Here's How You Underwrite Deals During Inflation with Andrew Cushman

wait one of the things that we talk a lot about andrew and you know looking back over the last five or six years is how could multifamily go up any higher yeah what's your outlook on that i mean are you buying right now or you're sitting on your hands like what do you what do you think we're net buyers right now um and you know kind of actually starting at the end you mentioned that we're selling something uh we are we're selling properties in atlanta right now just because we hit our our pro forma timeline and we were like you know what it does make sense to take some chips off the table off the table occasionally uh and it was it's been a really interesting process because i thought that most of the bids were just going to be people like just like so it's only 132 units so it's not like a massive property and we thought a lot of the bids are going to be people just like overly anxious just to get a deal or you know because this property is kind of within reach for a lot of people that was not the case at all out of the 25 legitimate offers that we had at least 20 of them were from very large extremely well funded very sophisticated and groups that own 10 15 20 000 units and they are getting their hands on as much multi-family real estate as they possibly can so that kind of made me stop and think well all right if these people these groups are that confident in multi-family then that helps give us confidence that it still makes sense to buy the right properties in the right locations and so we are still doing that inflation the right types of inflation do tend to benefit multi-family real estate in particular lots of hard assets but multi-family in particular tends to benefit from that and so we are trying to buy as much good multi-family as we can without lowering our standards for acquisition so what that's meant is we are averaging uh having to analyze 220 deals to make 28 offers to win one right but those those those that one that we do win we have high confidence that that's gonna be a great property for the next five you know plus years or whatever what do you mean by good inflation versus bad inflation and what is your outlook on inflation and how does that impact real estate um well if i knew the exact answer to all that um i'd be worth more than musk gates and bezos combined and you know but since i don't have my own rocket to space yet that tells you that i'm not quite there um you know when i say good inflation and bad inflation that that should probably clarify that quote-unquote good inflation for real estate is the type of inflation where we have um wages are going up meaning tenants can afford to pay higher levels of rent and the um cost of building is going up right again there's other negative ramifications of this but this is from the perspective of a landlord right so as the cost of labor goes up as the cost of building goes up the value of the properties themselves go up and um therefore you know prices prices go up and then as wages go up tenants can afford to pay higher rent which leads to increasing operating income and as anyone who's listened to you for a while knows that operating income is what drives this largely drives the value of your property right that's good inflation the i would say bad inflation or the one the biggest scenario that i see as a potential biggest risk is a situation where we have significantly rising interest rates without the corresponding rise of wages and costs right because that means your net operating income is not going up but if interest rates do go up then that means one or two things has to happen um to sell a building that means in order you're either gonna have to sell it for a lower price or the investors are gonna have to accept the lower yield so that would be the one situation that i would see as the biggest risk and there's ways to mitigate that but that that's how i would say inflation that's bad for real estate is rising rates with flat wages and flat income good for real estate is rising wages and income so andrew that's and that's such a great analysis of uh you know inflation but talk to me about what how you guys are actually structuring your deals around that as far as your capital stack like what does that look like nowadays are you guys doing fixed rate you guys going floating uh where are you guys hedging your risk yeah that's in that you touched on a key a key a really key piece of it right um you know the the right you know the wrong debt and and the right property goes together about as well as microwaves and tinfoil right i mean they can really screw each other up if you don't marriage marriage that properly so you know how we're mitigating it um on the most recent property that we closed we actually went with 12-year fixed fannie mae debt and you might say well are you going to hold that thing for 12 years then not the plan no but here's why because that debt gives us a good exit almost no matter what happens with the market here's why uh with 12 year fannie mae debt you can get two supplemental loans so if we get three years down the road and we want to pull some cash out we can and by the way our business plan is to hold this property for six years when we go to sell in year five or year six somewhat a buyer can come in and assume our low interest rate loan so let's say we're in a market where interest rates have gone way up right a buyer can come in and say oh hey instead of getting my own loan at six percent i'm going to take over yours at 3.7 get a supplemental i have a i have a low blended rate and because of the extra supplemental that buyer can get all the way back up to 75 leverage so we're not getting hurt on the having to have a buyer bring in ton of leverage so e so they can keep our low rate and get the leverage so it's the best best of both worlds for the buyer what happens if interest rates are somehow down when we go to sell in six years okay well that means we're going to pay some yield maintenance or basically prepayment penalty on that loan but if rates are somehow down five years from now that probably means cap rates are also lower which means the valuation at a property is probably gonna be even higher and we're probably more than more than happy to go ahead and pay that yield maintenance worst case scenario six year five six years from now somehow the market is in a horrible place maybe prices are way down we can't you know it doesn't make sense to sell or refinance we can hold for up to six more years and write it out