Today, we’re going to talk about Lessons Learned From 2023. So, in 2022, we structured over $5 billion in deals for operators, syndicators, sponsors, sellers, buyers all around the country in the commercial real estate market. In 2023, we’ve structured over $3 billion presently this year so far. Out of that, there are some lessons that we’ve learned about things that need to take place and things that I think are important for you. I’m asked by clients all across the country, ‘What are the major things that you’re seeing in the commercial real estate market?’ So, if you’re wondering what they are, then you’re in the right place because we’re going to talk about the top 10 things, in my opinion, that I’ve learned in this market.
Lesson One: Change happens.
The reality is we’ve seen rapid and historic rate rises. We’ve seen over 11 rate rises from 2022 to presently, where we were at 0.25% to 5.5% at the Fed. That’s outstanding from a bad perspective if you’re on the acquisition side. Nobody had predicted that, and that has put tremendous strain on everybody’s assets, regardless of the type of asset if you have leverage on it and you’re in the floating rate debt space. Insurance costs are another factor. We’ve had 20 consecutive quarters with several 100% insurance rate hikes, and there are some markets and submarkets where there’s no competition, literally no competition by other carriers. So, what that allows carriers to do is demand higher premiums than what has been historically averaged for that market or that submarket. That’s a significant change. And then we’ve seen the cost of rate cap. So, this floating rate debt, if you’re somebody who owns a property and you have leverage on it, which is debt and that debt is a floating rate, more likely than not that you were asked and have a rate cap put on that. That is basically a hedge between what the interest rates are going to hike to and what there are. Now, for a crazy statistic, think about this: a property, a three-year rate cap at 3% like a three, a 3% strike rate for one for a $100 million property would have cost $98,000 in April of 2019. And now that same rate cap on that same property at the same valuation is $3.48 million. Nobody can tolerate that type of stress. Your business plan cannot tolerate that type of stress. So, you need to understand and pivot and be flexible and understand that change happens. So, that certainly is one of the top lessons that we learned in 2023, that these changes happen.
Lesson Two: Despite changes, there is opportunity.
So, we just talked about something that was pretty bad, right? The three big key indicators of bad things. But despite that, I am still very bullish on the commercial real estate market. I have clients that sit for a long time on the sidelines with a lot of dry powder and capital, and they are ready to acquire assets. And why? Because there’s such massive opportunity out there in the commercial real estate space. We are living right now in the greatest transfer of wealth in human history. In the next 20 years, over $84 trillion will exchange hands. $84 trillion. A lot of that’s going to be in the commercial real estate market. So, if you’re thinking that you need to wait until things get better and then jump into the market, I want to tell you that that’s a mistake, in my opinion. I think you need to be in the market now or at least looking at underwriting, sending out LOIs that are important for your business plan, because there are assets right now that are able to be acquired at a much discounted price. So, you really need to think about the opportunity that really exists out there. So, that’s the second thing that we learned.
Lesson Three: Adapt to the changing environment.
So, right, you always want to buy a rate cap. So, many of you, there are a few of you out there, right, that did not buy a rate cap even though you had a floating rate loan because no one predicted this historic rise in interest rates. I’m not here to cast stones at people that did or didn’t buy rate caps, but the reality is, be conservative in your underwriting. Understand that if you’re going to be in that type of floating rate stuff, you’re always going to want to try to have a rate cap. Think of all alternatives for insurance. A lot of third-party property managers have portfolio insurance policies that you might be able to take advantage of. Certainly, they’re going to expect your business, and they should expect your business if you’re going to try to take advantage or piggyback off their portfolio insurance policy. But that might provide you an opportunity to lower those explosive insurance costs to be able to actually afford something. And then think about fixed rate or even recourse loans on smaller properties. So, many of you that are in the multifam space, Self Storage, Mobile Home Park, that’s the holy triumph of qualified non-recourse debt. The reality is, maybe with the explosion in the historic interest rates, you might be able to get a better rate at a fixed level, but it’s recourse from a community bank or a credit union. I think you should think about those types of things, particularly if your cash flow and your business model show that conservatively you can meet your monthly debt needs without any additional risk to the KPS or the guarantors that are going to have to be on that loan. So, those are some of the things for adapting to the current environment that I think are very important.
