where interest rates end up at the end of the year next year.<\/p>\n
Well, that\u2019s super helpful.<\/p>\n
By the way, if you\u2019re considering investing in residential real estate, put it on the BiggerPockets calculator and look at the property with a 30-year mortgage and reasonable appreciation and rent growth assumptions and put it on there without a mortgage and see what the returns look like. In a lot of cases, the returns are going to be better without a mortgage on the property, which, again, is something that is really interesting and something that should get the wheels turning. You need to really find some good deals right now in order for this to work, and you might want to consider being on the debt side.<\/p>\n
Awesome. Well, Scott, we really appreciate this very sober and thoughtful analysis. It\u2019s clearly something our audience and anyone considering investing in real estate should be thinking about and learning more about.<\/p>\n
Well, Dave, one question I have for you is, what do you think? I\u2019m coming in hot with a little bit of doom and gloom here worrying that there\u2019s a really big risk factor brewing in the commercial real estate space. Do you think I\u2019m reasonable with that, or do you think I\u2019m way off?<\/p>\n
No, I do. I think that it\u2019s a serious concern. I really have a hard time envisioning cap rates staying where they are. I can\u2019t imagine a world where they don\u2019t expand. As you illustrated really well, just modest increases in cap rates have really significant detrimental impacts on asset values. We\u2019re just seeing conditions reverse in a way that cap rates have been extremely low for a very long time, and economic conditions, I don\u2019t think, really support that anymore.
I think what you said about rent growth is accurate. The party that we\u2019ve all seen over the last couple of years where rank growth has been exploding, the economic conditions don\u2019t really support it anymore. I think it\u2019s time to be very cautious and conservative. I don\u2019t see any downside in being really conservative. If you\u2019re wrong and if I\u2019m wrong, then it\u2019s just a bonus for you. If you invest really conservatively and rent growth does increase and cap rates stay low, good for you. But as you said, I think that the most sober and appropriate advice, both in commercial and residential right now, is assume very modest rent growth, if any at all, assume very little appreciation, and if deals still work, then that makes sense. But I don\u2019t think hoping for improving conditions is a wise course of action, at least for the next year and maybe two years.<\/p>\n
Well, great. Again, I feel a little nervous voicing this concern. I\u2019m essentially coming on the show and saying, \u201cI\u2019m predicting a pretty\u2026\u201d I\u2019m not predicting. I\u2019m worried about an up to 30% decline in asset values in commercial multifamily. That\u2019s one area where I really enjoyed Ben Miller\u2019s podcast where he talked about the credit risks in here, but I really think multifamily is not insulated from this. His risk was for the commercial, like a retail office, those other asset classes. I think multifamily is very exposed right now, and I worry that some of these things have not been priced in appropriately in the market.
Again, it just comes back down to the simple fact of we\u2019re trying to make money as investors. How can you make money if rents aren\u2019t going to grow and your debt is more expensive than the cash flow that you\u2019re buying? That has to change. I think that a reasonable spread between cap rates and interest rates on a national average is about 150 basis points. That amounts to a very large increase that\u2019s going from about 5% on a national average right now to 6.5% cap rates. Again, that destroys a lot of value. So hopefully this is helpful.<\/p>\n
The only alternative there is that interest rates go down, like you\u2019re saying, you need this spread. But personally I think mortgage rates might go down by the end of 2023, but not a lot, I don\u2019t think by 100 basis points from where they are right now. That is my thought, but I don\u2019t believe that very strongly. I think there\u2019s a lot of different ways that this could go. So I think that the more probable outcome, as you\u2019ve said, is that cap rates go up to get to that historic healthy spread rather than interest rates coming down.<\/p>\n
There may be a combination. That could be a mitigating factor. They could come down some and cap rates could still go up a portion of this, but I\u2019m very fearful of this space over the next year.<\/p>\n
All right, Scott. Well, we really appreciate this honest assessment and you sharing your feelings with us. It\u2019s super helpful for everyone listening to this and given me a lot to think about. Before we let you get out of here, what is your quick tip for today?<\/p>\n
