The Wrath of 1031 Investors and a “Chaotic” Multifamily Market

Dave:
Hey, everyone. Welcome to On the Market. I’m your host, Dave Meyer, with James Dainard joining me today. James, what’s up, man?

James:
Oh. Just hanging out in the cold, rainy Seattle.

Dave:
I think we’re back to having the same weather. It’s just dark and rainy and … I don’t know.

James:
Got my space heater at my toes. Yep.

Dave:
Did you know that Amsterdam rains significantly more than Seattle?

James:
I was explaining that to my wife when we were trying to plan our vacation out there. She’s like, “No way.”

Dave:
Yeah. No. But it’s like April to August is super nice. So it’ll be fine. It’s just the whole winter. But, man, we had a long episode, long interview today. So let’s do it. We’re just going to talk quickly, but we have Ashley Wilson, who is a incredible multifamily investor on today. And just want to just give a quick warning. Not warning. Just disclaimer here that if you’re … This is more of an advanced episode, I think. Right? If you’ve never heard of multifamily or don’t know that much about it, you can … Ashley does a great job of explaining things, but there’s a lot of advanced concepts in here that … Honestly, I love this. I think this is one of my favorite episodes ever. But just wanted to give a heads up that there are some new terms that you might not have heard that we go over here.

James:
Yeah. Ashley is one of the brightest people I know in this space, and she will educate you beyond belief. And, I mean, even for me, I got a little bit lost at a couple points in it, so-

Dave:
Oh, dude. She was dropping bombs, dropping knowledge on it. But I think it’s super important what she’s talking about, just market conditions. She offers really concrete examples of what she thinks is going to happen in the multifamily market and why and gives really good examples of backing up some things you, James, have been talking about, some trends you’ve been seeing over the last couple of months.

James:
Yeah. She’s just a very talented operator that knows the nuts and bolts of her business, and she just broke it down, and I think the serious operators out there are seeing the writing on the wall for the sloppy operators. But she’s one of my favorite people to talk to.

Dave:
Totally. If you’re interested in multifamily commercial or just want to learn a little bit about it, this is a must-listen-to episode. There’s just so much good information that. So we’re going to take a quick break, and after that we’re going to bring on Ashley Wilson.
All right. Ashley Wilson, co-founder of Bar Down Investments, bestselling author of the only Woman in the Room: Knowledge and Inspiration from 20 Women Real Estate Investors, and of course an active member of The Real Estate InvestHER community. Ashley, welcome to On the Market.

Ashley:
Thank you so much for having me.

Dave:
Well, I just read your official bio, but can you give us, in your own words, a bit of your background and history in real estate investing?

Ashley:
Absolutely. So I started learning about real estate in 2007. My now-husband introduced me to it, so I’m really blessed that he kind of gave me the first sip of the Kool-Aid, so to speak. Started listening to BiggerPockets and being involved in the community in 2007. We made our first purchase in 2009 of a single family rental. I’ve house hacked short-term rental, long-term rental of single residential properties. I’ve done flipping, high-end flipping, and traditional flipping. And then I transitioned to commercial real estate in 2018 and have not looked back. So I’m in commercial real estate right now, specifically in multifamily.

Dave:
That’s amazing. And you and James, I learned, met … Did you guys meet at … Do I have this right? At Brandon’s Maui Mastermind? Is that right?

Ashley:
Yeah. We did. I am so blessed to have been invited to the event, but more importantly, I’m so blessed to have met James and met a lot of different people there, incredible people that now are my closest friends, including James. So really, really excited that we’re now on this podcast together.

Dave:
I was very jealous. James was telling me everyone who was at that. It was like the Avengers. It was all of the greatest real estate investors meeting at once. I was like, “Damn. I wish I was there.”

James:
It was like the Avengers. But I will say, Ashley and Kyle, her husband, are two of the most favorite people I met there. There’s definitely a little small group that I talk to most, and they are part of that, for sure.

Ashley:
Couldn’t agree more.

James:
Super stoked we met each other.

Dave:
Awesome. Well, now the history between Ashley and James. But let’s jump into this multifamily market. You’re obviously an expert in everything having to do with sponsoring syndications and multifamily. So can you just give us a quick read on what you’re experiencing in the multifamily market right now?

Ashley:
Chaos. No. I’m just kidding.

Dave:
All right. Podcast over.

