Limited partners are getting more nervous about some of the investments they’ve made over the last few years. Interest rates have risen faster than at any other time in U.S. history. This has placed a heavy cash flow constraint on many deals. This cash flow strain has forced a number of operators to pause distributions.
As an LP investor in one (or many) of these deals, you may be growing anxious about the state of your investment. The rising interest rate has increased the mortgage payment of many deals to the point where some deals are seeing negative cash flow. These deals are actually losing money each month. Recently, one group was foreclosed on 3,200 units after the rising interest rates forced them to default on their mortgage payments.
These rising rates accompanied by expanding cap rates have forced operators to focus more on capital preservation for a more conservative outlook. In a growing number of cases, this has led to the pausing of investor distributions. If you find yourself in a deal where distributions have been paused, it may be challenging to determine if you should relax because things are fine or if there is cause for greater concern.
To make this determination, you have to understand the cash flow and cash position, the stage of the business plan, and the plan to restart distributions or exit the asset.
The most important aspect of investing in income-producing assets is ensuring positive cash flow, meaning the income exceeds all liabilities, including debt service. It’s important to note that a deal can have positive cash flow without making distributions. There are factors that can take a property from positive cash flow to negative cash flow such as increased expenses, rising debt service, or a reduction in income. As an example, if inflation results in job loss for residents, the property may see an increase in missed rent payments that would lead to a reduction in income.
Cash flow is key, but to fully understand the property’s financial health, you need to also understand the cash position. Think of cash flow as the balance of a checking account with a number of transactions each month. The cash position is more like a long-term savings account with much less activity. If the checking account has any big purchases or other fluctuations, you might tap into the funds in the savings account to help cover those expenses. Coupled with cash flow, this cash on hand provides a more holistic picture of the property’s financial health.
When pausing distributions, some operators may be looking to replenish the property’s cash position or proactively prepare for a potential reduction of income. However, if the cash flow is negative and the cash position is light, there may be bigger issues at play.
The next item to note is the stage of the business plan. Properties in the first phase of their business plan, especially value-add deals, are still working to stabilize operations. As these projects are in the initial stages, they also have more flexibility to adjust their business plan in the face of a changing economic environment. On the flip side, these are the most vulnerable as they may not provide much cash flow in the initial stages. In this case, the property may burn through working capital leaving less funds for needed upgrades and repairs.
Properties that are further along in the stabilization period have less flexibility since the bulk of the business plan has been implemented. In this case, assumptions made during the initial business plan and implementation process may no longer hold true. However, if the bulk of the business plan has been implemented, the property should be in a better cash flow position. These properties are also better positioned for a liquidity event such as a refinance or sale. When pausing distributions in this phase, operators may focus on capital preservation or preparation for the liquidity event. Whether the property is in the early, middle, or late stages of the business plan, the key is determining how to pivot to create an optimal outcome for investors.
When distributions are paused, passive investors want to know when they will resume. The answer will vary based on the deal, the circumstances, and the operator. In some instances, the pause is a counter to an unexpected or increased expense. Once this temporary item is resolved, distributions should be able to resume. However, often the pause in distributions is a result of a more expansive financial issue. This could be driven by factors such as lower-than-expected rent collection or higher-than-expected debt service. These issues take longer to resolve and distributions may require a liquidity event such as a refinance or sale of the asset.
Many of the deals facing challenges right now were acquired in the last 24 months with floating interest-rate debt. As these loans mature, investors are faced with the option to refinance or sell. However, some of these deals may not qualify for a refinance without bringing more equity to the table and would not garner the target amount in a sale. If you are in a deal with an expiring loan, you will want to ask about the property’s current market value and options for refinancing or selling.
It should be noted that a refinance may not solve every issue. Lenders have tightened up their loan-to-value (LTV) and debt-service coverage ratio (DSCR) constraints, which may not provide enough proceeds to distribute to investors. Also, a refinance could mean increasing the debt service, adding additional stress to cash flow. As a passive investor, you should view a refinance as a bridge to a more profitable equity event down the road. The plan to continue to increase the value of the asset should be a part of the decision to refinance.
Pausing distributions is never ideal, but it also isn’t a cause to panic, at least not in and of itself. Understanding the property’s cash flow and cash position relative to the current stage of the business plan should give you a better sense of the property’s health. Most value-add deals have challenges with cash flow during the stabilization period, but when the cash position is also impacted, there may be more concerning issues.
While a pause in distributions can be alarming, the more important questions surround the health of the asset, the effectiveness of the business plan, and the preservation of your capital. As you understand the property’s operational performance and financial position, you should also understand the plan moving forward. How will the operators get from where things are today to the point where distributions can resume? What concerns do they have and what obstacles will they need to overcome to see success?
If you have concerns about your investment, talk to the operators and understand how they plan to navigate the landscape and protect your investment. Panicking won’t solve anything, and neither will blind optimism.
About the Author:
John Casmon has helped families invest passively in over $100 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Multifamily Insights. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.