Lesson Four: There are still a ton of 1031s.
When we’re saying 1031, we’re talking about the Internal Revenue code section 1031 that allows people to defer taxable gain on the sale of commercial real property or other types of real property when they buy like-kind replacement properties. In 2010, I’m going to give you some statistics: in 2010, over 170 million was exchanged through the use of 1031. And now in 2023, over $100 billion plus. That’s a massive amount of money that’s on the street and in the market right now. So, if you’re not taking advantage of or talking to individuals that have 1031 exchange proceeds that are looking to deploy into the commercial real estate market, I think that you’re doing yourself a disservice. But you need to educate your 1031 investors that they need to be prepared to provide information to the potential lender, particularly since there’s going to be debt on many of these assets and that they’re going to likely be required to sign the carve-outs on a guarantee, a lot of people call the carve-outs AKA bad boy or bad girl guarantees. That’s where the lender has limited recourse to go after you in the event that one of those carve-outs is actually violated. That’s the limited recourse aspect of it. That’s the bad boy or the bad girl act. Certainly, nobody wants to be a bad boy, nobody wants to be a bad girl. But my suggestion is that you always keep your 1031 potential investors informed about the process so that and you keep an eye, your eyes open, your ears open, and be ready to speak with those people for the possible use of their capital.
Lesson Five: Preferred Equity
I get asked this question a ton of time from sponsors and operators about the possibility of using preferred Equity. When we’re talking about preferred Equity, lots of people have different definitions about what a preferred Equity party really is, right? Most, you got to remember that most agency lenders, and we’re talking about agency lenders, we’re talking about Fanny Mae, Freddie Mac, or HUD, are not going to allow you to have a hard preferred Equity investor in your Capital stack inside your capital structure, inside your equity. And what’s the difference between a hard and a soft pref? Well, a soft preferred Equity partner just takes distribution rights in priority to other common equity, and they might have other special benefits, like in the event of a monetary default, maybe they’ve been underwritten as a replacement guarantor, maybe as a replacement manager, maybe they’re allowed to come into that deal and replace you. Those are types of things that actually can get done with agency lenders or Bridge lenders. But if you’re going to have a hard preferred Equity investor, many of those agency lenders are not going to tolerate it, and some Bridge lenders might not tolerate it either. And so, some of the warning things or issues that you need to be concerned about when looking at preferred Equity is this is really a last resort, in my opinion, or this idea that this is an exclusive arrangement. Remember, the preferred Equity investor does not have any skin in the game. Likely, they don’t have any at-risk Capital other than what their due diligence expenses are, and more likely than not, they’re asking you to fund those due diligence costs. So, if you’re funding the due diligence cost and you’re courting and wooing that preferred Equity investor, and they really have no risk or liability in the transaction, they’re not on the purchase and sale agreement, the senior lender may not even know about them, and they’re doing their due diligence and vetting the contract, and you’ve actually given them money in order to pay for that, that is more expensive than what the retail investor… And yes, I understand that given the size of the property, maybe it’s inescapable that you have to have preferred equity on there, and that’s okay. And preferred Equity certainly has its place in the commercial real estate market. But it’s super important for you as the sponsor, operator, syndicator, the person that’s a steward of other people’s money, that you understand the ins and outs of what that preferred Equity looks like and so you can understand whether it might be a viable strategy for you.
Lesson Six: You’ve got to be reasonable in hunting.