Ashley:
That wasn’t the answer you were looking for? So multifamily has had kind of a hectic past two years, all starting with COVID, and I think a lot of people across all real estate asset classes, but specifically in multifamily … A lot of people got gun shy at the beginning of COVID, and they really didn’t know how the market would respond, because they really didn’t know consumer sentiment, which is translation of tenants would respond and how rents would not only grow or compress, but also the ability to pay. I think there was a lot of sensitivity around employment and tenants being able to maintain income to be able to pay their rents, and then, as owners, how we would be able to continue to keep operating the properties.
So fortunately there was a lot of government programs both at a federal level, local level, and then also some charitable organizations that stepped up and provided some assistance along this past two-year runway. But what we actually saw was, I think, the opposite of what most people predicted, and I think that was in large part because just the abundance of stimulus that was thrown at this sector.
And what we saw firsthand as well as I look at national metrics all the time … We saw a higher than normal collected versus bill rate across multiple markets, and that’s because of all of these different assistance programs stepping up and not only paying one or two months, but also paying six months out for tenants that were in really difficult situations, loss of jobs being the number one reason, and probably number two is more tied to family dynamics with respect to how COVID was impacting their family and whoever was the breadwinner. So that definitely played a toll as well.
So what ended up happening, because multifamily … The most traditional way in which multifamily properties are evaluated is called the NOI approach. What essentially happened is the income grew, and the income grew at a faster rate than the expenses grew, because at that time initially, we didn’t … Even though we had chain supply issues, it wasn’t impacting multifamily up front. It actually had a little bit of a lag effect. So we saw it later.
When we look at development, and if you … I know I’m going kind of all over the place here, but I’m trying to paint a picture. The overall economy … We already have a shortage of housing supply, so when you look at supply and demand, the supply was shut off with not only federal mandates of supply being shut off when contractors were forced to shut down for that period of time, but also in terms of government agencies approving permits to construct new properties. In turn, what happened is we’re shutting off the supply, then we’re left with whatever supply is available on the market. A lot of people were forced into situations of renting. With the stimulus, we’re growing the income, but we’re not also seeing that expense growth.
Then the tailwind was the expense growth. So we started to see expense growth kind of come into play. But in terms of initially when you’re looking at income growth and you’re looking at the NOI approach, which is the most traditional way in which you evaluate the valuation of a multifamily property in terms of what you pay, you look at it typically on a trailing basis. So by the time of multifamily transactions, if we look at it through the tail of 2021, we saw Q3, Q4, and then spill into 2022 in respect of Q1 and Q2 having these record-setting transactions in multifamily. One example, one specific data point, is in 2022 in Q1 … I just posted an article about it. It’s not like I memorize all this stuff all the time. But I think it was 63-

Dave:
I was pretty impressed. I was like, “Man. [inaudible 00:09:51].”

James:
She’s like a walking robot.

Ashley:
63 billion in transaction volume in Q1 of 2022 across the nation, which is the second largest volume of transactions that have occurred in multifamily history, so I think with the first being in 2000, if I remember correctly. I forget which quarter. But the point remains the same, which is that all of a sudden we have this huge volume of transactions occurring that we weren’t seeing prior to that.
So now we’re in a situation where a lot of people were selling at top dollar and also the volume of transactions was super high. Lenders were really happy about it, because they were essentially achieving their placing of capital metrics, the goals that they have to hit each quarter. By the end of Q2, they were already hitting their goal for that year through almost Q4. So they only needed to transact a little bit more through Q3 and Q4 to hit their metrics for transaction volume. So in terms of where they wanted to place their capital, coupled with the fact that the fed interest rate hikes and how that impacts multifamily, that kind of caused a slow down.
But on the other hand, we now have all this 1031 money. So the 1031 money is now circulating, which is causing properties to still transact at a very high price point because of the fact that people would rather buy a property and even overpay for a property. Sometimes I’ve heard, from personal context of mine, they would overpay by $4 million just not to have a $5 million tax hit.
So because of that … And I see James shaking his head there, but honestly I agree with James on that. I think that’s crazy that people are doing that. But what ends up happening is then you don’t see the compression on the cap … Excuse me. Not compression. Expansion on the cap rates that you really should see, because expansion on the cap rates obviously translates into a lower price point and vice versa. So what we should be seeing is a lower price point on these properties with expansion of cap rates, but really we’re not seeing it. We’re seeing a little bit, but not as much, and it’s only being impacted due to the interest rate, not the cap rates, which is kind of a little bit unique situation.
So when I said it’s a little bit chaotic, I jokingly said that, but I do see indicators that lend itself to chaos. Why are people overpaying? Should they be overpaying? I personally don’t believe that you should ever overpay. I don’t typically think that there’s a good justification for that, but that is honestly what we’re seeing. Everyone said it was multifamily madness in Q1, but I would say it’s more the fallout of that madness that we saw is what we’re seeing today.

James:
Yeah. And it’s crazy that … The point that you just brought up about the 1031 exchange … I feel like that is starting to dry up a little bit in the current market. The 1031s are … They already sold off their property. They had a certain amount of time to reload that money in. It’s definitely starting to slow down. But yeah. That is a huge mistake. I was watching for the last 24 months. People were overpaying just to defer taxes. But if you’re going to lose that position or the gain down the road, it doesn’t matter. You’re just losing the position.
And someone told me … I remember I was trying to do a 1031 exchange about five years ago, and I was doing six properties. Or no. Three properties. And I had uplegged a couple during that time, and I was trying to find the next replacement property, and I could not find anything. And how I buy is deep value-add buy. I want walk-in margins, walk-in equity. And I was going to buy a property that did not meet my buy box, typically. And I was talking to one of my clients who’s a financial planner, and he literally just stopped me, and he goes, “Have you lost your mind?” He’s like, “What is wrong with you?” I’m like, “What do you mean?” I’m like, “I’m deferring these taxes. I’m saving these monies. I’m going to increase my cash flow.” He’s like, “Yeah. But you do what you do. What are you doing? You’re …”
And he mentioned to me … He goes, “There’s two things that put people in bankruptcy. A, thinking you have FOMO, where you’re … that you’re missing out and you’re leaving too many … or that you’re not getting … that you’re going to miss that return, and two, that you’re trying to defer taxes. At some point, you got to eat the taxes.” And I remember I ate 350 grand in taxes. I blew up the exchange and just reset my basis at that point. But that’s been this greed of what’s going on. There’s so much money getting pumped in. People made so much. They don’t want to pay the tax, but then they buy a bad deal, and it’s a huge mistake, and it ends up in the long run hurting you more than just paying the tax.

