One December 11th, 1958, an Argentinian man by the name of Nicolino Locche stepped into a boxing ring for the first time. He was small, had no power behind his punches, abhorred training, exercise, and a proper diet.
He also smoked two packs of cigarettes a day, often smoking a cigarette in the ring between rounds. However, despite all this he managed to build one of the most impressive careers in boxing history, with 117 wins and 4 losses.
So how did a boxer who couldn’t punch, and was seemingly determined to stay in poor physical condition manage to have such a successful career? The answer is that Nicolino Locche was a defensive genius.
His form, and defensive maneuvering was flawless, and the effortlessness with which he slipped and rolled his opponent’s attacks earned him the nickname “the untouchable”. No matter how violent or aggressive his opponent, they could not land a punch, and Locche’s defensive style would often wear down his opponent to exhaustion, frustration, and defeat.
So, what does an Argentinian boxer have to do with real estate investing?
Well, in times of volatility, having a defensive investment strategy can be the difference between persevering through tough times and losing everything.
Defensive strategies for the passive investor
As a passive investor almost all the defensive strategy occurs prior to making an investment. You need to do your research not only on the market, and asset that you are investing in, but also on the sponsor. You need to be absolutely confident in the sponsor’s business plan, the ability of the sponsor to execute the plan, and believe that the sponsor has the experience necessary to lead the business through challenges when things don’t go according to plan.
You should also speak with the sponsor prior to making the investment and understand the expectations for ongoing communication after the investment is made. How often will the sponsor be providing updates, what should you expect in these updates, and how can you get in touch with the sponsor if you have questions?
I have investors that email me almost every month with questions, or just to chat about the investment and what we are seeing in the market. These are some of my favorite investors because they are actively engaged in monitoring their investment, and as a passive investor this is the best defensive action you can take after making an investment.
Defensive strategies for the active sponsor
For the sponsors of an investment, defensive strategy is an active and daily pursuit.
The three biggest risks facing sponsors today are:
- Increasing uncontrollable expenses, such as property taxes, and insurance
- Increasing cost of debt service due to rising interest rates and the expiration of interest rate caps; and
- Risk of declining rents due to increased unemployment
The most important part of managing these risks is taking a proactive defensive position, by first knowing that these risks exist and monitoring their potential impact on the investment.
The worst thing that can happen is to be blindsided. By the time one of these factors have had a material impact on the business, it is already too late to take meaningful defensive action. That is why forecasting future revenue and expenses is so important.
As the cost of insurance and other expenses are increasing in all markets at the moment, you need to make sure that the operating account has enough cash reserves for the property to afford these increased expenses. Generally speaking, you need at least one month’s gross collections plus any potential unbudgeted increase in expenses. For example, if your property collects $230,000 a month in revenue, and your insurance premium increases by $100,000 more than the amount budgeted, you will need a minimum of $330,000 in the operating account.
It is equally important to forecast future revenue with a sensitivity to declining rents. You need to know where your break-even rents are and be monitoring lease trends weekly to ensure that you are accurately forecasting revenue going forward and that the business remains cashflow positive. In times of extreme volatility, you may even need to rewrite the annual budget midyear.
Knowing your market is key
It is also important for the sponsor to continuously monitor the market environment. This includes performance of the local economy, recent trades of similar properties, and new supply of competing product, in order to understand the current value of the project if you had to (or chose to) sell today.
Many sponsors in variable rate debt are not able to refinance in this current interest rate environment. At some point, this will lead them to a choice between selling now or finding a way to wait out market conditions and hope for improvement in the near future.
It is no surprise that now would not be an ideal time to sell. Given the increased cost of capital today, values continue to fall, and although general lack of inventory has kept it from becoming a total buyers’ market, the sellers’ market of the last few years is long gone.
Fortunately, rents have grown very impressively over the last two years which has created a lot of value for sponsors who have held the property for at least 12-24months. Some will be able to see a profitable sale even in this weaker market, but others have not seen enough growth yet to realize a profitable sale and are left to find a way to hang on and ride it out.
Will Rescue Capital save the day?
This exact situation has led to resurgence of the investment product known as “Rescue Capital”. Sponsors can seek out short terms loans from investors willing to provide this rescue capital. These loans can be used to cover shortfalls in operating capital, to purchase extension for interest rate caps, and to hopefully buy the sponsor the time they need to turn the project around, or just wait out poor market conditions.
This can be a reasonable solution in some situations, and it does avoid the dreaded capital call. However, it is important to understand that this rescue capital does add an extra element of cost and risk. After all, it is a loan, and it pushes the common equity investors further back in the capital stack.
If the sponsor is unable to turn things around or the market conditions do not improve, they may be forced to sell and liquidate in which case the senior lender will get paid first, then the lender of the rescue capital, and if there is anything left after that, the investors will then receive payment.
Communication remains paramount
When there is uncertainty in the market, communication between sponsors and investors becomes more important than ever. This last year has brought unprecedented change to the real estate market and forced many sponsors to pivot their strategy to accommodate the rapidly changing conditions, all of which is completely understandable, given the circumstances.
However, it is very important to communicate any changes in the business plan or market conditions to investors so that they understand in real time the status of their investment. It is almost always a lack of communication in situations such as these that lead to poor investor experience.
Keep an eye on the horizon and invest for the long term
Despite the many operational challenges facing multifamily investors, I still believe that most of these investments will deliver on overall returns over time. Real estate investing has always been a long-term investment, and although the scenery of the current market might not be pretty at the present time, the view on the horizon looks bright.
With housing still being dramatically under-supplied in many markets, and the ever-increasing construction costs slowing down new supply, rental housing is expected to remain in high demand long into the foreseeable future.
I also believe that the Fed’s aggressive interest rate hikes, and rising cost of insurance have provided the market a much need reset, and as prices continue to fall, I believe we will see a window of opportunity to purchase some quality deals for a great basis that we haven’t seen in a few years.
So, keep an eye out for opportunities on the horizon, and remember the importance of a good defensive strategy when considering new investments, and managing your existing portfolio.