In todays email:

• 💬 State of the market: Rates, house prices, vacancy and inventory.

• 😉 Mortgage Note Investing: Are my note purchases making money?

• 🫠 Syndication Investing: What sectors are working today and which are about to undergo a melting down.

State of Real Estate

• Interest rates continue slow grind up and remain elevated in 2023 and staying well above 7%. Oct 5 rates closed at nearly 7.5%. This is killing the mortgage market and the ability of people to buy homes at the elevated prices.

• Home prices have come down somewhat and in Q2 2023 the median sales price in US was $416,100 (off the peak of around $480,000). Not all areas have seen this reduction and in fact some are still seeing increases (all real estate is local). Bottom line, the higher rates are putting some downward pressure on prices but housing supply still remains low.

• The rental vacancy rates are ticking slightly higher to 6.3% from the 5.6% lows. This will probably increase slightly more as many new apartments come online.

• Homeowner vacancy rates continue to slide and now at historical lows of around 0.7%. The homeowner vacancy rate is the proportion of the homeowner inventory that is vacant for sale.

• The housing inventory (days on market) has come back down to 48 after spiking to 72. Again the inventory is staying stubbornly low due to high interest rates and everyone staying in their current home.

Mortgage Note Investing 

I am consistently buying mortgage notes, but today I want to focus the discussion on 8 NPLs (non-performing loans) which were all Home Equity Conversion Mortgages purchased in late 2022/early 2023. Most people know them by the name “reverse mortgages”.

I purchased the debt on the property (i.e. the mortgage note) and all borrowers were deceased and were 2-3 years delinquent and none of the family members had any interest in keeping the property.

So what happens when the property goes to the foreclosure auction sale? Either the property reverts back to the lender as an REO (Real Estate Owned) or a 3rd party investor buys the property for the opening bid or higher.

The below chart are the raw numbers for the 8 assets purchased. You can see the note price, the hold time and the profit. I usually set the opening bids based on approximately 80% of the value of the property. We have seen over the years that has worked pretty well as a starting point for the bidding. If we really do not want the property back we will start the bidding off even lower.

In each case, the total amount owed was much higher so the the bidders could bid up the asset price but the total payoff is the most I can collect. For example, the Oklahoma City, OK asset had a full debt payoff of $145,000 and I started the bidding at $100,000 and it bid up to $116,500. Now, I could have started the bidding at the full payoff of $145,000 but most likely I would have gotten the property back and I did not want to have to do the rehab and hold the property. Instead, I made around $43,000 (~96% annual return) and did not have to do any rehab to the property.

As you can see, not all assets had interested bidders. In fact, the top 3 in the chart were asset that we got back at foreclosure auction as lender (called REO - Real Estate Owned) as a result of no 3rd parties bidders at or above the opening bid. Now, we are in the process of selling these assets (light rehab and sell). The profit on the chart is a projected profit based on a conservation sells price and completing the process in 1 year. 2 of the 3 properties have undergone a light rehab and the third property I am going to sell as-is to an investor. I expect a total profit of around $79,000 for the 3 assets which results in a 45% IRR* for those REO assets.

We also have 5 assets that did sell at auction to a 3rd party bidder and the results have been excellent with a net profit of $157,000 which equates to a 55% IRR*. So in other words, our initial capital of $328,982 returned $157,019 in about 11 months.

*IRR = internal rate of return

Syndication Investing

I want to provide you with a few of my recent syndication investments and give you some idea of what's working and what is not working in today's market. This is not an all inclusive list, but gives you some idea of the possibilities.

Apartment Investing:

Boise, Idaho

In 2021, I invested in a new construction class A apartment community in Boise, Idaho. This was a 160 unit ground up construction. I normally do not like to do new construction since there's so much that could go wrong and the timeline is very long. However, this area was seeing strong job growth, increases in rents and high demand for apartments. The Boise MSA is one of the hottest real estate markets in country, with vacancy at the time of under 1% and rents growing by 5.2%.

The sponsor had secured a fixed-price contract that could deliver the apartments at a cap rate which would generating significant equity for all the limited partners investors. The one thing no one expected was the rapid interest rate increases and by the time they needed to get a construction loan the rates increased and the original lender bailed out. They did end up getting a loan on the property at a higher rate than anticipated however, once the property was leased up the equity in the property was significant (over 10 million) which provided a lot of downside protection.

The process took a very long time and it was nearly 2 years before I started getting income on this investment. Now the payments are coming in like clockwork.

I invested in 2 different classes. Class A and Class B. Class A was a straight 10% preferred return (IRR 10%) but no upside potential of equity when the property is sold or refinanced. Class B is a preferred return of nearly 8% with upside equity share and projected at 19% IRR.

Oklahoma City, OK

This is another investment but it was a class B apartment complex and was a 709 unit multifamily portfolio. The strategy was considered a “value add” since they were going to do some light renovations and increase the rents and then resell or refinance the property. The reason I liked this property is that it had 99% occupancy and great cash flow even without the value add. Also, the OKC area has good jobs growth and relative low crime.