Dave:
I just want to explain for a minute what you guys are talking about. Just the phenomenon here is that basically a 1031 exchange, if you don’t know what that is, is if you sell an investment property, you can take the profit that you earn and reinvest it into a like-kind property without paying any capital gains. You’re basically deferring the capital gains till some other time. But if I’m picking up right, what’s sort of happened over the last couple years is people would sell. They were often trying to sell at the top or take advantage of this appreciation. But then when they went to go and find that replacement property, they weren’t finding a deal with good fundamentals. But when you do a 1031 exchange, you only have 45 days to find that replacement property, so people often get desperate and make bad decisions. Right? Is that basically a summary of what you’re talking about?

Ashley:
Absolutely. And I think you see that more and more when the volume of transactions is so high. So I think that’s what we were seeing this year more than previous years is we had so much capital at play for people to 1031. So the scale of which the transactions happen, the ripple effect, was there was more 1031 money at play.

Dave:
And so you’re saying it’s sponsors’ 1031 money, and so they’re selling a multifamily asset and then they are trying to purchase another multifamily asset? Or is it the LPs in these deals are also having 1031 money and that’s also contributing to it?

Ashley:
It’s not just syndicators. It can be private owners. It can be REITs. It can be private equity firms. It’s really everyone across the board can benefit from this tax incentive. So I personally saw it across the board. I didn’t see it just limited to syndications trying to reinvest 1031. In fact, if anything, it’s actually more difficult. I have personally witnessed for syndications to do something like this, because it’s just a little bit more complicated. There’s more hair on the process in terms of the actual overall structuring, how the PPM was originally worded, how many LPs you have and whether or not they all buy into it.
There are work workarounds. Excuse me. I am not a lawyer, so I won’t pretend to know the answer, even though I’ve been told what I think the answer is. So just consult with your lawyer if you are interested in trying to figure out a workaround there. But ultimately the people that I’ve seen do it the most are really private owners. But either way, it doesn’t matter whether it’s private owners, syndicators, private equity firms, REITs. The impact it has on the market is massive. These individuals are doing it, but overall it’s impacting everyone, is really kind of the takeaway message.

Dave:
Yeah. Hey. Dave Greene on the BiggerPockets real estate show has been talking about this in the single family space for a while. Where he is, I’m sure it’s pretty common, especially in the Bay Area. But it’s interesting, because I hadn’t really thought about how that impacts the multifamily space.

James:
You always know when the market’s getting juiced up a little bit, because I would get phone calls from commercial brokers, and they’re like, “Hey. I got a 1031 exchange buyer. We will buy anything.” It was like if a broker landed that 1031 exchange buyer, they knew it was a done deal. Right?

Ashley:
Yep.

James:
They’re like, “What do you got? We’re just going to get the deal done. I’m going to rip my check,” and it was like that’s what the people were in the constant … Oh. They got to buy something. What do you got? Just give me … And it’s like, “I’ll sell you this.” We sold a couple of our properties because we got cold call with 1031 exchange wires, and they’re like, “We’ll pay you this,” and we’re like-

Dave:
Just find the biggest turd house you have a listing contract for, and you’re just like, “Here you go.”

James:
Yeah. Here you go. But we got paid well. I love 1031 exchange buyers. They pay very good money for your stuff.

Ashley:
The crazy thing about 1031 buyers or brokers, when a broker lands one, to your point, James, they don’t tell you the buyer’s buy box. They just tell you how much money they have to 1031. That’s my favorite part about it is they’re like, “This is how much we have to 1031. Do you have a deal that fits criteria?” It could be in Timbuktu for all the broker cares about. The broker just wants to place the capital, because they’re foaming at the mouth for the transaction, and it’s astonishing to me that it’s not like, “Okay. Well, it has to be built in 2015 or 2015 or newer,” or something like that. They’d give you no criteria except how much money that the buyer has to 1031.

James:
This is how much I can deploy. Let’s get it done.

Ashley:
Let’s get it done.

James:
Crazy

Ashley:
Send over the contract.

Dave:
That’s a great place to be. Ashley, you mentioned a few things about cap rates that I’d love to ask you some more about. But for those people listening who aren’t as familiar with commercial real estate and cap rates, can you just explain the role that cap rates play in valuations and in multifamily investing?

