Episode 120 - Navigating the Storm in Commercial Real Estate: Investment Opportunities Ahead

Today hosts Braden Cheek, Brian Duck and Joel Thompson discuss how to find potential opportunities within the coming market correction.

Guys, welcome back to another episode of How to invest in commercial real estate. And uh we got a good topic today. We thought we'd focus on market conditions because we've kind of got a storm brewing in commercial real estate. And you know, we don't want anybody to be scared about that, but the storm might bring some opportunities and we want to make sure we discuss why is there going to be a storm? How bad is the storm gonna be and why will the storm produce investable opportunities that you guys want to take advantage of? So that's, that's the topic today. It's kind of a paradigm when you think about it, it's a storm and it's causing it could be causing all of these potential foreclosures. But at the same time, it's massive opportunities. So interesting one to walk through, you know, storms also always give an opportunity for um good deals and, and you know, if it's hard for you guys to conceptualize why that is with commercial real estate, just compare it to something that you're more familiar with, which is investing in the stock market. If you haven't lived under a rock and you're not still in high school and you're an adult and you have any money invested in the market, you're gonna know that the market goes up and the market comes down and you're also gonna know that the best time to buy is not at the top of the market, but it's at the bottom of the market.

The problem is, is when the market's crashing, nobody wants to buy, they're all afraid. Uh And so when you think back to 2008, the market's crashing and crashing and crashing and everybody's, you know, it's crashing because people are selling right, they're selling their stocks causing the pricing to go back down. But generational opportunities were available to all those that purchased stock uh after the 08 crash. So let's let's capture that right. Somebody buying stock in the 08 crash had the ideally I ideal that there's an opportunity here. It's a discounted stock today. There's risk associated with it. But I believe in this good stock and that in a good economy, it'll be a good investment. And we, I think we have to put those same glasses on when we're looking at real estate opportunities, right? Because it's not like you're just gonna walk into this amazing opportunity. It's gonna cash flow, amazing in this shitty economy. No, it just got foreclosed on like you're, you're buying, it may have no cash flow. It exactly. It may have no cash flow. It may just be in a, in a great location or, or somebody maybe just over leverage it and there's, you know, not much wrong with it, but the thing is you're still having to wait for this good economy.

Right. But you're, you made your money on the buy, I guess, is what I'm trying to say. And I think the, the market bottomed out in maybe March of 2009 if I have to remember and, and it bottomed, the, the dow bottomed out at like 6000. Ok. What is it today? 35,000, right? Six times 600%. Now, it's been a few years. It's been 15 years. But if, if you could, you know, you know, raise your, your, your invested capital six times 600% and you know, 15 years you would do it. Uh So uh let's move back to real estate then why is there a storm coming in real estate? Uh And we're gonna try to answer that for you first is if you, we should put up, I'm gonna give you uh the, the graph of interest rates. I wanna do that. Are we doing like Wall Street Prime or? Yeah. Yeah, just like the US Treasury 10 year treasury note, right? If we, we're gonna graph that for you, what it, what it's done in my entire life is gone from up here all the way down to almost zero down here.

And, and so through that process, real estate pricing has gone up, lending has been more aggressive. And so after the crash, real estate was kind of depressed, but since the crash of 08 real estate's done nothing but take off like a rocket ship all the while interest rates driving down. And so that, that and so those, those things correlate with each other, uh the, the more uh real estate goes up, the more uh equity people can pull out and the more they can go buy more and then as interest rates go down, the more they can pay for new assets. And so it kind of feeds on itself. Yeah, you gotta imagine like a guy on a street corner saying, you know, I, I give away money for 3%. Like you can do a lot of stuff with 3% debt that you can't do with 8% debt. I mean, that's a, that's a massive amount of money. I, I did some rough math. A 2% interest rate change on a $5.5 million loan is 100 and $10,000 a year, 100 and $10,000 a year. That's probably the entire return they were expecting on a $5.5 million loan in the first place.

