June 13, 2022

JF2841: Investing in the Current Economic & Political Climate | Round Table


 

 

Each week for the Best Ever Round Table, the three Best Ever Show hosts — Ash Patel, Slocomb Reed, and Travis Watts — come together for a deep dive into a commercial real estate investing topic. 

 

In this episode, Ash, Slocomb, and Travis discuss how the economic and political climate in mid-May of 2022 is impacting the way they look at deals, the rules of thumb they follow when it comes to recession recovery, and the fundamentals of the economy.

 

 

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TRANSCRIPT

Slocomb Reed: Best Ever listeners, welcome to the Round Table. I'm Slocomb Reed, an apartment owner-operator and investor-focused real estate agent in Cincinnati, Ohio. Today, I'm joined by our other hosts, Ash Patel and Travis Watts. The hosts of the Best Ever show come together every week for a deep dive into a commercial real estate investing topic. And today, our topic is investing in the current economic and political climate. We are recording in mid-May 2022, and there is a lot going on in the world today.

We have the Russian invasion of Ukraine, inflation, rising interest rates, supply chain issues, a very skewed employment market, rising wages, and several other factors. So given what's going on, I am not a fan of asking people to predict the future, because as soon as you make a prediction, the only thing it does is guarantee that you are wrong. However, I do believe there's some value that Ash and Travis, and maybe I, can add here, considering what all is going on. So the question I want to ask is how is it that each of you are shifting the way that you look at deals? Are you shifting your underwriting, are you shifting your expectation, is your strategy changing at all with everything that's going on in the economy right now? If at all, is your strategy changing? Let's start with Travis.

Travis Watts: Cool. Yeah, I appreciate it. And these are so great. I point this out every time, but I love that we're all from different types of real estate backgrounds. So it gives every listener, no matter what you're doing in real estate or just looking to dive in, a whole different perspective to look at so, we don't all use our individual biases. So yeah, Slocomb, it's a crazy year, it has been. Seems like I say that every year now, but it continues to be crazy.

So a couple of things come to mind real quick. I'll just hit the high level and then we can pass it along and we can dive in deeper as we go along. First of all, Russia, Ukraine, that's the big news headline, that's a lot of people's focus, that's a huge worry, a huge scare. You've got to look at what it is you're investing in. Would I be worried if I was fully in the stock market? Yeah, I would, because every time scary headlines come out, stocks fall. That's pretty much the nature of the beast. What do I invest in? Safe, affordable workforce housing in United States. So does that really affect your average worker out there, coming home and needing a place a roof over their head? Not really. But I guess the caveat would be if the US gets involved and we go to World War III - ask me again, we'll do a follow-up. But as of right now, it is tragic. I'm not making light of the situation. It's just that it doesn't really affect too much of what I do.

From a macro level, and then I'll pause and I'll shift it off here, real estate is behind the curve, in the sense that it's a slow-moving machine. The deals that we're all looking at as comps right now were purchased two, three months ago plus at lower interest rates, and interest rates have really spiked up in a hurry. So there's a lot of negotiations happening and I think the story is not going to be told fully for six to 12 months at least in private real estate as to what happened with interest rates, how did that affect everybody. We just don't know yet, we need to give it some more time. But anyway, I'm going to take a pause there. I've got a lot more I want to share, but I don't want to take up too much in this episode. So there's some macro-level thoughts for everybody.

Ash Patel: Hey, Best Ever listeners, here are my thoughts. Keep in mind, I am a non-residential investor, so my assets are office, retail, industrial warehouse, medical. And everyone's heard, you can't time the market. I don't think anybody should try to time the market today. Back in 2016, I thought the market was at a peak, so I laid low for about six months, and I made excuses. There's a lot of coastal money coming into the Midwest, people are overpaying for properties... A lot of people had that thought, at some point in the last four or five years, and we were all wrong. The market was just on a tear for six, seven more years.

So you don't want to time the market, you don't want to stay out of the market. But what you do want to do is realize, we're in an environment with rising interest rates and that means your exit caps are going to be higher than what they are today. Everyone's been so used to buying at six caps, selling at five, selling into the fours, and now we've got to go the other way, and we have to underwrite as such. And with my asset classes, I've got to take into account increased vacancies, potential defaults on the horizon. It's going to be harder to fill vacancies. If we buy something that's a value-add, historically, it wasn't terribly difficult if it's in the right location and the right asset to fill vacancies, it just takes time and hustle. But going forward, that can change, so our underwriting has been a lot more conservative on deals that are in our pipeline now. Back to you, Slocomb.

