So today we're going to talk about three big dilemmas
that real estate investors are facing right now.
I'm facing.
And anybody that's bought recently or is about to buy.
Stay tuned, because these three things are something that you need to know.
Even if you're investing.
There are things that you need to ask.
So, number one, of course, is interest rate risk.
And if you guys don't know, you've been under a rock somewhere.
The Fed has now increased rates, at least
publicly, three quarters of a percent.
So a quarter percent and then a half percent.
And they say there's going to be more in their pursuit
to try to tamper down these high inflation costs.
If you have or you're invested in something that has any kind
of floating debt, in other words, nothing that's not fixed,
like bridge debt or short term debt of anything where you're doing
a value add, you are now in jeopardy of this interest rate risk.
So let me show you specifically how this works.
So here's how every real estate deal works.
There's income typically in the form of rent.
This is
where all your occupancy issues are, and this is where your other income is.
But anything that has to do with income specifically, mostly rent is here.
And then after expense, which is, of course,
utilities and property tax insurance and marketing and payroll
and all of those things you have what's called your net operating income.
And if you've bought into something or are investing into something
that let's say as a value add, where the strategy was to grow
the income or lower the expenses or manage the expenses better, and the strategy
you invested in was the growth of this net operating income.
That's a very basic real estate deal.
The bank, on the other hand,
is looking at the net operating income as a way for them to loan against.
So they take a look at this number here, and that's how they determine
how much debt payment that they can give you.
Typically, that's called a DCR or a debt coverage ratio.
So these debt covers ratios are getting harder and harder at the moment
because the banks are now taking a look at lower loan to values
and all kinds of things as they try to hedge some of these headwinds
that we're facing right now in their real estate sector.
So here's the basic math you got your net operating income
minus your debt, which equals your cash flow.
Your cash flow, of course, divided into your equity.
That tells you what's your cash on cash return is.
It doesn't tell you your IRR or your internal rate of return.
You have to sell the property for that.
But what this does do is it shows you what the cash flow will be
today, tomorrow and the next day based on your debt payment.
So the big variable here, of course, is your debt payment.
As rates of increase, that payments are also going to go up,
which is going to shrink your cash flow.
So if you've invested in something like this, even if the net operating income
is growing, the debt payment could also be growing
to wipe out even creating negative cash flow.
So this is the first headwind that I see for real estate investors
that do not have fixed rate debt that this variable here,
no matter what is going on with rent, is also going up
and is going to impact your future cash flow and your future investment,
which could then in turn turn into some kind of a sale
or exit from the asset prematurely The second thing
that I want you to watch for is the price of the equity.
So what is that care and what is the price of equity?
What that means is that most of us don't have all this equity
sitting around to do 5 million, 10 million, $20 million down payments.
That money comes from somewhere and it's priced very differently.
Think a hard money.
Hard money could be equity that might be priced eight, nine, ten, 12%.
But most equity is probably priced in the five to 8% range
generally, unless it's an institution.
And then you have to pay attention to the waterfalls,
which I'm going to talk about next.
So if you're a syndicator or you're an investor
where the equity was brought in from an institution
or a big company that might have this kind of waterfall
you're going to want to pay attention to this.
The first thing is if this equity came in from a big institution as an example,
you can be sure that they have a short timeframe on
how long that money is going to be out and when they want it back.
And that's typically three to five years as an example.
Let's say it's getting to the end of that period
where some of these big institutional equity
groups want their money back and they're saying, hey, time to sell.
And therefore, the general partner
and the limited partners now have to enter the exit plan.
The first thing that's paid in a waterfall is typically the debt
or the outstanding debt balance, whatever that is.
The interest payment, of course, is negligible.
It's not even relevant.
It just matters what is the outstanding loan balance.
That's the first thing in the waterfall that gets paid.
The second thing, of course, is the equity So the equity
typically has some kind of compounding price to it.
So let's say there was $1,000,000 of equity borrowed at 10% as an example.