Remember, there’s lots of opportunities out there, but if you’re just getting started in the commercial real estate market or the syndication space and you’re just trying to leverage other people’s money, right, raise money for to reach the down payment to back into the loan to get the keys to the asset that you’re trying to acquire, whether that asset is self-storage, whether that asset is mobile homes, whether that asset is multifam or raw land or whatever that asset might be, I want to encourage you: be conservative, particularly when you’re starting out. So, it’s not uncommon for people to think to go really big really fast. And what I want to say is, think about it first, pause, maybe slow down, think about your business plan in the market where you’re really hunting. And so, a conservative formula might be for you, and in my opinion, it might be a $5 to $7 million purchase price where you’re going to be raising half to $2 million or something even smaller. There’s nothing wrong with starting off small, buying an Airbnb or a duplex or a quadplex or a small 10-unit apartment complex. And those are very doable, very manageable. A lot of people think that they can’t raise Capital from passive investors and they underestimate the strength of your Rolodex, most people underestimate the strength of your personal Capital, that relational Capital that people like you, trust you, want to invest with you. And so, I want to encourage you that you should be reasonable in all of those aspects when you’re hunting for whatever asset you’re looking to acquire.
Lesson Seven: You’ve got to be prepared.
You really got to be prepared. So, remember, Freddie, Fanny, and HUD are the same regardless of the lender, meaning the seer. So, whether you’re going to go with Walker and Dunlop or CBR or some other lender, the likelihood is this, the regulations from Fanny, Freddy, and HUD are not changing. They are saying the same regardless of who your seer, the person that you identify as your lender is often the seer for the agency lenders and they are the same. And then I want to encourage you, this is the year of the operator. So, if you’re somebody that is a little weak on asset management, I want to encourage you to get more in-depth on asset management than you ever thought possible, that you ever thought that you might have to be because this is the year of the operator where operators are going to distinguish themselves by how they asset manage through the volatility in the capital markets. And then you need to keep lines of communication open with your lender. So, a lot of people think, close a loan, never talk to the lender unless I’m going to go for a supplemental loan, a refinance, or a sale. And I want to encourage you to revise that thinking. I want to encourage you to think about keeping those lines of communication open so that if your property falls into distress or you might need some sort of modification or restructure of your loan, that you actually have a clear pathway, a communication portal with whomever you recognize as your lender on that. So that will help you be better prepared, be able to be more efficient, cost-effective, and quicker to be able to do implement changes that might happen.
Lesson Eight: Get Aggressive with Problems
I want to say this is what I call getting aggressive with problems. So, I call this the slow to hire and the quick to fire model. So, the reality is, when you’re vetting potential strategic partners, whether those are property manager companies, rehab consultants, construction, or other types of strategic partners in connection with it, you should be very slow to hire, do your due diligence on people. But if there’s a problem, don’t wait to make a change. Remember, these people might be your best friends. The reality is the lender has the most skin in the game associated with your asset, and the lender has to protect its capital. So, if the lender is forced to foreclose on you because you’re too slow on switching property management companies and being able to manage your costs effectively, then that will be what happens. So, remember PM asset manager shortfalls, Capital calls, member loans, follow-on offerings, these are a variety of issues that you might encounter in the life cycle of your asset and you demands quickness in making associated changes. You need to communicate swiftly with your investors, general partners, and lender. All these stakeholders deserve clear, concise, transparent, and authentic communication throughout.
Lesson Nine: Underwriting and Over-raising
Analyzing the deal is crucial—a somewhat lost art, especially in the commercial real estate market. For newcomers, don’t merely skim through underwriting. Yes, there are numerous software tools teaching the basics, but I urge you to dig deeper. Truly understand how to analyze and underwrite a property’s performance. Over-raising is equally important.
Many tend to raise the minimum necessary for acquisition and stop. However, more funds might be needed for working capital, contingencies, or various fees—acquisition, asset management, or exit fees. Budgeting often hits the minimum raise, but I suggest aiming higher—over-raising.
Lesson 10: Don’t Let Fear be your Obstacle
Finally, fear—an obstacle many face. Everyone deals with fear; it’s part of being human. But are you letting fear paralyze you? Don’t fall into ‘paralysis by analysis.’ Push through. Fear might hinder various actions—submitting a letter of intent, meeting brokers, discussing issues with partners or investors.
Remember, overcoming fear doesn’t mean reckless actions. Shine a light on fear, be transparent, and share it. Press through fear transparently and authentically. Conquering this obstacle is key to success. It’s not about buying everything; it’s about addressing your fears.
Cheers to 2023 and taking all we’ve learned into 2024!
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