Travis Watts: Ash, those are really great points. And something I wanted to add on previously, too. Conservative underwriting - everyone talks about it, but are operators really doing it? So things like not exceeding 70%, 75% loan to value is something I'm looking at in these private placements that I invest in. Interest rate caps, basically is, to your point, we don't know how far the Fed's going to take this, or if they're going to reverse or whatever. So it's an insurance policy if you can buy an interest rate cap in an environment like this, if you've got a floating rate kind of thing.

Obviously, if you're in it for the long haul, get as low of an interest rate as you can, lock in for as long as you can. I like assumable loans, which would be that the buyer in the future potentially could take over the loan that you have today. So say you're locking in still at a low rate, mid-threes, something like that. Now interest rates are 5.5 in a few years. It's nice that they can assume that loan, help protect your downside.

And then yes, you pointed out exit cap rate. So as an LP, as a limited partner in syndications, you always want to be looking at what is the entry cap rate that we're buying at, and what is the projected exit cap rate. In my opinion, that always needs to be higher. So if you're buying it at four today, it needs to be five or six in the future, to remain truly conservative. So I love your points. Thank you for sharing. Slocomb, your thoughts?

Slocomb Reed: Yeah, a couple of things. One, just to add to what you were saying, Travis, I was just analyzing an apartment deal where the thing that appealed to us most was that we could assume a Freddie Mac small balance loan at 3.8% with two years interest only on the front end, and still get like a year and a half of that IO period. And that's a game-changer. This guy locked in his rate before Putin invaded Ukraine. So the opportunity you inherit that, of course, that's something that other people are looking at in their underwriting as well, and so there's no guarantee that I get that deal. But to your point, that makes sense.

So with the interviews that I've done most recently for the Best Ever podcast, which may or may not have aired before this episode airs, I have been asking every investor that I talk with if the current economic climate or anything going on in the world right now is changing the way that they underwrite, changing their strategy, and particularly changing the way that they look at debt.

And you know, the solid conservative answer that a lot of people give because they know it's what all the LPs want to hear, is they go for the longest fixed-term that they possibly can. There are some people who are still expecting even now that 24, 36-month type of bridge that is going to work out fine, because any sort of recession you can ride out in three years. Are there any good rules of thumb that you follow with regards to how long it takes to recover from a recession, if that's what we're coming up into?

Ash Patel: So I have the luxury of having lived through a few of these cycles, which just means I'm older. But it takes years; there's a lot of heartache. I remember in 2009 I was in the corporate world, and we had former vice presidents at other companies applying for a receptionist position, an entry-level position. So I think people need to take that seriously. We have people that are under the age of 33 that have never lived through a down cycle in their adult life,, and they can get bad, so you have to anticipate that.

When I hear people say, "We have a shortage of workforce housing, we are a million units underbuilt for housing" - I get all those stats. But still, take these things into account. Imagine, God forbid, a 9/11 happens or something that drastically overnight changes our economy. Another pandemic lockdown, something. And if this one has lasting effects, it changes the landscape of everything. Jobs, housing, investments, stock market. Everything changes, and people that haven't lived through that, you've got to plan for that, man. This is not going to last forever.

Travis Watts: Yeah, great points, Ash. I had a unique perspective; I was coming out of college in 2009, so I guess fortunate in some ways, but also, that's where my eyes started to open to everything. So I learned a lot. To your point, I remember putting in almost 200 job applications just to try to find work coming out of college. It was a rough, rough time, and now we've got grocery stores offering $20 an hour just to be a bagger in my area, which is quite crazy.

But the Fed keeps talking about how strong the underlying economy is; of course, those are just their words, not mine. But I think it's important to look at why we're going into a recession. I think that it was a little bit... Well, it was a lot of bit manipulated in 2020. When we have a crash, and then all of a sudden this massive V recovery, and six months later, everyone's doubled their money if you got in at the bottom, that kind of thing.

We're just severely stock-wise in bubble territory, and we're seeing it unfold. And how far does it go? I don't know. I'm with you, Ash, you can't time the markets, but this is why I always advocate for passive income. I don't care if you're a stock investor, a real estate investor, any kind of investor. If you're constantly able to get passive income produced out of what it is you park your money into, you don't have to suffer through these lost decades that we had from 2000 through 2009. Maybe we're going into that again, I don't know.

But the point is, I drew this example the other day on one of my podcasts here on the show, The Actively Passive Show. If you had bought Netflix in 2017 near the end of the year, you're back to where you were today. And that's a company that doesn't pay a dividend, it doesn't pay passive income. So you can do the whole buy low/sell high thing, but I think that's where people are really going to get beat up and hurt, and a lot of this speculative growth hyped up stuff. And it is why the Nasdaq is crashing harder than S&P and Dow, and all that kind of stuff. So something to keep in mind is, in my opinion, always focus on passive income in whatever it is you do. Just some food for thought there, Slocomb.