My quick tip is if you\u2019re analyzing commercial real estate or any other real estate, in today\u2019s environment try analyzing it with and without debt first. Then second, if you\u2019re looking at syndicated opportunities, if you\u2019re still interested in syndicated opportunities, make sure that the sponsor is buying deep, buying at a steep discount to market value, that there\u2019s significant opportunities for rent increases just to bring current rents to market, and that the property can still generate an acceptable profit when the syndicator needs to sell it three to five years later, even if that is at a cap rate that is 1.5% higher, 150 basis points higher than what it was purchased at today.<\/p>\n
Well, thank you Scott Trench, the CEO of BiggerPockets. We appreciate you being on here. With that, we are going to turn it over to Matt Faircloth and Andrew Cushman who are going to be answering some mentee questions about getting into multifamily investing.<\/p>\n
Philip Hernandez, welcome to the BiggerPockets Podcast. How you doing, sir?<\/p>\n
I\u2019m doing well. I am super stoked to be here. Thank you so much, Andrew.<\/p>\n
You are part of the inaugural group of the BiggerPockets\u2019s mentee program. You\u2019re here with a few questions that hopefully we can help out with today. Is that correct?<\/p>\n
Yeah, yeah, that\u2019s right. I\u2019m super stoked and thank you guys so much for your time. My question, in the multifamily world, but also just in the real estate world in general, a lot of times when we\u2019re starting out, the advice is given to partner with somebody that has more experience than you by providing them with some value, either finding the deal or managing the deal or somehow making it easier for the person that has more experience than you. What if the thing that you\u2019re able to do to add value is raise capital? I\u2019m starting to find some\u2026 My network is starting to be interested in investing with me more. What if I don\u2019t have the deal? What if somebody else has a deal, but I\u2019m just starting to get to know them, how would you vet the person that you\u2019re thinking of bringing your friends and family\u2019s money into a deal for? What would your checklist look like so you do that in a good way?<\/p>\n
Important topic. Just to make sure we\u2019ve got that right, your question is basically, if I\u2019m kind of starting out as a capital raiser, what\u2019s the checklist look like to pick the right partner or co-sponsor to invest that money with?<\/p>\n
Yeah, exactly. Because vetting a deal as far as doing my own due diligence, I feel reasonably competent at that, but that\u2019s if I\u2019m in control of everything. So what if I\u2019m not in control of everything?<\/p>\n
You\u2019re right on. Matt\u2019s probably has a lot to say on this, so I\u2019m going to just roll off a few things, and then I\u2019ll let him take over. Number one is I would say go read Brian Burke\u2019s book, The Hands-Off Investor, because it is written towards LP passive investors. It is the most detailed, in-depth manual for how to vet an operator that I\u2019ve ever seen in my life. So if you are looking at raising money and putting that money with somebody else, you need to be an expert in that book. That\u2019s the first thing that I would do. Even as someone who\u2019s been doing this for a decade and a half, I read every page of his book. There\u2019s a lot to learn in there. So do that.
Second of all is if you\u2019re going to raise other people\u2019s money and then put it in someone else\u2019s deal, do not be just in a limited partner. Make sure that you are either part of the general partnership or at bare minimum have some level of input or control in the deal. Unfortunately, just last week, a friend of mine raised money, put it with another sponsor in a deal in Texas. They had a fire. The deal is going bad. 100% of the equity is going to be lost. One of the biggest frustrations with the friend of mine who raised the money is he has no control. He can\u2019t even get all of the information into what\u2019s going on. So make sure that you have some level of input, some level of control.
I would also recommend when you\u2019re looking at a specific deal, underwrite the deal and do due diligence on the deal as if it was your own deal and you found it. You\u2019re basically duplicating the underwriting and the research that the sponsor\u2019s supposed to be doing. Hopefully everything lines up and you\u2019re like, \u201cWow, this guy\u2019s great.\u201d But if not, you\u2019re going to find that, and you\u2019re going to save yourself a lot of\u2026 You save your investors risk and save your own reputation. Then also realize you are really betting more on that operator than you are on any specific deal, especially as the market is now shifting. Asset management and good operations is where the money is truly made. We\u2019ve all been riding a huge wave for the last 10 years, that has crested, and the good operators are going to be the differentiating factor going forward.