The sponsor’s business plan was to raise average in-place rents by 14% over the projected 36-month hold period through light unit renovations. As of halfway through the investment term, 560 units (79% of Portfolio) had been remodeled and average rent was increased 12%. So they were on the right track. But then things began to break.

First, the insurance carrier was no longer able to insure in Oklahoma and the new carrier costs increase from $100/SF to $120/SF.

Second, one of the buildings incurred damage from a storm and another suffered damage from a fire. Due to these two events, 37 units (5.2% of Portfolio) were taken offline, and 75 units (10.6% of Portfolio) incurred damage. All this caused the occupancy to drop to 85%.

Third, the portfolio was not meeting a financial covenant of the lender. The test involves dividing the trailing 12 months of net operating income by the full loan balance. The result for the portfolio was 6.3% and needed to be 6.5%, so therefore all excess cash was being “swept” by the lender.

However, now the NOI has been trending upwards and the portfolio is projected to meet the required higher debt yield ratio which will allow the lender to release excess funds to the sponsor in Q1 2024 and then I will start getting paid again.

So as you can see not all things go as planned, but in the end things work out if you carefully vet the sponsor(s) and the property.

Industrial and Retail Investments:

Industrial distribution center in Oklahoma City

The industrial distribution center in Oklahoma was interesting since there was a demand for additional space in this part of Oklahoma and the sponsor and contractor had extensive experience. In addition, the project was already in process which removed many of the risk with new construction. Below is a list of things I look for in a good syndication and this one in particular.

• The sponsor and general contractor are seasoned and have strong industrial space experience.

• The sponsor projects to sell the property for nearly $20M above basis. The basis is the all in cost to build and was a 25% discount to comparable transactions in the region, thus making an attractive entry point.

• The project is past the soft development stage with vertical development already underway, significantly reducing the development risk profile.

• The sponsor executed a guaranteed maximum price contract with the construction company which ensures the project will be delivered within the timeline and price made in the projections.

• The project location offers great frontage along a road with immediate access to the main highways in the area.

• This location is just a 15 min drive to downtown Oklahoma City, and 9.5 miles to Will Rogers Airport, the main airport for Oklahoma.

• The submarket has seen increased demand for industrial space with Amazon expanding its footprint in the submarket and other metro’s top employers continuing to add to their campuses in the submarket.

• The overall desirability of the market, paired with limited availability, have kept industrial vacancies low at ~4.5%. These factors have driven rents to surge realizing an increase of 5.9% annually.

Retail building in Ft Lauderdale, Florida

On this deal, the investors will provided funding ($750,000) as a first mortgage on a 6,200sf retail building on the corner of Federal Highway in Fort Lauderdale. The loan was only 35% of the buildings value so it was a safe investment. The owner was an attorney who developed the property in 1983 and owned it free & clear. The building was leased to a cigar store for over 10 years and now that tenant was vacating the property. The owner was already in negotiations with a dog grooming and daycare facility to sign a 10 year lease at a rent of $40/SF ($248,640/year) with annual increases. The owner took the loan to pay for general property improvements (HVAC, roofing, hurricane windows, etc) and provide tenant improvements. The investors are funding $150,000 at closing with the rest of the funds being distributed per a draw schedule as the work is completed.

For our analysis, we are being conservative and using a rental rate of $30/SF and a 7% cap rate which would be a $2.2MM value. If we use the rent in the new lease, the value would be closer to $3.5MM which would put our fully funded loan at 21% LTV.

The term of the loan is 36 months with a floating rate of 12.00%.  I, as one of the investors in the deal, will earn 9.5% with any future rate increases. The return is good, but not fantastic. However, the investment is super safe/secure and I am confident that I will be paid back in full (interest and principal).

Perspectives on commercial real estate investments in 2023:

• Industrial - Industrial real estate, like warehouses, distribution centers, and fulfillment centers, is still seen as a relatively safe bet. E-commerce continues to drive demand for industrial space. Markets with major ports and transportation infrastructure are attractive.

• Medical office - Healthcare is a steady industry, so medical office space tends to be stable. Aging demographics will likely support continued demand. Proximity to hospitals and medical centers is key.

• Grocery-anchored retail - Retail anchored by grocery stores and pharmacies is defensive. People always need groceries and medications, so these stores tend to have steady foot traffic.

• Multifamily - There is ongoing demand for rental apartments in many metro areas. Focus on newer Class A buildings or those in walkable urban areas. Stay cautious on luxury high rises and Class C buildings.

• Triple net lease - Triple net leased properties with long-term leases (10+ years) to creditworthy tenants are stable. Tenants pay property taxes, insurance, maintenance.

• Self storage - Demand for self storage space has shown resilience through downturns. Target markets with population, business growth.

Some higher risk sectors now include malls, big box retail, hotels, and office in certain markets. Focus on necessity-based retail and established locations over discretionary and speculative development.

We would love to get your feedback and your thoughts! Let us know which topics are of interest or where you need more clarity. Just respond to this email directly 😌 or email [email protected].