Slocomb Reed: As an apartment investor with a lot of workforce housing, I'd like to express an opinion; whether or not it is my opinion matters less than having a good conversation about it. So I'm going to put it in a skewed perspective, and then Travis, I want you to comment on it, and then I have a follow-up question for Ash, specific to apartment investing and workforce housing.

Unemployment rates are at tremendous lows, wages are going up, which means that our residential tenants are now more able to afford rent and afford higher rents than they have been in a long time. So there's no reason to project that apartment investing returns are going anywhere. Yes, you may have to get a higher interest rate on your loan now, but there's a strong chance that interest rates go down in the near future and you can refinance, if not sell.

Break: [00:13:54] - [00:15:41]

Slocomb Reed: So the fundamentals with everything going on, supply chain issues, so long as they're not impacting employment numbers in a large way, don't really impact apartment investors or apartment investing, because the fundamentals of this economy are still strong for tenants being able to pay their rent and rents being able to increase. Travis, what's your take on that?

Travis Watts: This would be my simple math. Whether I've got a single-family home, a condo, a multifamily unit, you name it. We're at $1,200 a month rent right now today. I'm going to raise rents, the operator's going to raise rents 10% this year, because of - we'll call it inflation. That's $120 per month, that's $1,400 per year if you want to look at that annualized. So if my tenant has a job paying them $50,000 per year, and they're just getting a modest 5% rent bump in an environment like this, that's $2,500 per year, that's $208 per month. So to your point, they can more than justify a rent bump of $120.

As we all know, multifamily, the common denominator is increasing net operating income. As rents go up, the NOI hopefully is going up alongside it. That's raising the value of real estate. And what is real estate anyway? It's a box of commodities. You've got steel, and lumber and glass, and the whole deal. If these are individually going up in price, generally speaking, real estate's going up with it in price.

So yes, we do have headwinds, which are the interest rate environment. And then we also have inflation, which is generally a good thing for real estate investors, and we have a severe lack of inventory. So that's another bullish case for real estate in general. So those are just my comments to that.

Ash Patel: My contrarian approach... Slocomb, you mentioned the fundamentals of the economy are strong. That's great until they're not. So we have people in the Southeast buying apartments in the high 3% caps. Well, they've had historic appreciation in rents, prices, everything. What happens when that stops? Now, your 3.8% cap property, you got in at 3.5% debt, interest rates are going up, rents are no longer rising. What does that do to your business model? So you're now not able to capitalize on the projections that you had, with a positive economy, with the fundamentals being strong. Now things are shifting in the opposite direction.

I think there's a lot of carnage that's going to happen with apartment operators. I also want to host a Round Table where we talk about the syndication bubble that's happening right now. So I think, if you want to keep believing that the fundamentals will continue to be in your favor, awesome. But at some point, that's going to stop.

Slocomb Reed: Yeah, and that seems, Ash, that's specific to MSA and where these deals are bought. No one's buying a 3.5% cap in Cincinnati, Ohio, where I am, when it comes to apartments. So I can definitely see where you're coming from, and I think we would all admit that if you're buying at a 3.5% cap, unless you're talking about historic financials that are accurate on a deal that has a lot of forcible appreciation because of underperformance, then yeah, you're talking about buying on the speculation that the bull market of the last 10 years lasts another 10 years.

Ash Patel: Yeah, and that's happening though. These are some of the biggest operators out there, biggest syndicators out there, are buying in the high threes, and they're buying pretty much renovated Class A properties, banking on the future appreciation.

Slocomb Reed: Well, Ash, let me merge your dissenting opinion from ours. I think we're all in agreement that if a business plan is predicated upon cap rates continuing to compress and debt continuing to be available at historic lows, then it was a speculative business plan in the first place, and we are now seeing an economic and political climate in which that speculation may turn sour.

What do you think it would take for the economic fundamentals to shift such that someone who was investing with more conservative underwriting and expecting expanding cap rates and not reliant upon historic low cost of debt, what could shift in the economy that would bring a more solid business plan down?

Ash Patel: Historically, we've had stock market crashes for no reason. No predictable reason as to why they've happened in the past. So imagine that, just a panic sell. Let's take all these new Robinhood account holders, that, again, since they put money into their account, it's been going up and up, and they're all, in their own minds, and we were like this in our 20s - we felt we were the baddest stockbrokers out there, because during the tech bubble, everything was going up. Overnight, stocks were just going through the roof. So imagine there's a panic sell, not only in brokerage accounts, but in crypto, NFTs, everything. There's just a mass exodus out of all of these markets. That could bring the economy down very quickly.