Then also really from your perspective, Philip, just understand that no matter what, you to some degree are placing your reputation in somebody else\u2019s hands. Go through that vetting process, do it slow. If you do it right, it can be a wonderful thing for growing and scaling and focusing on what you\u2019re good at. But just keep that in mind. Matt, I\u2019ll toss it over you to see what you have to add?<\/p>\n
Well, I could just say, \u201cHey, I agree with Andrew,\u201d which I do most of the time. Everything Andrew said is 100% correct. Yes, vet them as if you were investing your own capital, and that\u2019s how you should look at it. Above everything else, Philip, is look at this as if this were your money going into this other operator\u2019s deal. Do what you would do if you were writing this check. Because in essence, the person investing is not investing in that deal. They\u2019re investing in you. They\u2019re coming to you to help them find a place to park their capital. They\u2019re not so much like\u2026 They could just go to that operator direct. Why would they need to go through you? The reason why they have to go through you is because they trust you. They\u2019re investing with Philip Hernandez in his network and his underwriting prowess and his market knowledge.
So do that. Go through and vet the market, find out why the market\u2019s amazing. Don\u2019t just listen to the syndicate or the operator or the organizer. Come up with your own homework as to why. Don\u2019t just rely on the syndicator\u2019s PDF documents that show financials. Get their real numbers in Excel. Underwrite the deal yourself. Get the rent roll and profit and loss statements from the current owner that they\u2019re buying the property from and do your own analysis of the property. Maybe come up with your own vetting, your own underwriting, and stress test the deal, too. All these things are done by good LP investors that want to invest in a deal, and you need to act as if it\u2019s your powder going into this deal, not your investors. That\u2019s number one.
I could also offer you some thoughts, if you\u2019re looking for it, on how you can protect yourself in raising money for someone else. Because my guess is you\u2019re a great guy, I happen to know that, but you\u2019re not doing this for a hobby. You\u2019re doing this because you would like to get some sort of compensation in exchange for placing one of your investors in the deal, correct?<\/p>\n
Yeah, definitely.<\/p>\n
The problem is, and unless I\u2019m wrong, you don\u2019t hold a Series 7 license. You\u2019re not a licensed securities equities broker, are you?<\/p>\n
Correct.<\/p>\n
So that operator can\u2019t compensate you for raising capital because what you\u2019re doing is you\u2019re selling a security for them. I can\u2019t cut you a check in dollars and equity that you raise in exchange for raising capital because that would be compensating you as an equity broker for selling a security, and you need a license to do that, which you don\u2019t have. But rest assured, I got you covered.
The way that you do that is you become a member of the GP, the general partnership, as Andrew had said. Now, there\u2019s a carve out there. You can\u2019t just become a GP as a capital raiser. You need to have an active role in the company. A capital raiser\u2019s job pretty much is over after the company gets formed. You know what I\u2019m saying? It\u2019s not like you need more capital forever. You raised the capital and the deal closes, and then you\u2019re done. So what the SEC will want to see, if there\u2019s ever scrutiny on the deal, and to be straight, not what your investor\u2019s going to want to see, do you remain an active partner in the deal? So Phillip\u2019s job does not end once the capital is raised because that gets you an active role in the company as an owner. If you\u2019re an owner of a company, any size owner, you\u2019re allowed to sell equity. You don\u2019t need a securities license if you own a portion of the company. You follow me?<\/p>\n
Yeah.<\/p>\n
Now, you own a portion of the company, but you also need to do something more than just raising capital. So you could sit on the asset management team. You could, as we do at DeRosa for my company, what we do is we form a board of directors, and that board of directors has a voice. They have say. We do regular board of directors meetings. We keep minutes. We even are total dorks and do the Robert\u2019s Rules of Order where there\u2019s motions and seconds and ayes and that whole thing. So you can do all that as a board of directors with the capitol raisers having a regular voice on the company. If the operator\u2019s willing to play ball with you and set things up that way, then that\u2019s a great way for you to become a member of the GP, for you to have a say and have control, and also for you to become a member of the GP so that the main organizer can legally compensate you in whatever form or fashion you negotiate for yourself.<\/p>\n
So if it\u2019s a smaller deal and if there\u2019s three people on the deal, four people on the deal, Andrew, you said make sure that you have a certain level of control. What does that actually look like? Control as far as in the dispo or control\u2026? What would I say, \u201cOh, this is how I want that to look?\u201d as far as control?<\/p>\n
