Commercial Real Estate Could Crash

Scott:
This is the BiggerPockets Podcast, show number 721.

Andrew:
Keep in mind, bigger is mentally more daunting, but bigger is easier. It’s 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’t be scared by the fact that, “Well, it’s a 100 units. I’ve never done that yet.” If you’ve taken down a 10, you’ve taken down a 100. It’s just the amount of the finances, and it actually gets easier the bigger you go.

Scott:
What’s 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.

Dave:
Oh, no. I don’t know if I’m the host or the guest. Whatever it is, we’re here together, and we’re taking over the show today.

Scott:
Well, thank you for having me on today, Dave. I appreciate it.

Dave:
Yeah, of course. You’re very smooth at that intro. You’re an old hand at this. We wanted to have you on because we’ve 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’re going to talk about here for the first 20 minutes of the show.

Scott:
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’s 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.

Dave:
All right, great. Well, this will be a great conversation. I’m looking forward to it. I have a lot of questions for you. Just for everyone listening, we’re going to talk to Scott for about 20 minutes. Then we’re 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’re going to cover a lot about commercial and multifamily, so you’ll definitely want to stick around for this. You have some thoughts about what’s going on in the multifamily and commercial space, and we’d love to hear what you’re thinking.

Scott:
I think the first thing that’s 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’m buying a piece of commercial real estate, I’m buying an income stream. If that’s 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’m actually going to get a better return by buying all cash or being on the lending side instead of the equity side unless I’m really bullish on appreciation. In the case of commercial real estate, that means I’m 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’t understand that. I think it’s a really risky and scary position.
So let’s 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’re 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’s possible that if things get really bad, they can stop construction, but then that just proves the point that there’s a big risk in this space.
Then the other side of this… So I think that’s a headwind to that rent growth assumption that the market’s 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’s saying something because the city’s 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.

Dave:
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’s even before, what you’re saying, this increase in supply comes online because I think that’s sort of towards the middle of 2023 when that’s intended to happen. So we’re already seeing this before the supply glut even starts to impact that dynamic.

Scott:
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’re going to explode.
On the demand side, I think we have a wild card here, and I don’t 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’s long-term trends supporting that. That’s true, but there’s 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’s a metric that can move and confuse economists. So I don’t 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’s a mild recession or interest rates keep rising, that’s going to put pressure in the economy. It’s going to result in less wage growth, and we might give back some of those rent increases. I think, if anything, there’s reason to believe that rents, again, stay flat or decline year over year. Again, that’s problematic.
So I worry that in 2023 we could see cap rates increase, which means multifamily asset valuations decline. So that same property that’s 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’s a 23% crash in the asset value of that property. If you’re levered 70/30, you used 70% debt, 30% equity, that’s 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.

Dave:
Do you see this across all multifamily assets? Are bigger syndications or smaller multi-families disproportionately going to be impacted by this?

Scott:
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’re going to see more pressure on larger assets. You’re 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’re going to see folks simply not selling in this period. If you’re invested in a syndication, your syndicator’s 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’re 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’re going to see cap rates reset at a higher level, maybe 6.5%, 7% on a nationwide basis, again, varying by region.

Dave:
Well, also ideally, most syndicators and operators will probably hold on. But given the nature of commercial lending, most of them don’t have long-term fixed debt. Some of them might have balloon payments coming due or an adjustable rate mortgage that’s adjusting in the next couple of years, and that could potentially force a sale or further negatively impact the cash flow of the properties.

Scott:
I think that’s true, and I think that’s a really big unknown in the space. I don’t 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’re all set? My guess is there’s a big spread in these areas and that different folks are going to get impacted very differently. My best guess is that there’s going to be a process rather than an event for this cap rate reset. There’s 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’s really hard to predict. I think, again, that’s a space where nobody has great data, and there’s a big unknown here.

Dave:
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’s called the Great Deleveraging with Ben Miller. Scott, I think this is fascinating and appreciate your take. I’m curious what you would recommend investors do. I guess there’s 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?