Ashley:
Cap rates. The best and the easiest, most simplistic way to understand it is actually something my husband told me when he was first teaching me about cap rates, and that is essentially if you were to purchase the property in cash, what your cash flow would be after all your expenses were paid. So if you’re buying a five cap market and you purchased something at a hundred thousand dollars, just for simplicity’s sake, you would receive 5,000 annually in cash flow. That’s essentially what a cap rate is.
In terms of how it is utilized with respect to multifamily and commercial real estate, it is used as a determinant to tell you the trading value across different assets, and it’s supposed to take into consideration risk profile and be able to go across different investments. So say, for example, you’re comparing multifamily to self storage. Well, let’s say self storage is a 10 cap and multifamily in the specific market in the specific buy box you’re buying it is at a five cap. You’re getting less of a return when you purchase a multifamily property versus a self storage, because self storage inherently has more risk. So that is kind of just high-level what a cap rate is.
In terms of how it’s utilized to determine value with the NOI approach, which I mentioned previously, there’s three ways in which multifamily properties are evaluated. One is the comparable sales approach, and comparable sales approach … Most people already understand that conceptually, because it’s the way in which residential real estate is valued. So if you have a property adjacent to another property with similar specs, one property sells, most likely that other property will sell at a similar valuation. Right? So if it sells for $300,000 … It’s a 2000, three bedroom, two bath home on a half an acre. Let’s say hardy siding, two story with a detached two-car garage, and you have the exact same thing. Maybe it’s even 1,950 square feet. You’ll probably be able to sell that for 300,000. They’re comparable. That’s why it’s called the comparable sales approach.
With respect to the second way multifamily is evaluated, it’s called the replacement value. So think of how an insurance adjuster would evaluate multifamily. So replacement value is based off of the replacement cost in which you would replace that same structure. The third approach, which is the most common way multifamily is evaluated on the purchasing side for buyers is called the NOI approach, which is you take your income minus your expenses, you annualize it, you divide it by the trading cap rate within that given market for that specific asset class. So there are different cap rates based off of markets and then also based off of different asset classes. So whether it’s an A class, B class, C class property, 2022 construction versus, let’s say, a 1980s construction, those cap rates are going to vary, and then you come up with an evaluation.
A very simplistic way to determine how you add value to a property … A five cap is typically a multiplier of 20. Well, it is a multiplier, not typically. It’s a multiplier of 20, so it’s a very easy way in which you can determine, “Okay. If I’m saving a hundred dollars a year, that’s an add evaluation of a hundred times 20, so a $2,000 add onto the property evaluation.” So you can see how the multiplier effect is great with value-add properties, because if you add $10 a unit across a hundred units, you can see how that can have a massive impact on the overall evaluation of the property.
So now kind of understanding that basic knowledge on those three approaches and knowing that the NOI approach is the one that is used, it’s important to look at mathematically what those factors are that determine the value. So you have the income and the expense, which people can manipulate those as well. Income and expense are based off of operating income and operating expense, but there are line items that are, quote unquote, below the line, which means below operating variables.
So let’s say, for example, you replace roofs. Replacing roofs is actually called a capital expense. Capital expense doesn’t get calculated into the evaluation, because it’s considered a one-time expense, whereas if you do a roof patch, most operators would agree that a roof patch would fall as an operating expense under general maintenance. So that would impact your evaluation. People do, though, get creative. You can call it fraud. You can call it whatever you want. I’ll throw around the F word. And they can hide that below the line so it looks like their repair and maintenance is lower than what it should be. So the more experienced you are in multifamily, the more you can gauge, okay, their R&M cost, repairs and maintenance, is really low for this vintage property.
A typical and the average expense ratio across the country … Now, it varies by area, so don’t take this to the bank, but typically A class property typically has around a 30 to 35 expense ratio, and then every decade kind of adds a couple percentage points. So like 1980s vintage, you’re typically stabilized. These are all stabilized ratios. Stabilized. Excuse me. For 1980s, you’ll probably be around a 50, anywhere up to a 60 percent expense ratio.
So knowing all these things, you can see that the income and expense can be manipulated. But the other thing that can be manipulated is cap rates. So one of the things we just talked about was the whole history of the past two years of how the multifamily sector has been a little bit chaotic. And the thing with cap rates are cap rates are determined by historic transactions. So in terms of setting the cap rate, it’s based off of transactions that have actually occurred. So in Q1 and Q2, when I was talking about having all of these record-setting transactions occurring, obviously the cap rates were compressed. The cap rates were compressed because we were seeing transactions at the highest or second highest rate that we had seen of all time.
So when that funnels down, then obviously when we get to a period in … Let’s say, for example, we have a halt in transactions. People are really kind of guessing on the cap rates, but they’re using historic sales to forecast where they should actually be at. With respect to the 1031 money circulating, if people are overpaying for properties, then we’re not seeing the cap rate expansion that we think we should see, because really property values have come down, but cap rates aren’t truly reflective of that, because 1031 money is making it look like the market is doing better than it is, because people are overpaying for properties. So that’s part of the issue.

Dave:
You said that property values have come down, but have they actually? Or are you just saying that they should be coming down? Because cap rates should be declining, and if NOI stays constant, they should be … Or excuse me. Cap rates are expanding. NOI stays constant. Then property value should be going down. Right? But is that actually happening? Or is that sort of just what you would expect to be happening?

Ashley:
Well, it’s my belief that it should be happening, because when you look at interest rates … And we haven’t really talked about this yet, but when you look at interest rates, there’s an inversion that just occurred. Right? So previously we saw interest rates lower than cap rates. And when you invest in multifamily, one of the things you’re investing on is that spread between the interest rate and the cap rate. But because we’re seeing interest rates, let’s say, for an agency loan at six percent, bridge loan anywhere from seven to eight percent, but you’re seeing cap rates at five percent, you’re seeing an inversion. You’re seeing interest rates actually higher than cap rates.
So in terms of where they should be at today, there should be some more expansion on the cap rates, and I think that there was … I think 1031s created a fallacy of what cap rates are. I also think with the chain supply issues … And I know this is kind of a divergence of what we’re talking about now, but I do think it impacts pricing. I’m a firm believer that you also have to consider replacement value. I don’t think that evaluation just should solely be off of NOI. I think you should also consider replacement value, because if you can’t build the same product today for the price that they’re asking for, then there’s a trickle effect that’ll eventually happen. There’s lag time. But we had a lot of chain supply issues. I mean, lumber was through the roof. It’s definitely come down significantly. But we still have chain supply issues and shortage of materials and shortage of labor, which is impacting the cost to build.
So when you’re in a situation where you are buying a 1980s vintage property at 150 a door, but to rebuild that it would cost you 195, how do you truly evaluate it? I’m not pitching for you pay 195 for it because that’s what it would cost to replace, but I’m just saying that in terms of trying to determine the value just going off the NOI approach alone … I don’t know if that’s necessarily the answer.