Control in as much as possible. So you get to vote on, like you said, disposition, when\/how, approval of price. You get to approve, does it get refinanced? Are you going to fire the property manager and hire a new one? You should have some input into that. You get input on whether or not to make large capital expenditures. Should they be held back, or should you go forward with them? You get to have input on, should distributions be made, or should they be held back to preserve the financial position of the property to get through potential rough times? So the more input you have, the better that is for your investors. Then also you\u2019re going to learn more, too. Especially if you\u2019re on the capital raising side, you\u2019re not going to be spending as much time in operations. You\u2019re going to learn more by doing that as well.<\/p>\n
What\u2019s interesting Philip, is that you had talked about, this is only a small deal. There\u2019s only three to four of you involved in this project, correct? I didn\u2019t want to scare you or anybody else thinking about, \u201cOh, board of directors. Well, geez, Microsoft has a board of directors, but this is a little however many size deal. It doesn\u2019t need a board of directors.\u201d Well, yes and no. You don\u2019t have to let terms like that scare you or anyone else. There\u2019s just ways to operate real estate that involves a couple of partners. It involves private capital coming into the deal. Every partner having a say, as Andrew said, in the project is imperative. Every partner having a vote.
By the way, it doesn\u2019t have to be what Phillip says goes. It just has to be Phillip has a vote, Philip has a voice. In all of these things, it\u2019s typically a consensus or even a \u201cAye say aye, nay say nay\u201d kind of thing to determine whether or not you take the offer, whether or not you decide to replace the roof. This is how semi-complex real estate happens. This could be a four-unit property or a 10-unit property, whatever it is. I don\u2019t want people to view this as any more complex than it needs to be. This could be a very up and down, quick Zoom call that you just make record that the Zoom call happened. Maybe here and again, put yourself on an airplane, Philip, and go out and look at the property.
The last thing I\u2019ll leave you with, and everybody else too, too many folks do real estate investing like this as a dabble. If you\u2019re raising private capital for an operator, you should not raise capital for that operator unless you\u2019re planning on doing it 10 times for their next 10 deals or maybe growing into your own thing eventually. But you shouldn\u2019t dabble in raising capital for an operator. You should do it over and over and over again so that your brand gets attached to them so that people view you as a capital source for them, and it\u2019s something you can do over and over and over again. It\u2019s not something you can try on one time because a typical real estate project could last five years, and if the economy changes a bit, it could be a good bit longer than five years in these projects to take. So you got to make sure that you like working with these folks, and you want to do a lot more work with them.<\/p>\n
That\u2019s great advice. Thank you guys so much. I really appreciate it.<\/p>\n
Philip, before you split man, I want to let you know, you were an awesome, awesome, awesome juggernaut in the Multifamily Bootcamp that we had in the one that we kicked off a few months ago, and I want to thank you for bringing the sauce you brought to that. It sounds like you\u2019re doing just the same for the mentee program. I am really grateful to see you here. Saw you at BP Con. I love your vibe, love your energy even though you\u2019re bundled up there in Los Angeles.<\/p>\n
Thank you. Appreciate it. Appreciate you guys.<\/p>\n
All right, take care, Phil.<\/p>\n
Andrew, we got another question lined up here. I want to bring in\u2026 I got Danny, Danny Zapata. Danny, welcome to the BiggerPockets Podcast, man. How are you today?<\/p>\n
I\u2019m doing excellent. Thank you for having me on.<\/p>\n
You are quite welcome. What is on your mind? How can Andrew and I brighten your day a bit? What is your real estate question you want to bring for Andrew and I to answer and for the masses to hear our thoughts on?<\/p>\n
Let me give you a little context. I\u2019m a small multifamily investor currently, I have some properties in Sacramento, and I\u2019m looking to take that next big step to scale. So it\u2019s a really great opportunity to pick both of your brains here right now. The question I have is, besides differences in lending between small and larger multifamilies, what are some of the other things you looked out for when you\u2019re scaling from less than five units to 10 to 20-unit properties?<\/p>\n
Well, I know, Andrew, you and I have friendly debates on which is better. Andrew got pretty much right into big multifamily real estate because he\u2019s a superhero and he\u2019s able to do that. Most commoners like myself have to climb their way up from five to 10-unit to 30 to 40 and scale up in that. Andrew, I know you have thoughts on this as well. But I\u2019ll give you my thoughts briefly, Danny, in that the profit and loss statement\u2019s still the same. There is still profit, and there\u2019s still losses in that. There\u2019s still income and expenses. So you\u2019re still going to have an income stream.