Scott:
Well, I think if you’re in a current syndication, you got to just kind of pray and hold. There’s not really another option. You’re a limited partner, and there’s nothing to do. So it all comes down to what you can do going forward. I think that if you’re considering investing in a syndication, make sure that it’s a huge winner even in a no-rent growth environment. Throw out the syndicator’s projections on market rent growth and say, if there’s 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…? That’s 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’s preferred equity, which is really consistent with debt in terms of its return profile, although it’s 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’s 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’re 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’s going to produce a yield at a 5% cap rate, consider using no debt at all. That’s actually going to increase your returns in a no or low-rent growth environment while being lower risk. So that’s really attractive.
These are super bold opinions that I’m trying to bring in here, but I really want to voice this concern because I feel like folks don’t understand this and I feel like they’re getting information… If you’re getting all of your information from people who syndicate real estate deals, recognize that these syndicators, they’re great people, they do a great job in a lot of cases, but this is their livelihood. It’s 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].

Dave:
That’s great advice, Scott. Thank you. Do you see this potential downturn in commercial real estate? From what you’re saying, it sounds like. I personally believe we’ll 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?

Scott:
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’t 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’m an amateur aspiring journeyman in understanding the commercial real estate markets here. But in the residential space, I think we’ve got a reasonable handle on that. There’s 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’ve been discussing for residential depending on where interest rates end up at the end of the year next year.

Dave:
Well, that’s super helpful.

Scott:
By the way, if you’re 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.

Dave:
Awesome. Well, Scott, we really appreciate this very sober and thoughtful analysis. It’s clearly something our audience and anyone considering investing in real estate should be thinking about and learning more about.

Scott:
Well, Dave, one question I have for you is, what do you think? I’m coming in hot with a little bit of doom and gloom here worrying that there’s a really big risk factor brewing in the commercial real estate space. Do you think I’m reasonable with that, or do you think I’m way off?

Dave:
No, I do. I think that it’s a serious concern. I really have a hard time envisioning cap rates staying where they are. I can’t imagine a world where they don’t expand. As you illustrated really well, just modest increases in cap rates have really significant detrimental impacts on asset values. We’re just seeing conditions reverse in a way that cap rates have been extremely low for a very long time, and economic conditions, I don’t think, really support that anymore.
I think what you said about rent growth is accurate. The party that we’ve all seen over the last couple of years where rank growth has been exploding, the economic conditions don’t really support it anymore. I think it’s time to be very cautious and conservative. I don’t see any downside in being really conservative. If you’re wrong and if I’m wrong, then it’s 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’t think hoping for improving conditions is a wise course of action, at least for the next year and maybe two years.

Scott:
Well, great. Again, I feel a little nervous voicing this concern. I’m essentially coming on the show and saying, “I’m predicting a pretty…” I’m not predicting. I’m worried about an up to 30% decline in asset values in commercial multifamily. That’s one area where I really enjoyed Ben Miller’s 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’re trying to make money as investors. How can you make money if rents aren’t going to grow and your debt is more expensive than the cash flow that you’re 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’s 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.

Dave:
The only alternative there is that interest rates go down, like you’re 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’t think by 100 basis points from where they are right now. That is my thought, but I don’t believe that very strongly. I think there’s a lot of different ways that this could go. So I think that the more probable outcome, as you’ve said, is that cap rates go up to get to that historic healthy spread rather than interest rates coming down.

Scott:
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’m very fearful of this space over the next year.

Dave:
All right, Scott. Well, we really appreciate this honest assessment and you sharing your feelings with us. It’s 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?

Scott:
My quick tip is if you’re analyzing commercial real estate or any other real estate, in today’s environment try analyzing it with and without debt first. Then second, if you’re looking at syndicated opportunities, if you’re still interested in syndicated opportunities, make sure that the sponsor is buying deep, buying at a steep discount to market value, that there’s 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.

Dave:
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.

Andrew:
Philip Hernandez, welcome to the BiggerPockets Podcast. How you doing, sir?