James:
That is one of my favorite metrics to buy on, buy well below replacement cost. When I’m uncertain on a deal, any type of deal, multifamily, single family, whatever it is, if I’m buying at like 30 percent off replacement cost, I feel pretty good about that deal. In the long term, it usually clicks out.

Ashley:
Yep. I completely agree with you, and I actually just recently was talking about this on LinkedIn, and I got some … Obviously, there are some people who feel differently about that than you and I feel, and they’re proponents of, “Well, it still needs to make money. You still need to operate as a business, and you’re buying the business.” I completely agree with all of that. What I’m saying and I think you’re probably saying as well is you can’t just look at it solely off of the business. It is a very important factor, but you can’t discount replacement value. You can’t discount replacement value, just like you can’t discount location. You know? You can’t discount path of progress. All of those variables come into play on evaluation. And you and I might have a different opinion of how much we push or pull back, but my whole point is gone are the days that you just look at a trailing 12 and say, “Okay. That’s what I’m going to offer,” and be done with it.

James:
Yeah. And that’s a big mistake people make is they want to stick to one straight way of underwriting things, and that’s not the truth for anything. You have to look at all those little … There’s little data points everywhere, and you got to take them all, put them in a bucket, figure out what makes sense to you and how you want to evaluate it, and then that will help you make a decision, and that’s really important in today’s market, because it’s hard to know whether you’re buying a good deal or not. And so you have to look at all the factors, and then that will help you make that comfortable decision whether to pull the trigger or not.
But yeah. But, I mean, I love buying below replacement. If I can’t build it for … Because building apartments is expensive. Going back to the supply and demand conversation we were having earlier, the reason the supply is low and it’s going to continue to be low is builders are bailing out of these big complexes. They waited two to three years to get their permits, it took too long, their bill costs are 20 to 30 percent higher than they’re anticipating, maybe even 40 percent, and their cost of money is now up 40 percent, and they’re toast. And now those units are never coming to market, because they’re getting sold and repurposed at that point.

Ashley:
Yep. I completely agree with you.

Dave:
James, are you seeing cap rates sticking lower than you would expect in your market as well?

James:
Well, there’s the sellers asking for it, but they’re not transacting. We’re seeing good buys. In the last four weeks, we … I mean, we closed on a big deal up in Everett, and our stabilized cap rate’s 6.1. Couldn’t get that. No way we were getting that the last couple years. We have another one that we’re looking at in West Seattle that’s … I mean, the deals are out there, but it’s a matter of also making sure that it’s the right buy for yourself. We’re seeing people negotiate pretty rapidly up here. There’s definitely a huge demand fall in Seattle, which is great, because that means we’re going to step up into it, but things are definitely transitioning.
It could keep slipping too. So maybe a 6.1 cap today … Maybe I want a 7.1 cap. I don’t know. That’s what we’re trying to figure out, and that’s why it’s really important to know those extra metrics. The one that we got at 6.1 cap we bought at least 20 percent below replacement cost. No way we’re getting that built for that. We paid under 200 a door. They usually trade at 300 a door up there. So it’s like all these different categories are … That’s why it’s so important to know these extra little factors in your underwriting.

Dave:
So, Ashley, given all the market conditions that you’re seeing and, it sounds like you believe, overinflated prices at this point, how are you handling that in your business? Are you sort taking a pause? Or are you still active bidding on deals?

Ashley:
We’re actively bidding on deals. I don’t think I would ever pause ever. To me, there’s always a good time to buy. It’s always a good time to buy. But the way in which we evaluate deals hasn’t changed, in terms of we’re sticking to our guns on how we evaluate deals. We’re conservative. In terms of the actual numbers, they’ve changed in forecasting interest rates and cap rates on sale. But with respect to general underwriting practices, we have not changed. We have stayed very consistent on being conservative in our approach, forecasting out what we think the interest rates will be upon exit.
A lot of the interest rate issues right now in today’s market, especially on the commercial side, has to do with volatility and uncertainty. So lenders with respect to how they’re pricing interest rates … They’re pricing them base off of a lot of uncertainty. So once the fed hikes kind of stabilize, and it’s not directly correlated, but it does impact the commercial rates, we’re going to see lenders feel more comfortable adjusting the spread over [inaudible 00:35:46] and being more favorable on the terms. For example, LTV. They’re little gun shy on LTV. They want owners to have more equity in the deal, and they don’t want to carry so much of that risk on the deal. But, I think, once that stabilizes, which I hope we see in Q1 or Q2 of next year at the latest, I think lenders will feel more confident coming down off their rates a bit.

Dave:
Yeah. And just to further that, I don’t know personally as much about commercial loans, but I was reading something earlier that said that the spread right now between the 10 Year Treasury and a residential rate is almost 300 basis points right now, so basically three percent. Bond yields. 10 Year Treasury is about four percent right now. Residential rates. Owner occupied about seven percent. Normally, it’s 1.8 percent. So this is exactly what you’re talking about.
Banks … They don’t know what to think. Right? There’s so much volatility. They’re nervous, so they’re … Just like we talk about, they’re padding their margins. Right? They want to make sure that they are going to earn a good interest rate regardless of what the fed decides to do. And to your point, I think there’s a lot of people who are expecting mortgage rates, even if the fed keeps raising rates, might at least moderate or actually come down in 2023, because that spread might actually decrease back to the historical levels that they’re normally at.