But as you get into bigger and bigger deals, it perhaps becomes a few more income streams. Perhaps it\u2019s not just rental income. Perhaps your P&L is going to show laundry fees and all kinds of other fun things like trash valet or charging the tenants for cable or other things that come in. So it gets more complex in the revenue side. Additionally, things like late fees and that. I got scrutinized for showing late fee as income on a four-unit property because you\u2019re showing that as revenue. You\u2019re kind of trying to stretch it. But guess what? On bigger multifamily, it becomes more common, and it becomes expected for that to be part of revenue.
Additionally, on the expense side, that can get very big on the expenses on multifamily, not big in the dollars but big in number of line items you may have. On a five-unit, what do you got? Real estate taxes, insurance, maintenance, maybe four or five other line items. For a larger multifamily property, you could have 30 or 40 line items on an expense sheet. You\u2019ve got a big one that a lot of people on small multifamily don\u2019t think about, and that is payroll. Here\u2019s what that means. For a four-unit property that you own, give me a real-life example, Danny, of a small multi that you own right now.<\/p>\n
I have a fourplex in West Sacramento, a mix of two bedrooms and one studio.<\/p>\n
Who\u2019s managing it?<\/p>\n
We have a property manager for that.<\/p>\n
You don\u2019t write a W2 check to that property manager\u2019s salary that collects your rent and runs that property for you, do you?<\/p>\n
Correct.<\/p>\n
For larger multifamily, you\u2019ll see a property management fee, but you\u2019re also going to see staffing charges. It\u2019s a good and a bad thing because that means that you\u2019ve got full-time personnel. The rule of thumb is somewhere over around 80 units a property can afford full-time personnel, and that\u2019s awesome because that means that person\u2019s career, their job is based on making your multifamily property meet its goals, correct? That could be a leasing agent, that could be a maintenance tech, those kinds of things. But you do not have those line items in your four-unit or in your 10-unit or in your 30-unit. It doesn\u2019t have those things.
So you need to budget for full-time staff whose job it is to make that multifamily sing the song you want it to, leasing agents, perhaps larger properties may have a site manager. Larger properties may have multiple maintenance technicians whose job is to repair things that come up on the property big and small. That is far and away the line item that a lot of smaller investors, as I did, get surprised and say, \u201cOh, wow. I have to budget for that,\u201d but also exciting. I now can give these people job descriptions and give them task lists and use software or whatever to help them fully optimize their positions in what they do and help that bring along my property. So it\u2019s a good thing but you have to get a budget for it. Andrew, I know that you\u2019ve thought of this, too. What other things do you see in the buckets on bigger multifamily that are maybe not in the buckets on small multifamily income expense-wise?<\/p>\n
In your comments, so I jumped straight to 92 units because of one of the things you said is that the bigger properties will be able to support their own full-time staff because I was like, man, I don\u2019t want to manage a 30-unit from out of state. That\u2019s really difficult. You really mentioned quite a few of them and a lot of the really important ones.
