The Lies We Tell Ourselves
"If you don't know history, then you don't know anything. You are a leaf that doesn't know it is part of a tree." - Michael Crichton
Recent collapses in the banking industry have spurred so many articles on what's happened or what's going to happen, that it's tough to keep up. The Federal Reserve has raised rates on an aggressive path for the past year and things are starting to break, which perhaps is what is needed to trim the fat and bring the financial markets back to reality.
So far, I have read articles from a variety of pundits that have related our current situation to the Fall of the Roman Empire, the 1920's Great Recession, the 1970's, the 1980's S&L crisis, the 2000 dotcom bubble, the 2008 GFC and perhaps the decline of civilization as we know it. It all becomes an exhausting way to say we've been here before. My feeling is that you can always find a common thread through good times and bad: human greed and ingenuity. These two forces are the biggest reasons for market cycles. As much as we would like to think we are the smartest animals in the universe, our collective memories are perhaps more in line with the fruit fly. Ok, what does this have to do with commercial real estate?
Inevitably, when times are good, we think that things will continue to be good and this includes underwriting commercial real estate. We start to see assumptions that take the current goods times and extrapolate them out into the future, disregarding the cyclical nature of the market. We have seen this in offering memorandums and private placements, where current assumptions are simply dragged across the cells without much thought as to why.
What are the lies to look for?
Rent growth projections. Rent growth in the past two years has been robust as the Covid rebound started to push occupancy levels (office excluded) and subsequent rents. However, do these rental increases align with long-term rent growth? Will this continue and why?
Downtime vacancy assumptions. Are these included in the cashflow analysis and are they compatible with the current market trends?
Missing line items. No allowance for leasing commissions, property management or tenant improvements. Are we just doing this all ourselves now?
Value-Add Propositions. Ok, are you really adding value to the property or are you just raising rents because the owner before you was too lazy? Riding rental growth on the back of external factors does not make you a value-add investor.
Floating rate debt. We've had low rates for so long, they will probably get back to a lower rate at some point like we saw at the beginning of 2021. Don't bet on it! That gravy train is likely over, at least for the foreseeable future as banks reassess risk in the commercial real estate sector. If your cashflow is based upon lower future lower rates, then you will be in for a rude awakening.
Exit capitalization rate. Much like your floating debt, you have now idea where rates are headed. Many IRR's are blowing up right now from investors that bet the house on further cap rate compression. If your exit cap is higher than your going-in, you should really consider a new line of work, because you are setting yourself and other investors up for a disaster.
As the great Warren Buffett said, "Only when the tide goes out, do you discover who's been swimming naked." We are about to see quite a few naked swimmers defaulting on properties that should have been more thoroughly questioned. Pushing assumptions to show higher IRR's is a negligence of one's fiduciary responsibility. If you are approached to invest or are considering purchasing, make sure you do the due diligence and don't lie to yourself or others. Nothing stays the same. Learn. Read. Anticipate.
Do you know what happens to leaves in winter? They shrivel and fall off. Winter is coming...