Ashley:
Yeah. I think the spread has widened just because of the uncertainty, but that’s something they can control. So to your point, in commercial, it’s about 200 basis points, 200 bps. So in terms of that spread, we could see that spread come down once there’s more certainty and comfort in the risk profile of where the 10 Year Treasury is paced.

Dave:
Yeah. I asked you that question, because I ask everyone that question, how they’re adjusting to it. And the thing I love about talking to everyone, and James gets to do this too, is just every single experienced investor is like, “Yeah. Of course, I’m still bidding. Of course, I’m still doing stuff right now,” and I just hope people listening to this who are worried about this market, which is understandable … There is more market risk right now than there has been in a long time. But just listen to Ashley and James advice here is like if you just keep underwriting the same way, you behave conservatively, there’s no reason why you can’t participate in this market.

James:
Yeah. Go back to your underwriting you were doing two to three years ago. I was talking to my sales guys about this the other day. I’m like, “No. You guys, we’re writing offers.” They’re like, “Well, the deals are too good.” It’s like, “No, no. These were the deals we were doing three years ago.” They just got brainwashed by this last market and what the yield and the profit expectations would be. And so now it’s like everyone’s just resetting. The banks are resetting. The banks are just getting their spread. We’re trying to get our margins in there. And it is balancing out though. I’m noticing it’s balancing a lot quicker than I would think.

Dave:
Ashley, I want to switch gears and ask you one question. Obviously, as an operator, as an investor who’s active in these deals, you’ve shared some really helpful insights for us. What about for people like me who invest passively into syndications? What advice do you have for people who are interested in being an LP for investing in these type of market conditions?

Ashley:
So one of the things that I actually spoke about at BiggerPockets Conference … I had a talk on the speculation and manipulation of cap rates. It was called The Cap Rate Con. And one of the things-

Dave:
I like that name. Very catchy.

Ashley:
Thank you. One of the things I did during that speech is I polled the audience. So there are about three or four hundred people in the audience, and I said, “How many of you passively have invested in the past two to three years in a multifamily syndication?” and I would say about 75 percent of the audience raised their hands. And then I said, “How many of you did well over those years if it sold?” and it first had to sell, so we had a drop off about 50 percent, so about 150 people still had their hands up. And then I said, “How many people did well?” and everyone had their hands up. And then I said, “Okay. Out of all of the people who have their hands up still, how many of you asked for a detailed breakdown on the original projected exit cap rate, the original projected NOI performance, and the actual?” and only two people had their hands raised.
So the takeaway is that when things are doing well, you don’t bother the operators. You don’t ask for the financials. You don’t actually prove up their operations. You never verify that they were able to exit successfully based off of what they did, not what the market did.
And one of the metrics that I had up on this speech as well was a sensitivity analysis table. So ever since we got in multifamily, we have presented the sensitivity analysis table on every single offering we’ve ever done to all of our investors, and what it is is on the Y axis it is the cap rates by 25 bps, and then on the X axis it is the percentage of hitting NOI. So dead center, it’s 0 percent, meaning you hit your projected NOI. And then it goes off in either direction at two percent intervals. So you over perform your NOI by two percent, or you underperform your NOI by two percent. And then on the Y axis, you have that 0.25 basis points.
And what we show to our investors is the risk associated … That’s the intention of the sensitivity analysis table is the risk associated with investing in general. So if we hit our NOI dead on, let’s say, and we have a four and a half exit cap, let’s say, for example, we’re projecting a 14 IRR. Right? But if we underperform our NOI but we still hit a four and a half cap rate, it might go down to a 12 and a half IRR, let’s say. Right?
So what I showed on this table was that when the cap rate compressed to three and a half, so we had a hundred basis points difference on the cap rate, and people underperformed their projected NOI by eight percent, they still achieved over a 20 IRR.

Dave:
That’s crazy.

Ashley:
But that being said, today, if you look at the cap rate expansion, so if you take a four and a half and you go to five and a half, so a hundred basis points expansion, you have to overperform your NOI by eight percent to just get a 12 and a half IRR. So the expansion of cap rate actually translates into you having to better perform on your NOI than initially projected.
So the takeaway message there is twofold. One is, first of all, when you’re vetting people as a passive investor and they’re spouting off all these wonderful performance metrics that they’ve been able to achieve over the last three to five years, dive into it a little bit further. Ask for original projections versus actual both on the NOI and the cap rate, because then you can do the calculation very simplistically to figure out if the operations were the reason that there was success. And then also ask for a sensitivity analysis table on the current investment that you’re considering and how the impact of cap rate expansion will have on your actual returns.
I think we’re in a situation right now … Maybe the cap rate expansion three to five years won’t be … hopefully won’t be a hundred basis points from where it is today. But you never know, so just educate yourself and be prepared for what those returns would look like, and make sure that you’re comfortable with those returns.

James:
What’s that old saying? You never go skinny dipping when the tide’s going out-

Ashley:
Going out.