Some of the other ones that are actually not necessarily line items on the P&L, but some of the other differences, Danny, one, keep in mind, bigger is mentally more daunting, but bigger is easier. It\u2019s the same amount of work to take down a 10-unit as it is to take down a 100-unit. So my philosophy is go as big as you comfortably can. When I mean comfortable is without putting you or your investors at financial risk, but just don\u2019t be scared by the fact that, \u201cWell, it\u2019s a 100 units. I\u2019ve never done that yet.\u201d If you\u2019ve taken down a 10, you\u2019ve taken down a 100. It\u2019s just the amount of the finances, and it actually gets easier the bigger you go.
The other difference when you\u2019re starting to scale from fourplexes to 10 units and 20 units is demographics become that much more important. If you have a fourplex and it\u2019s in a market that\u2019s flat or maybe even declining a little bit, it\u2019s not that hard to fill a vacancy or two because you don\u2019t need that many people to stay full. But if you\u2019ve got a 20-unit and people are moving out of the area and you start getting two, three, four vacancies, it\u2019s going to get harder and harder to keep that property full, and it\u2019s less and less likely for rents to go up. So as you scale up, demographics becomes more and more important because you\u2019re becoming a bigger fish in the pond. When you\u2019re a fourplex in an MSA with a million people, you can kind of swim in your own direction and get away with it. As you collect 10 and 20, 30-unit properties, you\u2019re a little bit more subject to the currents that are flowing around you.
Then also another thing to keep in mind when you get to 10 and 20 units is, if you buy a fourplex, let\u2019s say you house hack it, you get an FHA loan, you move in, you get a vacancy, you probably have the reserve to cover that vacancy for a month or two or three. When you start going to 10 and 20 units, it\u2019s a mental shift of, \u201cNo, I am not personally going to be able to cover all of these properties as I add them to my portfolio.\u201d Because if you buy five 20 units, now you\u2019re talking about 100 units. So you have to shift the mentality to really running them each as a business, and that means capitalizing it well upfront. Yeah, you\u2019re not going to be able to float that $30,000 a month mortgage, but that\u2019s okay because you brought an extra $250,000 to the table when you bought it and you set that as a reserve account. So those are also some of the differences that I would keep in mind as you shift from smaller fourplexes to 10, 20, and then on up from there.<\/p>\n
That\u2019s a great perspective because I\u2019ve always kind of looked at the larger scale in terms of if you have 20 plus units, one vacancy doesn\u2019t hurt you nearly as much as a small multifamily, but at the same time you got to consider all those other things and declining areas and demographics that can affect you and make it super hard to fill and keep it that way.<\/p>\n
It\u2019s a double-edged sword, Danny. Meaning, it can be very difficult to take a larger property and bring\u2026 I\u2019ve brought a 200-unit from 30% occupancy up to 95% occupancy, and I can tell you that was a grind. That\u2019s where I got most of my gray hair. It was tough. Because each time you lease one unit, well, great, that\u2019s a half a percent occupancy. You just move the needle. Whereas you lease an apartment on a four-unit, that\u2019s 25% occupancy, and you just moved the needle. Leasing one apartment could take you from from being in the red into the black. You might have to lease 30, 40, 50-units in a larger multifamily to really make significant cash flow differences.
The good side is that properties like that can take a bit of a hit from the market with regards to occupancy, maybe 5%, whatever. It\u2019s not going to put you underwater. So you lose a couple of apartments, it\u2019s not the end of the world. Your budget is going to have vacancy baked into it. Whereas for a four-unit, you\u2019re either vacant or you\u2019re not. You\u2019re either 75% occupied or you\u2019re 100% occupied. Whereas for a 100-unit apartment building, you could be 85% occupied and be doing okay. Other questions, other thoughts, Danny? What other light can we shine for you here?<\/p>\n
That\u2019s great. Thank you. As I mentioned, I have a few small multi-families that they do okay cash flow-wise, and I\u2019ve actually budgeted some of that stuff that you\u2019ve talked about in terms of the larger units and keeping accounts for vacancy and different line items there. But what I understand, I\u2019ve gotten some good advice or some interesting advice recently around balancing cash-flowing versus appreciating properties. So I\u2019d like to get your advice on, how do you balance those? Because you know have cash-flow properties that kind of pay the bills. Then you may invest in appreciating properties where you see a lot of potential, but they may not necessarily pay the bills or barely break even. Is there kind of a calculus that you do in terms of how much of each you have in your portfolio?<\/p>\n
Danny, I can jump in. I\u2019ve got a few thoughts on that. I know David talks a lot about this kind of thing on the podcast as well. It changes when you move from the smaller stuff into the bigger stuff. Number one, it also changes with the market. David\u2019s talked about a lot of times he would buy stuff the last few years with almost sometimes negative cash flow because he knows in three or four years it\u2019s going to be worth a lot more. That was a great multifamily strategy for the last seven years as well. You could buy a value add that had negative cash flow, get it fixed up nice. Like Matt was saying, he took something from 30% to 95% occupied. Well, it was negative cash flow at 30%, but it probably was cash-flowing pretty well and worth a lot more at 95%.
