Recently, an apartment investor defaulted on $229M in loans across four properties in the Houston market. When the group was unable to make their mortgage payments, their lender foreclosed on the 3,200 units.
This group won’t be alone.
Some investors will read that last line with excitement for future deals and opportunities. Others may read that in fear that they could be next. This is not about exploitation or fearmongering. This is about understanding what went wrong, recognizing and assessing risk, and applying those insights to our own investments.
Recently, I’ve been reading a book called Getting to Neutral by Trevor Moawad. The general concept is that while most people know to avoid negative thoughts, positive thinking can be dangerous as well. The reality is that there are things you cannot control. Positive thinking can provide a false sense of optimism and mask potential threats. Taking a neutral approach removes emotion and allows you to analyze the situation and your options with a clear focus on what you can control.
Real estate investors are generally optimistic people. When those investors acquired the 3,200-unit portfolio between August 2021 and April 2022, they believed they would be able to increase rents, drive NOI, and sell at a profit. Less than a year after the final acquisition, they were handing the keys back to the lender.
While I’m not intimately familiar with exactly what went wrong, it would be a mistake to treat this as an isolated incident or someone else’s mistake. Instead, this is an opportunity to understand the high-level factors to ensure we recognize, minimize, and avoid these issues whenever possible.
The biggest threat to any real estate deal is negative cash flow. Many investors understand that income minus expenses is the net operating income (NOI), but cash flow is what is left of the NOI after subtracting debt service and capital expenditures.
Income - Expenses = Net Operating Income (NOI)
NOI - Debt Service - Capital Expenses = Cash Flow
As investors, we’re trying to understand the projections of each of these items and recognize where there may be risk or vulnerability. Let’s dive in on each component.
Income is the first thing most investors consider when looking for a deal. Ideally, you want to find a property where the income is high enough to cover expenses, debt service, and capital expenditures (CapEx), while still delivering favorable returns. Oftentimes, investors look to add value to the property to increase rents and drive income. In this case, investors are projecting future rents. In addition, they may factor in annual rent growth.
There are factors that can hurt income. However, it boils down to less or slowing demand. This can be driven by the market as well as the quality of the apartment and experience. In the case of the 3,200 units, many factors were likely in play. The rent growth in the market started to slow after record-breaking rent increases.
On top of that, rent collection can be problematic with lower-class assets. When the economy worsens, residents who are the most strapped for cash will naturally have the hardest time paying rent. For higher-class assets, concessions and occupancy may be a factor, especially if there is strong competition in the area. Because of these factors, it’s important to conservatively project future income and economic occupancy to mitigate some of these risks.
Many operators assume expenses will remain relatively flat from the previous ownership, but this isn’t always the case. In fact, two line items routinely explode for new buyers: insurance and taxes. When looking at expenses, it’s critical to ensure they are projected based on the feedback and consultation of experts using your future business plan, not the T12 from the seller.
Sellers are looking to show the best financials when selling an asset, which may mean cutting expenses to boost the NOI. Buyers want to understand how the property has performed and how similar properties perform when making these projections. They should also plan for reassessments and inflation on expenses.
The biggest factor in the $229M portfolio default was the rapid increase in interest rates. The rate on those loans had risen from 3.4% to around 8%, according to loan information obtained from data firm Trepp, Inc. The inference is that there was not an interest rate cap on these loans. The lack of a rate cap meant that loan costs shot up 135%.
Rates are just one component of debt service. Other factors include terms, loan-to-value ratio, and pre-payment penalties. Some investors overemphasize the interest rate and pay less attention to the other aspects. In some cases, a lower fixed-rate loan could be more expensive than a loan with a higher, variable interest rate. Beyond the rate, it’s critical to select a loan that matches the business plan and risk profile for the project.
CapEx and Reserves
Most people don’t want to be associated with owning what the Houston Chronicle referred to as “a rat and roach-infested” apartment community. Even the shrewdest investors would only invest in such a project to turn it around. This value-add strategy requires a hefty CapEx budget to deliver on the transformation. In some cases, investors are looking at a lighter renovation plan, but being able to implement the plan within the allocated budget is paramount to success.
Many renovations go over budget or extend beyond the initial timeline, so having some contingency built in is recommended. It also helps to have proper reserves that match the level of risk based on the other components of the business plan. This is especially key if there are other shortcomings from operations while the property is being stabilized.
In the case of the 3,200 units, the owners ran out of cash to cover the expenses and debt service and could not increase their income fast enough to stay afloat. To avoid this outcome, investors may want to troubleshoot what could go wrong with the deal and decide how they mitigate the issues. Some questions they may want to consider are:
- What if rents don’t grow as much or as quickly as projected?
- What if expenses grow faster than rents?
- What if the renovation costs go over budget?
- What if rates rise quickly?
The goal is not to ask these questions in a state of fear or to brainstorm every doomsday scenario, but to pressure test the plan to evaluate where there may be exposure. Once identified, investors can find options to mitigate those potential risks. The key is removing emotion (positive or negative) and taking a neutral approach to evaluating and addressing risks.
While the lending landscape has changed, the appetite to find value remains strong. Those who are level-headed and understand how to identify and manage risks are poised to find great deals during this next cycle. As an example, those 3,200 units were sold at auction to a New York group for $197M, estimated to be at least 30% less than what the previous owners paid.
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.