James:
… or whatever that … I feel this is where we’re going to see whether operators were good operators or not. It was all asset classes. It got so juiced up that everyone was hitting their metrics, hitting their profits. And now as things compress down, you have to operate this as a business and operate it well, or you will not make money doing this. And I think it’s going to be a little scary, because we’re going to see a lot of these … Yeah. They have false success, and then they reload into something else, and because they had that success, they went a little bit more aggressive on the next one. And we’re going to see a little bit of issues coming out of this. I think the IRRs are going to fall quite a bit on people that did not perfect their business. It was just kind of like they bought this thing, they got it somewhat stabilized in an inefficient manner, but they still hit it, and they’re not going to be able to … You have to implement the right plan and really dig down on your core metrics now to make these profitable.

Ashley:
In 2019, I was on a panel at Dave Van Horn’s MidAtlantic Summit, and I was on the panel with Brian Burke, Paul Moore, Matt Faircloth … The fourth person’s escaping me right now, but I will remember in a second. Anyway, long story short, as I said that, in this business, operations are very important, but in a downturn, operations are the most important, and I have stood by that quote forever. That is my personal belief, and I think we’re seeing it right now.
I also think that a lot of people’s business models over the 10-year track and multifamily, this run up that we’ve seen, has been solely based off of … Even though they don’t say it, they’re buying for appreciation, A, and, B, buying for fees. So in terms of when they’re syndicating, they’re so focused on acquisitions. And case in point, to be honest with you, and I’m not trying to pitch this at all, but when I first got started in multifamily, I really struggled to find resources where I could find education, so I contemplated going to these different coaching programs. So I vetted all the coaching programs available at the time, and what dawned on me was the fact that everyone taught you how to find and fund the deals, but no one actually taught you how to operate them. No one. Not a single coaching program.
So we have a coaching program today that literally … That was a deal breaker for me if we didn’t spend the majority of the time of the coaching program focused on operations, because it’s like it’s kind of reminds me … And I know this is probably dark to say, but it kind of reminds me of September 11th when the terrorists learned how to take off the plane and fly it, but they didn’t focus on landing it. You have to focus on the entire process, and when someone’s not focused on the entire process, that should shoot up a red flag.

Dave:
That’s phenomenal advice.

James:
A hundred percent agree with that.

Dave:
That’s a really good point. Yeah. James said on a show recently that he thinks we’re going to see a lot of defaults in the multifamily space over the next couple of years, because people maybe were too greedy, bought too high, and we’re going to start to see … Like you said, the tide’s going to start coming out. We’re going to see who’s swimming naked. Do you agree with James’ assessment?

Ashley:
I am foaming at the mouth to answer this, because the answer is simply yes. And it’s not only for the reasons that you just mentioned, but it’s also because of how people bought. So it’s not about overpaying. It’s about what they did with debt. So what they did with debt is they got variable rates without securing rate caps, and a lot of people are in positions right now where, A, they can’t afford the rate caps.
So rate cap rates … And truth be told, we’re in a situation with our rate cap being astronomical, and I’m happy to share the information just for people to learn, because it’s definitely a mistake we made. Now, fortunately, we also have a lot of reserves, and we counted on some of it, but we didn’t … Honestly, we didn’t count to the extreme that it’s at. But let me just kind of give perspective here on why I think this is going to be an issue.
We purchased a property in September of 2020, and we did a variable interest rate with a one strike for a three-year term. We paid 30,000 for that rate cap. In October of 2021, our lender told us they were going to change the accrual rate. So it was a three-year rate cap, and similar to insurance and taxes, lenders accrue for the next rate cap that you’re going to purchase with your mortgage. So they were accruing at a rate of 1100 a month up until October of 2021. In October of 2021, I received an email saying that they were going to adjust our rate cap accrual to $303, and I said to our accountant, “That concerns me, because the rates are not going to be this low come the time we need to buy the rate cap. So we can pay the 303 to the lender, but I want to accrue on a separate line item for the balance, because this is very concerning.”
In March of 2022, we got a letter from the lender saying that they had just done another audit and that they were going to change our rate cap accrual. So this isn’t our mortgage. This is just for the rate cap accrual, for 9,200 a month. And I was like, “Holy crap. That’s crazy.” Okay. Well, that, I thought was crazy, but like life, it’s all about perspective. So three weeks ago I got another letter from the lender that said, “We just did another audit, and we are going to adjust your rate cap accrual to $54,000 a month for the rate cap.”
And the reason why they’re adjusting it … So let me just talk about how rate caps are set. So we purchased the rate cap for $30,000. It’s a three-year rate cap at a one strike. I get an email every single morning or between 4:00 and 5:00 AM, and it lists out what it would cost if we repurchased that rate cap today. It is now around 515 to 520 thousand dollars to buy that same rate cap.
So a couple things. One is that now I have to accrue based off of the remaining term that I have left, but it’s compressed to account for the deficit that we were accruing at. So that’s the one issue. The second issue is that we’re in a situation where we have reserves. We had factored in a larger purchase on the rate cap when we went to buy it, but we didn’t factor into 530,000. Fortunately, we have reserves and we’re under budget on other items that we can pool from different money, but now this is cash we don’t have access to.
So we’re in negotiations with the lender, and the lender has communicated to us that we’re by far the highest change in rate cap accrual, probably because we went with the one percent strike. And you have to go back to your loan terms to see if there’s ways that you can renegotiate what they’re accruing for, whether it be the term or the rate, the one percent strike. So there’s room for us to have a discussion, which we’re in the process of now, and hopefully we can come to some sort of agreement. But what in turn that has done is that has put us in a situation where we’re telling our investors, “Until we have this figured out, we want to put distributions on hold just till we have this figured out, because it’s the responsible thing to do.” Now, do I ever want to do that? No. But I would rather do that than later say, “Oh, yeah. Well, I didn’t tell you about this thing,” or “I did tell you about this thing, but I didn’t tell you how it impacted you, and now we have to do a capital call.”
So sometimes having difficult conversations is not what operators even want to do, so what ends up happening is it gets too late in the process and then all of a sudden the property’s in a situation where they’re either on lockbox, they’re on the watch list, or they’re foreclosed on, and the passive investors have no idea that this even occurred. And I’m pretty sure if they were informed of the situation when it occurred and you communicated to them what outlook you had and what steps you were going to take, they would all be in agreement for conservative measures to be taken, especially if you attract the right investors.
So we’re in a situation where it’s tough for us, but we’re heavy focused on operations, and we’re going to come out on the other side favorably. But how many other people are not in that situation? Right? How many other people didn’t even factor reserves into when they purchased the property, or aren’t under budget on other projects, or bought a rate cap without even thinking, “Okay. The lenders can audit it every six months and change the rate cap accrual rate”? So I think, to James’ point, I think there’s going to be a lot of people that we see when the tide goes out who were swimming naked because they didn’t factor these variables in.