We\u2019re in a different part of the market. If you\u2019re looking at, again, a 10-unit, 20-unit, I would stick with something that at least cash-flows so that, in a worst case scenario, if the market shifts against you or the rent doesn\u2019t grow or you can\u2019t exit or you can\u2019t execute your value add yet or whatever your business plan is, your worst-case scenario is you hold it and you wait. We are at a point now where the greater focus is hedging against downside risk. Then once that\u2019s hedged, now you focus on, what can I do for upside?
The other beautiful thing about multifamily compared to single family is with single family you really are at the whim of the market. It\u2019s the sales comps. With multifamily, if you are a good operator, you can execute a plan that increases net operating income, and you can force value increase of that property by increasing the net operating income. For me, if I\u2019m looking at a 10-unit property, the current cash flow is important in terms of hedging downside risk and then future cash flow by executing a business plan and buying in the right markets. That is important in terms of creating equity. So with multifamily, you really can have the best of both worlds. You don\u2019t have to say, \u201cWell, I\u2019m going to get no cash flow just so I can get appreciation.\u201d The multifamily, to me, is one of the best investments out there because you can do both.
Also take a global view. Can you carry it personally or within your business? We talked a minute ago about, if I\u2019ve got a 20-unit and I got one vacancy, that\u2019s probably not going to affect me. That\u2019s correct, and, again, that\u2019s one of the advantages. If you\u2019re going to buy a 20-unit that\u2019s almost completely vacant, how are you going to cover that until it is not vacant? Can do it personally? Are you going to raise a big interest reserve upfront before you buy it? There are ways to mitigate that, but just make sure that you have it covered. In today\u2019s market environment, factor that in much more than we have the last five to seven years.
Just as a quick recap, my approach is to try to get both, cash flow and then be able to force appreciation. If you forego the cash flow, to try to get even more appreciation. Make sure you bring lots of reserves to the table, whether it\u2019s yours, whether it\u2019s investors, whether it\u2019s partners, to carry you through that period and get you out to the other side. Matt, you got anything else you want to add?<\/p>\n
Yeah, man. I\u2019ll throw just\u2026 Andrew, you and I are both old enough to be able to say we both invested in 2007\/2008 when the bottom fell out. I do not believe that\u2019s what\u2019s going to happen again to the market, but I do certainly believe the market\u2019s going to change. It\u2019s going to go somewhere in 2023, and I would not be banking on appreciation. Appreciation has made a lot of people look like geniuses over the last 10 years, but really what they did was they picked the right markets and they made a lot of money on appreciation that they had no control over. Meaning, just cap rates went down, property values went up, certain markets blew up off the charts. A lot of people have made a lot of money on activities that they had no real control over, but they\u2019re able to tout that they did. So I think you\u2019re going to see a shift.
Personally today, just given what I learned in 2007\/2008, cash flow is king, and I think it\u2019ll become more king over the next couple of years. The properties that I owned in 2007\/2008 did just fine during that recession if they were cash-flowing. The properties that were cash-flowing, they might not have been worth what I paid for a year or two ago. But if they were cash-flowing, you can weather the storm. You\u2019re not just having to throw money at them to keep them going. Personally, my investment strategy would be invest in nothing that doesn\u2019t cash-flow the very first day that I own it. I\u2019m not doing negative appreciation stuff. I don\u2019t judge anybody that does. That\u2019s just not our strategy. I would be investing in cash flow because cash flow gives you time. Cash flow will give you time to hold it for a while, and cash flow with fixed interest rate debt will give you time to hold it. If things get funky in the market for a little bit, just keep cash-flowing it until you can sell at some point in the near future.