It could be. Could be. Ok, so Joel, uh, it's done nothing but go up. Why do we think that the prices are gonna go down? Why do we think there's gonna be some decrease in prices and some good deals out there. Well, first of all, why did the prices go up so much? Uh one in inflation? Ok. Uh It moves along and it was pretty low for, for years after the crash of 08. Uh But what we had is a perfect storm of extremely low interest rates. We had COVID where uh trillions of dollars were pumped into the economy, right? Causing massive inflation. Inflation is typically at one or 2%. It was all the way up at like 9% 10%. And so, and with all this money in the economy, it just, it just flooded money into commercial uh real estate assets. Well, it's, it's amazing when you shut down the economy, you have to mail everybody money rest stimulates the economy and when you think about it, that's, that's what we did. And right, right now we're taking money out of the economy and we're raising the cost of interest rates to try to slow down. Right. Yeah. So the main reason prices are gonna come down uh is that interest rates have doubled. So we were borrowing at, I mean, there was, I got a hud rate.

Uh I didn't close it but I the rate it was like 2.62 0.8%. Uh you Fanny Fanny Freddie debt around the same 3%. We had, we had commercial retail loans from just banks at uh 3.5, 3754. Well, today, uh, you're looking at 7.5, you might get a 6.5 or seven, from like a Fannie Freddie, uh, which is still double the 3% that it was. And so what that does commercial real estate, you know, it's a leverage game and most commercial real estate uh built on borrowing 60 70 80% of the total with that debt. And so that if the debt gets more expensive, it limits the amount you can pay for that asset and still make money. Um So these rise in interest rates, especially as fast as they're happening. I is gonna cause uh prices to come down. Some because people just can't pay what they normally pay. Now you say, well, why don't they hold it some, some will hold it. Ok. But eventually people have to sell for whatever reason, they may have a loan coming due. They may have a death in the family. They may need the money for a business venture.

Just some reason people need to sell and, and so forcing people to sell when interest rates are really high, uh causes uh the prices to tick down. Well, could there also be a situation where it, someone has to refinance and, and refinancing at the new interest rates? They can't even their, no, I doesn't even cover the increase in debt service and they're either gonna like we said before, either give it back to the bank or they're gonna need a, a fire sale. Right? Yeah. So we, we can't forget about how these loans work. Like Joel said, it is a leverage game. That's, that's how real estate is played because you're leveraging the bank's low rates to make a higher return on less amount of money. That's, that's the name of the game, right? So when a loan is expiring and you have to go refinance that they're going to quote or an appraisal or, or selling the property, it's all gonna be the same thing. A bank's gonna say, yeah, I'll give you 75% loan to cost or loan to value or a 1.25 debt service coverage ratio whichever's less, right? So, but it, but it has to cover, right.

They have debt service coverage ratio requirements and they want you to cover the cost of the debt service by at least 1.2. So that's your leverage rate and in today's rates at, at, you know, 7% or double whatever it is, that means your leverage rate could be 50% right? But you went in and borrowed 75%. So now the bank is saying no, you know, yeah, we'll refinance this but you owe us $2 million. Where are you going to get that? $2 million? You, you can't get it from loan proceeds if you were to sell the property, you probably couldn't get enough funds to pay off the loan. So that's when this is going into foreclosure. Yeah, if you, if you purchased real estate 15 years ago, um, then, and you, and you maybe haven't refinanced for whatever reason, maybe you got a long term loan. Yeah, you're ok because the property is appreciated in value, the income has gone up. And so when you, if you did go put debt on it, even if the debt's higher, it'll still cover the debt service. Uh, what? Well, the problem is gonna be is that we've had, you know, from about 2016, 17 until now, but especially 2020 2021 is, is that the prices were going up so fast and, and the debt was so cheap that people just were buying at the very top of the market and they may, they may have not, uh, fixed their, their interest rate, maybe they got a bridge loan, maybe they got a five year fix.

Well, if you bought in, in 2018 and you got a five-year fix and let's say your rate was three. Well, now your loans coming due and you haven't had enough time for that property value to go up enough or for the income to go up enough to handle double the debt service. You haven't paid down a whole lot of five years. You haven't paid down much of anything. And so those are the people that are gonna really struggle when they, when they go to refinance, those are, that's where the opportunities are gonna come. It it adds a lot of risk on the business plan, right? Because the the best asset and an amazing business plan, like if, if you needed 5 to 7% rent growth, you get an amazing asset, you probably got that. But for a property that was maybe on the borderline of working it, it's, it's now definitely not working, right? Because the the cost of this debt is just so expensive. Let me give you a real life example. Uh maybe a couple of them but one uh about three years ago, three or four years ago, uh I got hit up uh by some guys out of uh Texas. I won't give the exact city or the exact property name, but they call me and they're like, hey, we're looking for equity, your name's precision equity.

