So today we're going to talk about how deals are flowing in.
Many are toxic and you need to be careful that you don't catch a falling knife.
So make sure you stay out to the end, because I believe
this is the biggest threat to the real estate industry.
And it's not single family, but it's commercial mortgages
that are coming due and about ready to mature.
So one of the biggest issues
I'm seeing right now is a lot of these banks
that are already in a little bit of
trouble have commercial mortgages coming due when a lot of these property
values are actually less and the mortgage itself.
So two things we're going to talk about in this video.
The first one, what is the Fed doing?
And the second one, of course, what are the banks doing
and what are their big concerns in 2023 and 2024?
So most of you know that the Fed has increased
interest rates nine times since March of last year.
And it's only reduced the inflation rate about 3%.
Their target is 2%, and we're currently sitting at 6%.
Chairman Powell has said over and over and over
that he's very concerned about inflation
and he's trying to decrease this asset bubble, which is definitely happening
in both the single family and really happening in the commercial markets.
So most of you follow the single family market and the commercial market.
We have serious issues because the capitalization rates,
which we're going to talk about later, have gone up, which have severely affected
many of the values. So let's first talk about the basics.
Every single deal has the same math formula.
You have your income and many commercial properties.
This is your rent or other things that might be income.
The second one are the expenses, and those are under attack too,
with property taxes, insurance and utilities and all kinds of labor supplies.
So these two things are actually in jeopardy right now.
But for this particular video,
we're just going to say that they're the same from year to year.
But as you dig deeper, you're going to see that
many properties are struggling in these two areas, specifically.
If you think about it, commercial office buildings where a lot of people
are not coming back to work and they're having high vacancies,
therefore the income's low where the expenses are the same or more,
which results in less net operating income.
So if you're a bank that holds an office building, for example,
and you have declining income, higher expenses,
you're actually concerned when that debt is due.
So the biggest issue by far is going to be the debt maturity that's coming.
For many of these commercial mortgages, just consider a moment.
If this property had the debt maturing, it would now have to go to the open market
and get a value based on the existing operations,
which is really based on the net operating income.
So all that all mortgages are based against what
the property makes, which is the net operating income or an ally.
If this is lower, your debt will be lower.
If you're a little confused, that's okay.
There's another video I did on debt service coverages
that talk about how a bank size is their debt against the asset itself.
Because as you would imagine, as you would do yourself,
you're not going to lend
a lot of money on something that doesn't have a lot of income.
So what is the biggest threat to these banks?
It's the rise of the interest rates.
These interest rates have almost doubled.
So not only do we potentially have problems, higher debt
costs are going to create cash flow issues right here.
So if this property, let's say, has a variable rate loan
and the debt costs have gone up over this past year, there's no question
that their cash flow has been impacted and could be even negative.
So the banks are going to be looking at the cash flow, the cash reserve.
So even if you have a lot of cash on hand, you're probably funneling it
in to this property to try to save it from actually going back to the bank.
So quietly, a lot of these properties are being shopped around.
And I'm talking about retail office, industrial, multifamily.
All kinds of them are quietly being shopped around
because of the debt is maturing either this year or next year.
And they know that these interest rate increases have increased their debt
and therefore they're going to get less of a loan.
So as a general partner or an owner that have a maturing debt,
they could be doing house calls to try to keep the property
and the short term basis bringing in new money or raising
money from the existing living partners, or they might even be trying to sell.
And all of those are options happening right now on a number of properties
all over the place. But that's not all, folks.
The one thing that you have to know with rising interest rates
is that not only is cash flow down, which we just explained in the prior
slide, but cap rates are also up through capitalization
rates are used as a valuation, as many of you know,
against a net operating income to determine what the property is worth.
If you're a little confused about what a capitalization is, then just take a look
at some of my other videos.
I go into a lot more detail, but just know this as interest rates go
up, cap rates also go up, which basically just means
that the properties are being sold for less money and the cash flow
is definitely down on these properties because a new person trying to buy
something is actually solving to cash on cash or return.
And as debt goes up, cash flow goes down for the new buyer
and therefore they're offering less money for the exact same property
that they would have tried to buy a year ago.
So now let's talk about a real life scenario.
Imagine that a property had 2 million in income, 1 million expense
and they had 1 million
of a net operating income and their debt payment was, say, 700,000.
And they had a cash flow of about $300,000.
Now the loan matures the exact same property
to a million in income, 1 million expense, 1 million and a Y.
And because of the new interest rate, which is almost double,
we put the date around 1.2 million.
Now, that same property is looking at about a $200,000
a year negative cash flow.
That is not going to happen.
The lender is never going to do this deal because as I said before,
how they get paid back is in net operating income itself.
And that also assumes that the net operating income holds at 1 million.
As I told you before, we're also battling those issues by just keeping tenants
into some of these buildings.
So how would a lender take a look at this building?
They would look at the net operating income and they would apply the cap rate.
That would be one type A valuation.
So if we took $1 million of net operating income and used a 4% cap rate,
we would have a value of about $25 million.
But as cap rates have gone up from 4 to 5 and they have that value has dropped down
to 20 million.
It's simply just taking the 5% in the body and into the million or the 4%
dividing into a million.
So in theory, this property has dropped in value
at about 20% as a result of the interest rate increases.
So now let's take a look at what this really means.
I was just looking at a property yesterday with our investment committee
where we actually did all the work, all the underwriting.
We took a look at a very cool building that we would have loved
to buy just a year ago with lower debt, and we realized
that the loan was actually higher than the property was worth today.
Now this property is not listed.
It's actually being shopped around to a bunch of people because,
of course, the syndicator, the general partner, is trying to keep it
from going back to the bank because right now, currently in today's environment,
the loan is actually higher than the property's worth.
So there's two things that we look at birth what is the current loan balance?
And second, what is the current value?
And the value,
of course, is based on whatever the capitalization rate is at the time.
And of course, based on the debt quote that we can get based on the cash flow.
And as you guys know, the interest rates are a lot higher
and therefore the mortgage payments are a lot higher.
So you just using simple math, you have to offer less to be able
to accommodate the higher debt cost using that same methodology with a $1 million
and a Y and a 4% cap rate, we come up with a value of about $25 million.
Well, this particular property had a $20 million loan in place at the time.
The investors put up the other $5 million in equity.
Let's fast forward one year later using the exact same amount of Y and you can see
using a 5% capitalization rate, the actual value is about 20 million.
When you look at that based on the existing loan,
you can see that there literally is no equity.
So one of the things that we said
in the meeting yesterday is that the limited partners don't
actually realize today probably that all their equity is gone.
And why is it gone?
It's gone because the interest rates and the cap rates have gone up
and the cash flow has gone down.
It's that simple.
As the debt is maturing or these properties are trying to be sold,
recapitalized or even refinanced,
this is exactly what the lenders are going to look at.
They're going to look at the value versus the load and then reconfigure the equity.
So the biggest threat to real estate in 2023 and 2024
is literally these loans that are maturing and these cap rates that have gone up.
The Fed continues to raise their federal funds rate
and the interest rate continues to go up, then these problems are just going to
continue to get worse.