We are often asked when a good time to buy real estate is.
Our response is best summed up in what Waren Buffet once said: “Be greedy when others are fearful and fearful when others are greedy”.
The above wise advice from the Oracle of Omaha describes our investment philosophy. We believe that any time is a good time to buy, as long as the numbers make sense, even in volatile market environments.
So how can one navigate the markets during a period of volatility and uncertainty? As a real estate investor you make your money when you buy – thus vetting the deal and mitigating potential risks upfront is key to one’s success. Needles to state, if you can time the near-bottom of the market would be ideal. However, that is very difficult to do.
Below we will discuss how we approach investments during periods of frothy markets and offer a few suggestions on questions you can ask of your deal sponsor when vetting potential passive investment opportunities.
First and foremost, one must adhere to the fundamentals of cash and cash flow, which will carry you through stormy waters when (not if) you encounter them.
Cash refers to having adequate reserves – operating and capex. We usually like to carve out at least six months of operating expenses and debt service for our rainy day fund. As to capex, we build in a contingency factor (10-20% cushion) based on the capex estimates provided by our PM or contractor to account for unexpected cost fluctuations related to labor and materials. If all else fails and a sponsor faces extenuating circumstances on the horizon, the sponsor may also decide to postpone certain capex projects and potentially distributions in an effort to preserve liquidity (we have continued to pay distributions to our passive investors despite the current market environment as we are performing ahead of plan).
As to cash flow, making sure that cash flow is present and continues all starts when vetting the deal upfront. Especially in the current environment, one should ensure projection assumptions are reasonable. For example, projecting no rent growth in year one, is not out of the question in today’s environment. During a period of recession, it is also not uncommon to face higher physical and economic vacancy. Next, carefully assess entry and exit cap rate assumptions – entry cap rate is usually the market cap rate (which is not necessarily the purchase price cap rate). In a period of rapid interest rate increases like the current one, it is not uncommon to assume an accelerated cap rate reversion. Then, assess whether the debt terms are consistent with the business plan and what (if any) the interest rate risk is. For fixed rate loans, the interest rate risk volatility is eliminated; however, one needs to account for the prepayment penalties, if any, if the loan term exceeds the planned exit time frame or for a planned refinance. Last but not least, the sponsor should be able to share with you their sensitivity analysis showing the impact of different levels of cap rates, rent, vacancy, etc. on valuations or debt service coverage. Knowing your break-even point upfront is also key, as it shows how much cushion you have on day one.
At the end of the day time in the market vs. timing the market has a bigger impact in building wealth over time. One cannot predict everything that will go wrong but planning ahead and being able to successfully pivot is key to success. As we stated before, the only way to avoid risk is not to take one. But in that scenario one can miss out on all the wonderful benefits of investing in real estate.
As a wise person once said: “The best time to plant a tree was twenty years ago and the next best time is today.”
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.