At this point, buying a property with a goal of appreciation to meet your long-term investment goals for yourself or for your investors is really investing in something you can\u2019t control. Yeah, you can push a forced appreciation by increasing rents, by increasing NOI on the property. But the other factor in forced appreciation is cap rate, and cap rate is how a property gets valued. NOI divided by that cap rate is the value at the time. So if cap rates expand a bit, if interest rates stay high for a while, cap rates may start going up. The multifamily that was worth X today could be worth X minus 10% a year or two from now if cap rates continue to stay\u2026 if cap rates come up and investors aren\u2019t able to pay for properties what they\u2019re able to pay today. I can\u2019t control what cap rates do. I can\u2019t control NOI. I can control the way I operate my property in that. So I\u2019m investing 100% in the things I can control over the next couple of years. I\u2019ve got no faith in the market taking me to the promised land anymore.<\/p>\n
I concur with Matt. Personally, I don\u2019t buy negative cash flow anymore. We did that in the beginning. I don\u2019t do it anymore. I think 2023, a lot of the, let\u2019s say, motivated sellers are going to be people who bought in the last year or two and don\u2019t have the cash flow they need to hold onto the property unfortunately.<\/p>\n
I 100% concur. Again, I don\u2019t think a bubble\u2019s going to burst, the bottom\u2019s going to drop out. But I do think you\u2019re going to see properties on the market for people that, as Andrew said, they just need to get out just to stop the bleeding or whatever it may be.<\/p>\n
Quick follow up here. It\u2019s really interesting you mentioned how the market\u2019s changing and you have all these folks who have properties which don\u2019t cash-flow, which may present an opportunity for investors who want to get more in the market. Then you both mentioned, \u201cWe don\u2019t want to invest in things or don\u2019t want to invest in things where it doesn\u2019t cash-flow on day one.\u201d
I also live in California, which has some really interesting tenant laws, pretty restrictive. So I look at some of these properties, and from my experience from the smaller ones, the tenants that you acquire the property with aren\u2019t always the ones that you want to keep long term when you reposition. So from that perspective, I\u2019ve been thinking lower occupancy is actually better because it helps you accelerate the repositioning. But if I\u2019m listening to you folks correctly, it\u2019s not an ideal for this kind of market situation. So maybe get a couple thoughts on that.<\/p>\n
I\u2019ll throw quick thoughts on that one, Andrew. Remember, Danny, when I talk about negative cash flow properties or properties aren\u2019t performing, occupancy, you can solve. Again, we\u2019ve got into a property that was performing economically at 30%. I probably would do that deal again today, I would, because if a deal gets brought to market, and whatever market rate occupancy is, 90, 95%, and it\u2019s still lean on cash flow, that\u2019s not a good deal. But if I can do what I can control, I can lease up, I can run leasing specials, I can put in beautiful kitchens and beautiful bathrooms and those kinds of things, and I can do what I can control to get a property to cash flow, I\u2019m all in. If you\u2019re talking about a property that\u2019s maybe 70% occupied in a market where there\u2019s a lot of rent control and those kinds of things, that\u2019s perhaps an opportunity where the other 20% of units you can put back on the market, you can put back on at market, I like that. Andrew, what do you think, 60%, 75% occupied property in today\u2019s market?<\/p>\n
Again, just make sure you can cover it and make sure you can cover it for longer than you would\u2019ve planned last year or the year before. There is opportunity there. There\u2019s just greater risk. Risk, there\u2019s ways to mitigate it, and if you\u2019re going to take on that risk, just make sure you\u2019re doing that.<\/p>\n
Danny, this has been an awesome conversation and hopefully relatable to everyone here. I appreciate you, man. Thanks for coming on the show today.<\/p>\n
Good talking with you, Danny.<\/p>\n
All right, thank you very much.<\/p>\n