Uh Do you guys wanna invest with us on this apartment deal? I'm like, well, I happen to specialize in, you know, workforce housing apartments in, in Tulsa, which one is it? And they told me and it's really close to stuff I own. And so I, I know what I paid for mine and this is across the street and, and they said, well, we're gonna pay this X price, you know, uh I think it was like 65 a door and I was like, guys uh that, that's a heavy, that's a heavy price for that. And, uh, they're like, oh, yeah, well, we, we've just been hit, hitting home runs on buying apartments and we're gonna buy this, we're gonna put bridge debt on it, which means bridge debt means that it's, it's most likely floating and it's short term because they couldn't get a better long term option. Well, I think, I think the reason they put bridge debt on it is because they were in this mindset that everything's gonna keep just going up and we're gonna fix it up and then we're gonna flip it for a million dollars, 2 million $3 million in profit. So they didn't want a long-term loan because they were gonna fix it up and gonna sell it for profit. They didn't want that prepay penalty. So, uh I said, guys, look, I, I don't feel comfortable at this price level, uh paying for this asset in this location in Tulsa.

And I asked him like, when did you guys, when did you guys start investing in multifamily? And they're like, 0 2016, you know, and I'm thinking, well, that, that, that answers a lot because they've never had a loser, right? 2016 till the time I was talking to him, the market was just shooting up and interest rates were plummeting. And so they thought, man, every deal we touch is gold. We are so good at this. It's like the, the wolf of Wall Street Line. Can we just cut that in? I tell all my clients don't judge me by my winners. I asked them to judge me on my losers because I have so few. So, uh, you know, fast forward three years. And, um, and it's in, it's in Receivership. Right. It's getting foreclosed on. And, uh, I think, I think they paid 65 a door and I, the, the whisper price is that I might be able to buy this thing for 40 45 a door. So not only are they losing 100% of their equity, the bank might be losing millions of dollars as well. And that's just one example of how this thing is gonna play out. Um So let, let's say, let's ask this question real quick and then we're gonna, we're gonna dive into how to take advantage of the opportunity.

Why is, why is criterion and why is precision? Why are we not at risk? You know, why can't we get hurt from the storm? Yeah, I mean, uh just a year or two ago when you said, you know, debt was so cheap. I, I think very specifically we were paying more than the cheapest option to fix it for as long as we could. So they would, everyone always quotes a five year rate. They just kind of do. But we said, hey, would you guys fix it for longer? Would you guys do? Seven years? Would you guys do 10 years and, yeah, they may be, you know, 2025 basis points more expensive, maybe more, you know, depending on, on where you're at or how the economy is. But a lot of the times that's, that's worth it. Right. Because if you have any disparity on, um, or, or any disparity in, in rate, like, say you could borrow at 3% for five years. But if you want to lock it in for 10 years, it's 3.5 or 375, like debt doesn't need to go up that much for that to be a home run of a deal for you. Like it's, it's less than a point of disparity and interest rates move within a point all the time.

I mean, they're, they're constantly fluctuating. So fixing for as long as possible and be willing to pay for that fix um, in an increased rate premium I think is, is valuable and, and we did that, right. So we have lots of deals that are locked for for 10 years and, and neither precision or cri criteria, neither one have any variable rate loans, right? Um Well, at least on existing assets, maybe on a, maybe on some development. Yeah, on, on development, we have a, we have a few. Sure. Um but not on a, on a completed asset. Now, I would say the same thing. Uh we really focused on uh fixing the debt for as long as possible. That doesn't mean guys that, that we have zero exposure. Ok. Sure. Uh, I have some loans that are coming due in the next couple of years and so we'll see what interest rates are doing, uh, two years from now. But yeah, we have, we fixed as, as many of them as we could for 10. Uh, and if we didn't fix them for 10, we fixed them for five and a lot, a lot of the loans that we have, we refinanced kind of in the COVID post COVID world where the interest rates were really, we were, we were, you know, refinancing and fixing for five years at least, you know, so we, we have a, we have maybe some exposure but not very much.