Philip:
I’m doing well. I am super stoked to be here. Thank you so much, Andrew.

Andrew:
You are part of the inaugural group of the BiggerPockets’s mentee program. You’re here with a few questions that hopefully we can help out with today. Is that correct?

Philip:
Yeah, yeah, that’s right. I’m 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’re 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’re able to do to add value is raise capital? I’m starting to find some… My network is starting to be interested in investing with me more. What if I don’t have the deal? What if somebody else has a deal, but I’m just starting to get to know them, how would you vet the person that you’re thinking of bringing your friends and family’s money into a deal for? What would your checklist look like so you do that in a good way?

Andrew:
Important topic. Just to make sure we’ve got that right, your question is basically, if I’m kind of starting out as a capital raiser, what’s the checklist look like to pick the right partner or co-sponsor to invest that money with?

Philip:
Yeah, exactly. Because vetting a deal as far as doing my own due diligence, I feel reasonably competent at that, but that’s if I’m in control of everything. So what if I’m not in control of everything?

Andrew:
You’re right on. Matt’s probably has a lot to say on this, so I’m going to just roll off a few things, and then I’ll let him take over. Number one is I would say go read Brian Burke’s 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’ve 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’s the first thing that I would do. Even as someone who’s been doing this for a decade and a half, I read every page of his book. There’s a lot to learn in there. So do that.
Second of all is if you’re going to raise other people’s money and then put it in someone else’s 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’t even get all of the information into what’s going on. So make sure that you have some level of input, some level of control.
I would also recommend when you’re 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’re basically duplicating the underwriting and the research that the sponsor’s supposed to be doing. Hopefully everything lines up and you’re like, “Wow, this guy’s great.” But if not, you’re going to find that, and you’re going to save yourself a lot of… 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’ve 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’s 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’re good at. But just keep that in mind. Matt, I’ll toss it over you to see what you have to add?

Matt:
Well, I could just say, “Hey, I agree with Andrew,” 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’s 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’s 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’re investing in you. They’re coming to you to help them find a place to park their capital. They’re not so much like… 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’re 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’s amazing. Don’t just listen to the syndicate or the operator or the organizer. Come up with your own homework as to why. Don’t just rely on the syndicator’s 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’re 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’s your powder going into this deal, not your investors. That’s number one.
I could also offer you some thoughts, if you’re looking for it, on how you can protect yourself in raising money for someone else. Because my guess is you’re a great guy, I happen to know that, but you’re not doing this for a hobby. You’re doing this because you would like to get some sort of compensation in exchange for placing one of your investors in the deal, correct?

Philip:
Yeah, definitely.

Matt:
The problem is, and unless I’m wrong, you don’t hold a Series 7 license. You’re not a licensed securities equities broker, are you?

Philip:
Correct.

Matt:
So that operator can’t compensate you for raising capital because what you’re doing is you’re selling a security for them. I can’t 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’t 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’s a carve out there. You can’t just become a GP as a capital raiser. You need to have an active role in the company. A capital raiser’s job pretty much is over after the company gets formed. You know what I’m saying? It’s not like you need more capital forever. You raised the capital and the deal closes, and then you’re done. So what the SEC will want to see, if there’s ever scrutiny on the deal, and to be straight, not what your investor’s going to want to see, do you remain an active partner in the deal? So Phillip’s job does not end once the capital is raised because that gets you an active role in the company as an owner. If you’re an owner of a company, any size owner, you’re allowed to sell equity. You don’t need a securities license if you own a portion of the company. You follow me?

Philip:
Yeah.

Matt:
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’s Rules of Order where there’s 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’s willing to play ball with you and set things up that way, then that’s 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.

Philip:
So if it’s a smaller deal and if there’s 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…? What would I say, “Oh, this is how I want that to look?” as far as control?

Andrew:
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’re going to learn more, too. Especially if you’re on the capital raising side, you’re not going to be spending as much time in operations. You’re going to learn more by doing that as well.

