The Federal Reserve is aggressively trying to fight inflation with the increase in the interest rate by another 75 basis points in the September session adding to the already 150 basis points during the last two sessions.
As the Federal Reserve is trying to fight inflation, we are inevitably seeing a rise in the cost of our debt service on new acquisitions. This means that cash flows are getting tighter and tighter as the debt service is eating into the profits.
This debt environment makes it much harder for our team to find good quality assets that perform well during a recession and that cash flow enough for it to make sense for us to acquire.
Resetting Seller Expectations
The problem with acquiring assets in this market is that the sellers are still not resetting their sales expectations. They are still seeking to sell at prices and valuations from last year which do not work in the current market environment.
Our team is seeing many deals with pricing guidance that simply does not work with the higher debt service due to the rising interest rate environment.
As a matter of fact, our group is one of those sellers that pulled deals off the table due to the buyers not able to hit the strike prices. These assets are ones that are performing well but if we can go ahead and sell them sooner then we would consider it. We are not being forced to sell these assets, so we decided to not sell.
The brokers are the ones that are providing the potential valuations for sellers to market their assets and the strike prices set by the brokers are not being achieved in most cases.
Our acquisitions team is still actively underwriting, touring, and vetting a variety of deals and submitting offers almost every week. This is helping to reset the sellers’ expectations.
The DSCR Limiting Factor
As the interest rates are rising, this subsequently is causing the debt service to eat up cash flows which affects the debt-service-coverage-ratio (DSCR). The DSCR is what the lenders use to determine whether the asset is spinning off enough cash flow to make the monthly debt service payments.
Most of the lenders like to see a minimum 1.25 DSCR and when the DSCR drops below the 1.25 minimum threshold the lenders begin to lower the loan-to-value percentage (LTV %).
Cap Rates Expanding
As the LTVs are being adjusted down due to the DSCR constraints discussed earlier, we are also seeing the cap rates expanding to a higher point than last year.
For example, in September, we released an offering out of Myrtle Beach, SC, called Banks at Bridgewater, where we are buying the asset direct from the developer. Last year, this asset would have likely traded around a 3.2-3.5% cap rate. Today, we have it under contract for an ~4.2% cap rate. This allows us to still buy the asset where we have plenty of cash flow to distribute to you (our investor) and also pay the debt service.
If we were to buy the Banks asset last year, we would likely be paying $15-20mil more for the asset. Being able to buy the asset at a more favorable basis, allows us to have an even greater runway for higher returns when we are ready to sell in the next 3-5 years as interest rates start to fall again.
Investing Now? Yes or No (or Maybe)
There are always opportunities to buy assets in any market condition. It is my opinion that you should always be looking to invest, as money sitting in a bank account does nothing for you. Well, except for losing value due to inflationary pressures.
It is our team’s job to find these great quality assets at great valuations, that allow us to set ourselves up for capital preservation and a solid return in a tumultuous market cycle.
Looking at the Banks at Bridgewater deal, this asset is poised to perform very well throughout the next 3-5 years. The asset is located in the fastest growing mid-size coastal city with an astounding 37% projected increase in market rents. We have conservatively underwritten the offering at an ~4% YoY rent growth which allows us a ton of opportunity to increase the rents over the next 3-5 years and keep up with the projected ~7.4% YoY rent growth estimates.
Can Rent Growth Continue – Supply vs Demand
Many of you have raised concerns over whether or not we would be able to hit some of the rent growth projections and the concern is valid. Continued rising inflation allows us the opportunity to increase the rents which exponentially sets our investments up for success.
The reason why rents are growing across the markets that we are investing, is that the demand for housing continues to increase. With the migration of people away from cities that have less favorable tax situations to markets like Florida, South Carolina, North Carolina, Georgia, Texas, and Arizona, an already high demand for housing continues to rise, causing the supply to be limited.
With limited supply and higher demand for housing, we are able to continue to raise rents, due to this imbalance. As long as people are continuing to get paid higher wages and demand stays high, then we will continue to see the ability for us to increase rents.
Single family housing prices are also at an all-time high and this has priced out some of the typical first-time home buyers. These people are being forced to rent, or at least continue to be a renter, which is, again, affecting the demand for rental housing.
Self-Storage Recession Resiliency
This article has primarily been focused on the multifamily asset class; however, many of the principles discussed also apply to our other asset classes including self-storage assets.
Self-storage, much like multifamily, has historically been a recession resilient asset class. As people are downsizing in a down economy, they need a safe, secure place to storage their stuff.
As more people are forced to stay in the rental market, this also increases the demand for storage which allows us the opportunity to increase our storage rates across our self-storage portfolio.
We have an open opportunity for self-storage right now which has room for a few more investors and this would be a good way for you to continue to diversify your holdings as we set our portfolio up to weather any type of economic storm on the horizon.
Bottom-line: Should You Invest Now?
Since 2015, many investors have been sitting on the sidelines. I have spoken to many of these investors who want to sit on the side lines because they are scared to invest. They think the valuations are at a peak and they are “waiting for blood in the water.” The problem is that those investors have been missing out on an excellent opportunity to earn returns like we have never seen.
I truly believe this is a great time to invest your hard-earned money to see some great quality returns during these times.
One of the best things you can do is find an operator that has skin in the game and that is using conservative measures to find assets that meet the criteria for solid returns. Also, an operator that sets up their assets with ample operating reserves that should allow us to weather most economic storms that may be on the horizon. This mitigates the potential for capital calls in the future.
If you still have questions, I encourage you to schedule a one-on-one phone call with one of our investor relations team members so they can provide answers to your questions or simply talk through a situation that you may have right now.
One final thing to remember is our real estate debt fund. If you have stagnant capital sitting around, or your own capital reserves, we can help you earn a solid return while not locking up your capital for an extensive amount of time. Email someone on our team for details on the debt fund if you are interested in investing.