James:
Yeah. We might see some saggy stuff out there. It could get [inaudible 00:54:18].

Ashley:
It could get ugly.

Dave:
You should see what the beaches are like here in the Netherlands.

James:
But what-

Dave:
Good description of what’s going on here.

James:
Yeah. I mean, what she just talked about is huge. Right? I mean, that’s a big deal, and that’s where things … And operators like Ashley … Like she said, having that tough conversation is important. No one wants to do the responsible thing ever. Right? I’d rather to be irresponsible for the rest of my life. It’s a much easier, fun way to live. But it’s like you’re going to have to have those conversations, and you got to address those and make it up in, to Ashley’s point, the operations. You have to figure how to turn your units for less. You got to keep your units more full. Operators are really going to have to excel to push through this little hump. You can push through that hump, but you’re going to have to perform well.

Ashley:
Well, and to your point, James, if something like this pushes someone to say, “Oh. I got to figure out a way where I can skim on operations,” well, if you never learned operations in the first place, now you have a learning curve to contend with, plus then you have to figure out what you’re going to change, and there’s too much time that goes by. Right? So between learning what’s actually going on at the property.
I talk to so many people that … The thing that was so surprising to me when I first started a multifamily is I would talk to these people who would own properties for 10-plus years, and I would try to have a conversation with them about operations, and they had no idea what was going on with the property. They’re like, “Oh. The property management company handles this.” I’m like, “But you’re responsible for the financials of that property and the performance and the business plan. How do they know how to pivot strategies? How do they know what your overall business plan is?”
I mean, that’s a whole separate conversation, but that’s why I think most people turn to vertical integration. It’s because it’s actually a deficit of themselves, because they lack communication with their property management company. But case in point is they lack communication because they actually don’t know what’s going on. They never spent the time to realize what the property management company is dealing with day to day, coupled with how you then match your overall operations and your business plan together. So I think that situation is going to be exacerbated in this environment.

James:
A hundred percent agree.

Dave:
Yeah. That’s great, great insight. I would love to keep talking about this, but unfortunately we’re almost at the end here. But, Ashley, this has been so helpful. Thank you. If people want to learn more from you, where should they do that?

Ashley:
If you’re interested in becoming a passive investor, Jay Scott and I have bardowninvestments.com. That’s our company. And then if you would like to be an active investor, you could also learn from us through apartmentaddicts.com, which is our coaching program. You can also follow me on Instagram, @badashinvestor, which is B-A-D-A-S-H investor.

Dave:
Awesome. Well, Ashley, thank you so much for joining us. We really appreciate your time.

James:
Good to see you, Ashley.

Ashley:
Great seeing you guys. Thanks again.

Dave:
All right, James. That was incredible. I just learned so much. I do listen to all the episodes, but I’m going to listen to this one like three or four times. I feel like she just dropped so much information I want to use in my personal investing.

James:
I’m going to need to listen to it three or four times, because that was packed full of information where I’m like … At one point, I was like, “Do I need to Google something real quick?” I should have had my search bar open.

Dave:
Oh, man. She’s just so sharp and knows everything, and I just thought her understanding of cap rates and cap rate expansion and what she was talking about validating something you’ve been talking about where you think that there’s going to be a lot of default in the multifamily space. Really interesting dynamics that are probably going to start playing out here in the next three to six months.

James:
Yeah. I mean, how she broke down the baking, the different ways to perform of the deal, the operation side … I mean, she is just … I mean, Ashley … I mean, I remember the first time I met her, we just kind of connected right away on work ethic, because we could really see how much they care and passionate about her business. But she went over that in all of this today, and she broke it down to a next level to where, yes, I’m going to have to listen to this at least two or three times.

Dave:
Yeah. It was great. Well, we’re going to get out of here, because this was a long interview and don’t want to keep anyone too long. But thank you, James, for joining us, and thank you all for listening. We really appreciate you, and we’ll see you next time for On The Market.
On The Market is created by me, Dave Meyer, and Kailyn Bennett, produced by Kailyn Bennett, editing by Joel Esparza and Onyx Media, research by Pooja Jindal, and a big thanks to the entire BiggerPockets team.
The content on the show On The Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.