So worst case when uh maybe some of these loans come up due in three years or two years or whatever, I suppose, uh we could refinance, maybe distributions might have to get cut back for a while until interest rates drop further. And then we can refinance at a lower rate and then start to catch back up on distributions. Is that, yeah, for sure. It's whatever you have to do. Uh in that scenario. Yeah, and, and keep in mind, we can always change the leverage, uh Fulcrum, you know, we, we can always change that. We don't have to be so high on the leverage and that, that gives you less yield, but it gives you more security. So I think you're constantly evaluating that and then even, even more than that is timing, right? Like we've seen the writing on the wall for years on this. We've been, we even actually missed out on deals because we thought this was coming several years ago. And so we passed on some stuff that like, like the one I was the example I was telling you guys about where I was like, no, this doesn't feel right and we passed and sure enough there they are in foreclosure. Um So what what I'm getting at though is nobody got surprised with, oh shit, debt's expensive.

I woke up one day and debt's 8% right? So if you have loans, you should know when those loans expire and if you see, you know the the debt market going to hell in a handbag and getting expensive really quick, it may be worth a conversation to you're a lender a couple of years before and hey, I see debt starting to tick up a little bit. I've got a loan expiring in a couple of years. What would a refi look like today? Can I go ahead and lock that in? Yeah, yeah, you can. That's a, that's a great idea and there's things you can do proactively to prevent yourself getting foreclosed on. Um thinking, you know, everything that and you know, again the banks give you a leverage point and a debt service coverage ratio requirement but you can still go get like mezzanine debt or a second loan or un some sort of unsecured loan, the more you borrow, the more you're at risk because they're guaranteed terms. A lot of investor equity isn't it, it isn't guaranteed recourse. They don't have guaranteed minimum rates that you have to pay out. I mean, debt is just inherently a lot riskier um in the form of recourse than, than equity is ok?

So now that we've talked about why there's a crash coming and you know why we may or may not be exposed to it. Let's talk about the opportunity because that's, that's really what we wanna focus on is the next, the next few years are gonna provide a lot of investing opportunity and to go back to the example of getting foreclosed on, you know, it, it some uh owners are gonna get double whammied when they uh it's time to refinance their debts due. The debt is double and oh, they had a huge tenant or to move out like right before they have to refinance, which significantly dropped their noy. And so there's gonna be people that just didn't plan on that and they go to refinance and they can't, they can't refinance because they, they borrowed 80% and now they can only get 45 you know, percent debt on it and, and they can't sell it because they, once again, they have to pay off that note at 80%. Uh And so it's just gonna put a lot of people in a very difficult position. And once again, it's not everybody, but we don't need everybody to be foreclosed on that would be catastrophic.

All we need is one out of 100 or one out of 1000 because that, that still has a lot of properties to pick up on the cheap. Uh And so we're excited about this because we feel we feel like there anybody that was new to the investing business, you know, in the late, you know, 20 teens, early, uh 20 twenties and they, they just felt like they couldn't miss, they couldn't lose and they, they got cheap debt and they didn't fix it for long enough and they overpaid for the asset. And, and so those are the ones that we think are really gonna have a hard time and we're excited about not excited about them going through foreclosure, but we're excited about being able to pick up assets at really low uh price points. Now, like you were saying at the beginning of the show, it doesn't mean that it's gonna look sexy or that it's gonna look like a good deal or it's gonna cash flow. Ok. The thing about good deals, I'll say it again, good deals don't look like good deals otherwise everybody would be buying them, right? So they're gonna look a little messy, they're gonna look a little risky. And so but if you have really good fundamental market knowledge, you're gonna know.