So that would be 1 million, 100,000 owed on the equity in year one.
And then of course, 10% of that number, four year to et cetera, et cetera,
So the second thing in the waterfall is the equity.
The third thing, of course, is the GP and the LP
or the general partner and the limited partners.
So only after this is paid and this is paid with all of the interest
do these guys get paid, including the LPs.
So as you run your waterfalls based on the sales price,
you're going to want to make sure that this category is still in the money
and as interest rates go up and as sellers have to sell
and as equity partners force you to sell, this is something that you're
definitely going to want to watch because all general partners
in all limited partners on the tail end of the waterfalls.
So if cap rates go up,
which we're going to talk about in a minute and asset values go down,
then these waterfalls are going to become very important
because the debt is secured in the first position of the waterfall.
And then the water hits the second position, which is the equity,
the institutional equity, which is typically higher priced money
and has a little more meat on it around the returns.
And then the last position is the GP or general partner and the LP.
They're in the riskiest position of all of this
because most of these waterfalls are based on the market's going up.
So if you guys like this, please hit the like subscribe and notification bell.
These things are hard to do.
They're fun to do.
I'm enjoying them, but I also need a little love.
So the third thing is the exit cap rate.
So for those of you
like me, when you first got into this business, what's a cap rate?
I put the definition here so you know what it is.
It's the properties.
Capitalization rate is a snapshot in time of a commercial assets return.
The cap rate is determined by taking the property's
net operating income, the gross income, less expenses.
We just talked about that and dividing it by the value of the asset.
Commercial real estate is an investment type,
so the return is a reflection of the risk and the quality of the investment.
The cap rate does not take into account the consideration of the mortgage,
if any, as most useful in a market where sales
occur often and buyers can use comparable sales.
So that's happening right now.
Of these stabilized assets to compare, determine if the price is
being offered is reasonable or relative to the other sales,
there is a clear, distinct chain between cap rates and interest rates.
And we know that interest rates are rising right now.
The difference between interest rates and cap rates is called a risk premium.
And a lot of investors look at that risk premium before they invest.
So while interest rates and cap
rates are not directly correlated interest rates have a big factor
on what people can and are willing to pay for property in the future.
As a general rule, rising interest rates are bad for property values,
but there are a lot of other things to consider, like growth,
supply and demand, investor confidence and of course, market liquidity.
Is a big factor
on what it's going to do with real estate investing, both on debt and equity.
So here's one great example.
Let's say you invested in or syndicated a property
where you projected a $1 million net operating income.
And of course, as you guys know, that's income minus expenses
and you've projected it to be about $1 million.
At the end of, say, two or three years at a 4% cap rate
or 4% into the 1 million that gives us a value of about 25 million.
If cap rates go up using the exact same and a Y.
So in other words, you've performed, rents have gone
up, expenses have done fine, and you're hitting your 1 million
buy cap rates have gone up, your value is now at 20 million.
So you've technically lost 5 million in value
even though you've performed by getting the NOI up to 1 million.
So this is why you need to pay closer attention to exit cap rates
because most institutional groups are taking a hard
look at these exit cap rates because they're so low right now
and they're a real risk, no matter what's going on with the A.I.,
no matter what's going on with the rent growth, they're concerned that the values
could be less because the cap rate goes up.
So hopefully now you can see if cap rates
go up and you're on the tail end of the waterfall.
A lot of those GP and LP investments that I was talking about
in the last slide, this is potentially the result of rising cap rates.
So as you guys are doing your underwriting, as you guys are investing,
make sure that you're looking at the exit cap rates by your syndicator
or the ones that you're using because interest rates are going up.
And while they're not a direct correlation to cap rates,
they do affect the property pricing.
So with that,
if you like that, please like subscribe and hit the notification bell.
As always, I appreciate you guys.
This was a question we got from four of our listeners, so thank you for that.
Very much appreciated.
I hope you enjoyed this video. We'll see you next time.