Matt:
What’s interesting Philip, is that you had talked about, this is only a small deal. There’s only three to four of you involved in this project, correct? I didn’t want to scare you or anybody else thinking about, “Oh, board of directors. Well, geez, Microsoft has a board of directors, but this is a little however many size deal. It doesn’t need a board of directors.” Well, yes and no. You don’t have to let terms like that scare you or anyone else. There’s 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’t 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’s typically a consensus or even a “Aye say aye, nay say nay” 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’t 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’ll leave you with, and everybody else too, too many folks do real estate investing like this as a dabble. If you’re raising private capital for an operator, you should not raise capital for that operator unless you’re planning on doing it 10 times for their next 10 deals or maybe growing into your own thing eventually. But you shouldn’t 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’s something you can do over and over and over again. It’s 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.

Philip:
That’s great advice. Thank you guys so much. I really appreciate it.

Matt:
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’re 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’re bundled up there in Los Angeles.

Philip:
Thank you. Appreciate it. Appreciate you guys.

Andrew:
All right, take care, Phil.

Matt:
Andrew, we got another question lined up here. I want to bring in… I got Danny, Danny Zapata. Danny, welcome to the BiggerPockets Podcast, man. How are you today?

Danny:
I’m doing excellent. Thank you for having me on.

Matt:
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?

Danny:
Let me give you a little context. I’m a small multifamily investor currently, I have some properties in Sacramento, and I’m looking to take that next big step to scale. So it’s 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’re scaling from less than five units to 10 to 20-unit properties?

Matt:
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’s a superhero and he’s 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’ll give you my thoughts briefly, Danny, in that the profit and loss statement’s still the same. There is still profit, and there’s still losses in that. There’s still income and expenses. So you’re 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’s 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’re showing that as revenue. You’re 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’ve got a big one that a lot of people on small multifamily don’t think about, and that is payroll. Here’s 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.

Danny:
I have a fourplex in West Sacramento, a mix of two bedrooms and one studio.

Matt:
Who’s managing it?

Danny:
We have a property manager for that.

Matt:
You don’t write a W2 check to that property manager’s salary that collects your rent and runs that property for you, do you?

Danny:
Correct.

Matt:
For larger multifamily, you’ll see a property management fee, but you’re also going to see staffing charges. It’s a good and a bad thing because that means that you’ve got full-time personnel. The rule of thumb is somewhere over around 80 units a property can afford full-time personnel, and that’s awesome because that means that person’s 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’t 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, “Oh, wow. I have to budget for that,” 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’s a good thing but you have to get a budget for it. Andrew, I know that you’ve 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?

Andrew:
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’t want to manage a 30-unit from out of state. That’s 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’s 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’t be scared by the fact that, “Well, it’s a 100 units. I’ve never done that yet.” If you’ve taken down a 10, you’ve taken down a 100. It’s just the amount of the finances, and it actually gets easier the bigger you go.
The other difference when you’re 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’s in a market that’s flat or maybe even declining a little bit, it’s not that hard to fill a vacancy or two because you don’t need that many people to stay full. But if you’ve got a 20-unit and people are moving out of the area and you start getting two, three, four vacancies, it’s going to get harder and harder to keep that property full, and it’s less and less likely for rents to go up. So as you scale up, demographics becomes more and more important because you’re becoming a bigger fish in the pond. When you’re 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’re 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’s 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’s a mental shift of, “No, I am not personally going to be able to cover all of these properties as I add them to my portfolio.” Because if you buy five 20 units, now you’re 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’re not going to be able to float that $30,000 a month mortgage, but that’s 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.

Danny:
That’s a great perspective because I’ve always kind of looked at the larger scale in terms of if you have 20 plus units, one vacancy doesn’t 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.