Slocomb Reed: How many layers of ripple effect are required though before my tenants who are making $15-$20 an hour are no longer able to make $15-$20 an hour at their jobs, working at places like Amazon?

Ash Patel: Yeah, that's a tough question. It's a great question. I don't have an answer for you. But again, I've seen times -- like Travis mentioned, you're desperate for a job. So when there's massive job losses, you're back to people cannot pay rent, evictions, loss of revenue, NOI goes down, and the market changes.

Slocomb Reed: So to summarize, Ash - and I want to hear Travis's perspective on this as well; when or whether or how the stock market fluctuates is not going to impact real estate investing, at least residential or commercial multifamily real estate investing, until we see it impact jobs and wages. And when we see that, we're probably at the point where it could be too late to adjust. Is that what you're saying?

Ash Patel: Also, keep in mind, there's sentiment. People's opinions of what's going to happen.

Slocomb Reed: Of course.

Ash Patel: Very important. So maybe investors start feeling like they're not going to get proper returns on their apartment investments, or the risk is much higher than what they're comfortable taking on. So that sentiment can drastically change the economy as well.

Slocomb Reed: Travis?

Travis Watts: Yeah. That plays in a lot to -- I just loosely call it, the wealth effect. So what we're seeing right now, as we're recording here this past week, is that your consumer staples are getting hit right now. Target, Walmart, everyone's crashing now all of a sudden, so demand is going down. People are spending a little bit less money than what we all hoped for. So maybe we do head into recession; that's two negative quarters of GDP. We've got one right now. So a lot of people are starting to look that direction.

But yet again, you've got to look at the fundamentals. Why are we going into a recession? We have very, very low unemployment right now. You can't find enough people to work, and we have a weird issue going on at this point. And one thing that companies tend not to do as much - when they're giving people these bumps year to year, these 3%-5% bumps or whatever it is, they tend to not take those away from people because inflation went down and the Fed says, "We're good now, we're at 3%." They're not going to take 20% away from people now. Now it can happen, of course, but generally speaking, that's not the way it works.

So again, I guess back to just my simple math... Look at what you're investing in. Are you speculating on the growth of a Peloton bike and the demand for that in the next five years? Are you investing in affordable housing? Are you investing in water? Are you investing in energy and oil and gas? You've just got to know how essential it is, what it is you're parking your money into. So I have faith that safe, affordable workforce housing is here to stay. I think it's highly demanded today. It has been for 20+ years, longer. And I think that if the government has to intervene, that they'll come up with something. Maybe it's expanding the Section 8 housing, or maybe it's a new program to help supplement rent. I don't think we go from $1,600 a month rent down to $400 a month and everyone loses their ass, so to speak, but just my hopeful optimism.

Slocomb Reed: Any final thoughts as we wrap up this conversation?

Ash Patel: Listening back to the things that I've said, it appears that I might be very negative, but I'm still buying assets, more so now than ever. We're just buying it right. And when I see people doing proformas and they look at, "Okay, I'm buying it at 70% occupied, 30% vacancy," and they have all these different models built out where if I get to 80%, 90% occupancy... Again, in my world, it's retail office, this is my proforma, but I don't ever see anybody model it with "Let's say I go down to 50% occupancy. What does that do? Let's stress test this."

So just keep that in mind. Underwrite both ways, not just the positive NOI. So prepare for some headwinds and stress-test all of your deals. And listen, keep buying assets, don't try to time this market. Just buy right.

Travis Watts: Yeah, that's a great point. It is all in how you structure things. I've used my dad as an example before because he's publicly pointed some of the stuff out. But he has a lot of these single-family homes paid off, and he's like, "I could care less what the economies do. They go up and they go down. I don't have debt on my property." So that's one way to do it, and he's speculating that rents don't drop from $1,500 down to his cost every month. Maybe $400 a month or something.

So there's different ways. You could do less leverage, to your point, you could go super... Let me point this out. Circling back, final thoughts is what your question was, on passive income... I've always looked at cash flow and passive income as the number one metric that I'm betting on, and I have not, since 2015 doing syndications, ever speculated myself on future appreciation of these deals that I do. Now, has it been there? Yes. Will it always be there? Maybe not. So you've got to look at what you're comfortable with, and for me, clipping a cash flow coupon and the percentages that I invest in is good by me. It meets my own goals. So you've got to ask yourself what meets your goals and what's realistic.

Slocomb Reed: Focus on cash flow instead of speculative appreciation in your assets, and be sure to stress-test your business plans and your proformas. Excellent advice, Ash, Travis, thank you. Best Ever listeners, thank you as well. If you've gained value from this conversation, please do subscribe to our show. Leave us a five-star review, and share this with your friends who you know need to hear the valuable information that's been shared in this episode. Thank you, and have a Best Ever day.

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