right so that's that's one example and there's there are ways to do this type of stuff with bridge debt too but that is one example of structuring your debt with your business plan to give you a good exit almost no matter what happens so this is the thing we're not in the risk avoidance business we're in the risk management business that's that's the definition of entrepreneurship and a lot of people confused i was like oh my gosh how do i what happens if this what happens to that well it's if you want to avoid it then you sit there and you watch news all day long right then you avoid it entirely you said it's all about mitigating you said hey we win whether or not this or that happens it gives us flexibility we don't know what's what's going to happen though it's our business to kind of figure out what the probabilities are right and so you talked about the right kind of debt on this and it's you know in the beginning it was just like well we're just going to lock in the 10-year fixed debt at five and a half percent because it how can it possibly go lower you know because you in the beginning you don't think through these things but you want to think through those things and again you are you do think in probabilities and one of the things that i think people are concerned with is interest rates going up now you just said that oh my gosh you know the next 18 to 24 months is not likely to go up okay that's great and then what right you know what is the risk and what is the mitigation of the risk if interest rates were to spike up when you talked about this bad inflation right if interest rates go it goes up and wages go up and inflation goes up and the rents keep going up well then we can preserve that return that we're looking for somehow right and so uh you know what is your what talking in probabilities like when you as you're underwriting deals how are you mitigating that possibility or how strongly are mitigating that possibility based on what you're seeing in the next five years two um so three things come to mind one we already talked about structuring the debt to mitigate it the other two things that uh immediately pop into my mind as to how to mitigate that are your rent growth assumptions and your exit cap rate right so on rent growth uh what we do is we look at you know take a market like savannah for example you know we look at the historical rent growth for the last 10 years and then we look at the future projected rent growth for the next um 10 years and see what that what those two numbers are and then we will put our pro forma rent growth somewhere a little bit significantly below that right so you know if you look okay well um and actually let me i'll switch to market so we were looking at a property in augusta recently augusta georgia the uh you know for the last five or six years rent growth there has been like above four percent for the next two years uh in this sub market it was projected to be like seven to eight percent and then just kind of slowly trails off after that so what we did is we took that basically a 20-year average and the 20-year average was like in the hot i forget what the number was but we we performed it at 2.5 right saying well if we got a 20-year average that's well above this number and we assume a 2.5 and it's almost never been below 2.5 that is a realistic assumption right you everybody who talks about multi-family these days talks about conservative assumptions and conservative underwriting but no one actually says exactly what that means to me that's what that is like saying hey my 10-year average is three we're gonna perform a 2.5 and if it comes if it ends up at three and a half you look like a hero but if projections are wrong and it ends up a little bit low you're still at least meeting your numbers right the second is exit cap rate right and cap rates are kind of this confusing thing everyone gets all worked up about when you're buying especially if you're doing value-add candidly you don't worry that much about cap rates look at your cash flow your internal rate of return your equity multiple all those things that are real dollars in the bank right cap rate is really more a measure of market sentiment right how excited and eager are investors willing to be to purchase the cash flow that comes from a multi-family property so how do you use cap rate to mitigate risk one way that you do that is when you're buying a property regardless of the state that it's in whether it's value-add stabilized or whatever find out um what the cap rate would be for that property in today's market if it were fully stabilized and fully marketed right so you know let's say you're buying a uh you know 1985 property in atlanta and you know and someone was you know and if that property was you know fully stabilized and you know listed for six weeks you know 37 offers all that okay well this might trade at a four cap and so then what you do is you take that number you're not using that for cap to determine your purchase price you're using it to determine your exit right so how you mitigate the risk of rising interest rates and rising cap rates you use that four as a starting point and then add 10 basis points or some people do 15 we do 10. add 10 basis points of cap rate expansion for every year that you're going to hold the property so if you plan on holding it for five years you're going to underwrite to a four and a half percent cap rate on the exit so what does that do well that significantly lowers your projected sales price from what it would be if you were at a four cap so that's how you mitig what's one way to mitigate the rising rates and cap rate and guess what if those cap rates don't go up again you're a hero at the end because you're gonna just blow away your projections if they do go up well hey you you plan for it you're hitting your numbers um so all these little things added together are what make for you know what i like to say realistic and risk mitigated underwriting [Music]

Channel: Financial Freedom with Real Estate - Michael Blank

Views: 538

Keywords: apartment buildings, investing in apartment buildings, buy apartment buildings, syndication, analyzer, deal analyzer, rental analyzer, real estate analyzer, Real Estate (Industry), Commercial Real Estate, inflation 2021, Real estate underwriting, Nighthawk Equity, Michael Blank, Andrew Cushman, Garrett Lynch, Financial Freedom with Real Estate Podcast, real estate, real estate investing, apartment building investing

Id: ZDRERhuBjtA

Length: 12min 49sec (769 seconds)

Published: Tue Sep 21 2021