Matt:
It’s a double-edged sword, Danny. Meaning, it can be very difficult to take a larger property and bring… I’ve brought a 200-unit from 30% occupancy up to 95% occupancy, and I can tell you that was a grind. That’s where I got most of my gray hair. It was tough. Because each time you lease one unit, well, great, that’s a half a percent occupancy. You just move the needle. Whereas you lease an apartment on a four-unit, that’s 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’s not going to put you underwater. So you lose a couple of apartments, it’s not the end of the world. Your budget is going to have vacancy baked into it. Whereas for a four-unit, you’re either vacant or you’re not. You’re either 75% occupied or you’re 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?

Danny:
That’s great. Thank you. As I mentioned, I have a few small multi-families that they do okay cash flow-wise, and I’ve actually budgeted some of that stuff that you’ve talked about in terms of the larger units and keeping accounts for vacancy and different line items there. But what I understand, I’ve gotten some good advice or some interesting advice recently around balancing cash-flowing versus appreciating properties. So I’d 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?

Andrew:
Danny, I can jump in. I’ve 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’s 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’s 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’re in a different part of the market. If you’re 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’t grow or you can’t exit or you can’t 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’s 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’s 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’m 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’t have to say, “Well, I’m going to get no cash flow just so I can get appreciation.” 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’ve got a 20-unit and I got one vacancy, that’s probably not going to affect me. That’s correct, and, again, that’s one of the advantages. If you’re going to buy a 20-unit that’s 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’s 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’s yours, whether it’s investors, whether it’s partners, to carry you through that period and get you out to the other side. Matt, you got anything else you want to add?

Matt:
Yeah, man. I’ll throw just… 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’s what’s going to happen again to the market, but I do certainly believe the market’s going to change. It’s 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’re able to tout that they did. So I think you’re going to see a shift.
Personally today, just given what I learned in 2007/2008, cash flow is king, and I think it’ll 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’re not just having to throw money at them to keep them going. Personally, my investment strategy would be invest in nothing that doesn’t cash-flow the very first day that I own it. I’m not doing negative appreciation stuff. I don’t judge anybody that does. That’s 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’t 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… if cap rates come up and investors aren’t able to pay for properties what they’re able to pay today. I can’t control what cap rates do. I can’t control NOI. I can control the way I operate my property in that. So I’m investing 100% in the things I can control over the next couple of years. I’ve got no faith in the market taking me to the promised land anymore.

Andrew:
I concur with Matt. Personally, I don’t buy negative cash flow anymore. We did that in the beginning. I don’t do it anymore. I think 2023, a lot of the, let’s say, motivated sellers are going to be people who bought in the last year or two and don’t have the cash flow they need to hold onto the property unfortunately.

Matt:
I 100% concur. Again, I don’t think a bubble’s going to burst, the bottom’s going to drop out. But I do think you’re 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.

Danny:
Quick follow up here. It’s really interesting you mentioned how the market’s changing and you have all these folks who have properties which don’t cash-flow, which may present an opportunity for investors who want to get more in the market. Then you both mentioned, “We don’t want to invest in things or don’t want to invest in things where it doesn’t cash-flow on day one.”
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’t always the ones that you want to keep long term when you reposition. So from that perspective, I’ve been thinking lower occupancy is actually better because it helps you accelerate the repositioning. But if I’m listening to you folks correctly, it’s not an ideal for this kind of market situation. So maybe get a couple thoughts on that.

Matt:
I’ll throw quick thoughts on that one, Andrew. Remember, Danny, when I talk about negative cash flow properties or properties aren’t performing, occupancy, you can solve. Again, we’ve 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’s still lean on cash flow, that’s 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’m all in. If you’re talking about a property that’s maybe 70% occupied in a market where there’s a lot of rent control and those kinds of things, that’s 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’s market?

Andrew:
Again, just make sure you can cover it and make sure you can cover it for longer than you would’ve planned last year or the year before. There is opportunity there. There’s just greater risk. Risk, there’s ways to mitigate it, and if you’re going to take on that risk, just make sure you’re doing that.

Matt:
Danny, this has been an awesome conversation and hopefully relatable to everyone here. I appreciate you, man. Thanks for coming on the show today.

Andrew:
Good talking with you, Danny.

Danny:
All right, thank you very much.