Ok, this apartment complex, the one I was talking about earlier, it sold for 65,000 a door. I can buy it for 40 a door. It probably doesn't look like it's worth 40 a door today. Maybe it looks like it's worth 30 a door, but eventually it's gonna be worth 65 again a door. And so there's millions of dollars of profit there. So can I get that asset, get control of that asset and break it even make it work and wait for these rates to come down and wait for uh inflation to do its magic and then sell later. Uh That's what we're looking for. It's hard to make sense of now without forgetting some of the competition in a good economy, right. In a good economy. These assets are going out sometimes unpriced, sometimes with a dozen or more bidders. And it's hard to stand out above the crowd and it's hard to buy great deals. We can't forget about those times because that's, that's a lot of the advantage right now is getting the opportunity to buy that asset. A lot of people can't make it work, they won't make it work whatever it is. But like you said, if it looked like a great deal and a great economy there, there'd be a dozen people bidding on it and it would be hard, you would end up driving the price higher and higher and higher and making less and less money.

So that's a lot of the advantage right now is you kind of get to take your pick? Oh, that's, man, that's a great asset. Nobody wants to buy that right now. Nobody wants to buy that right now. If I can just buy it, I know it'll be good. And if, if it's a, if it's that much of a stretch, you know, right now, like it's, it's got to be a great deal again later on in a good economy. That's, that's how you gotta model it up. You gotta model it up now and make sure you're not gonna lose your ass and you need to model up a stabilized version and what you think it will be in a good economy. So another example II I told you I'd give you a few, you know, Brian's entry into commercial real estate. Uh was exactly this scenario. Ok. We had been investing in apartments uh in like 2005, 67. Ok. That was the run up. Uh everything was hot and, and then the, the market crashed and so some of those same apartments that were going for 30 40 50 a door, we were picking up in 2010, 11 12 for 9, 10, 12,000 a door.

Ok. And so uh one of the first deals that we, we bought, we bought a package of 318 units at 9000 a door if you can believe that 8900. Uh and so then we, we wanted it at auction and once again, it didn't look like a good deal. It looked like a lot of work and a lot of risk. But I, I pitched you on it and, and you invested and we tripled your money or quadrupled your money. And so guys, that's what we're talking about here is those opportunities. Hopefully we're savvy enough to take advantage of them is there can be some huge returns, buying foreclosed assets during a market crash. Uh, and we hope that we get to see those. The beautiful thing I love about that story is you guys aren't the, the only ones who've made millions of dollars on those same shitty apartment complex since you guys have sold them for a bargain to somebody else. They sold them to a bargain for somebody else made millions of dollars. They sold them to a bargain for a bargain to somebody else who made millions of dollars. Right? So that's how this works. If you think about it, if you guys held on to it now, like, hey, we bought these for 8900 and they're worth $50,000 a door or something crazy. Yeah. Well, so there's always that question. I mean, if you hold on to them too long, they'll, they'll be worth 30 again.

Instead you go back down. Uh So you always want to try to time it. But, but hey, we made a lot of money and we left enough money for somebody else to make money. Um, but that, that's really what we wanted to talk about today. We wanted to talk about, uh, the crazy run up the high prices, the low interest rates that's caused people to lose their minds. Hey, and people made tens of millions of dollars. During this time, we passed on apartments, literally passed on apartments that could have made us millions of dollars thinking like, oh, I don't want to pay too much because we might have this market crash and we might have the interest rate rates rise and yet it didn't happen for another two or three years because of COVID. Well, now we're, we're finally to that point and so we're, what we're doing is we're sure shoring up our assets. We're making sure that all of our debt is fixed as long as we can get it. I think most of our debt goes out to 2025 2026 which I expect interest rates to be a little lower by then. And then we're, we're really looking for, uh people that, that paid too much, didn't fix their interest rates, got bridge debt and we're looking for those foreclosures. We're looking for the fire sales.

Uh, and I think, you know, maybe not this year, but I would say 2024 we're gonna be able to pitch you guys a lot of those good ideas or those good properties. And hopefully, you know, we can make triple the money like we did on, on Brian's first deal. I'm ready. I want triple my money again this time. That's, that's all you. That's all he wants is to triple his money. He didn't ask for a lot, this guy. Ok. Well, that's, that's a great show. I think the big overwhelming theme, right? If you own real estate, you probably have a loan, pay attention to your, your debt markets, right? You've got to keep uh a fine tune on that now more than ever. But, um, that is it for today's show. We will catch you next time on how to invest in commercial real estate. Thanks guys. Thanks guys.