April Edition 2023 - View From The Fort

Teaching moments – whether you had them as a child or you are now the mom or dad who is implementing your child's missteps to guide them – they can be powerful tools for learning. Sometimes we learn from our mistakes, or if we're lucky, from others. Either way, it is essential to file them away in the critical lessons category. I have heard myself speaking to my son about a poor decision, and I felt like I was channeling Mr. Brady a la The Brady Bunch.?

You may have caught wind of?Arbor Realty Trust?foreclosing on a quartet multifamily property in Houston valued at $229 million. The properties had a combined 3,200 apartment units, purchased by?Applesway Investment?between August 2021 and April 2022. As an LP, the worst possible outcome is to have your investment foreclosed on. Investors fear pausing distributions, capital calls, or additional loans, which could dilute their investment. While these are not wanted or expected outcomes, they are damage control to do what's necessary and retain our valuable assets. When the bank forecloses on an asset, the investor loses everything, and the mere thought of this can make us feel queasy. What's the #1 rule of private equity? Never lose the investor's money. While capital preservation isn't sexy, it is the most critical element of investing.

So let's put on our Mr. Brady hat and go through some of the teaching moments of this unfortunate event. Trust me when I say this is not to pile on the operator, but valuable lessons can be learned.?

Lesson 1:?Conservatively underwritten deals. Everyone says they use conservative underwriting, but it is up to you not to be romanced by the glossy numbers and to carefully look under the hood of those numbers. The Applesway offering promised some gaudy numbers. 22.44% IRR and 31% AAR. If a deal is projecting these numbers, ensure you understand how they achieve such high returns. The underwriting on this portfolio didn't account for rising interest rates, property taxes, insurance, or material costs. I have had an investor tell me he will only look at deals above 20% IRR. If you are not looking beyond the returns, then good luck to you.

Questions that you can ask:?What assumptions are you making here? What rent growth are you projecting (compared to market rent growth)? What are the rents you are trying to achieve compared to the comps? What price or cap rate are you looking to accomplish upon exit? What are your projections for future property taxes and insurance compared to the t12?

Lesson 2:?These were rough properties in rough areas, bought at high prices, with lofty business plans. Some demographics don't want the gold-plated toilets – they want cheap rent. Make sure the business plan matches the demographic, and if you are taking on a "heavy lift," make sure this is in the operator's wheelhouse. For the record, there were murders, fires, and trash piling up at these properties. No thanks.

Questions that you can ask:?What are the local demographic measurables? As an investor, you can find this information quite easily by going to?Justicemaps.org?,?city-data, or?BLS.gov. What are the tract's average median income and demographic makeup, and what is the crime like? If it is a rough area or heavy lift, what experience does the operator have with such challenges?

Lesson 3:?Overleveraged with risky debt structure, and no risk mitigation. This is the one that has me scratching my head the most. How could this loan get approved with no risk mitigation put in place? This property was purchased with 90% leverage, a floating interest rate, with no rate cap! As we have recently learned, rate caps present their challenges (increasing escrow requirements to fund future rate caps). Still, it boggles the mind that the lender turned a blind eye to this interest rate exposure.

Questions that you can ask:?How is the debt being structured? Is it a fixed or floating rate? If it is floating, do you have a rate cap in place, and if so, how long is the term on that rate cap? If you don't have a rate cap, do you have ample replacement and contingency reserves?

Lesson 4:?Undercapitalized. This team severely underestimated the challenges and expenses of this portfolio.

Questions that you can ask: What are the reserves that you have in place on the project? Check for operating reserves, replacement reserves, financial contingency, and cap-ex budget. Are we well capitalized to weather any storm? Business plans don't always go to script, but how well are we positioned to pivot and survive?

Lesson 5:?No local presence. It got so horrible that one of the properties was featured on the local news, about how bad the living conditions were, with roaches, rats, and overflowing garbage bins. From what I understand, it was an absentee owner with negligent property management.

Questions you can ask:?Who are property and asset management? Will the property have onsite management, maintenance, and leasing? What is their track record? Are they responsive to tenant needs? How many units have they managed? Are they local and regional? Does management have a local competitive advantage? Do they have the local expertise and a logistical network in place?

Lesson 6:?Growing too fast. The team purchased 3200 units from August 2021 to April 2022. 3200 units in 8 months; that is scary. What is the hurry?!

Questions you can ask:?How many units has the operating team acquired over the last 12 months? Do you have a track record of success – especially in the local area?

I am not writing this intending to scare you – this is an outlier under the microscope. However, it should influence investors not to be swayed by pretty numbers on the surface and to ask important questions.?

Mr. Brady would have put his arm around Gregg and asked him: Son did they have ample reserves on the properties? Did they have attentive, professional property management who will look after the property as if they owned it themselves? Teaching moments - use them to your advantage.

On to other news...

Economic Notes from?Pensford

Pensford?publishes good reports that balance data and opinion. Here are some key takeaways from April.?

The FED is Hiking While Forecasting a Recession.?

The Fed’s most recent Summary of Economic Projections puts the Unemployment Rate at 4.5% at year end. That means they project about 1.5mm Americans will lose their job by year end.?That’s an average of 167k job losses per month…and?that?assumes we start losing jobs this month. So either they are dreaming…or the wheels are about to fall off.

Oh, and they are calling for a recession in the back half of the year…while still hiking.?At some point I have to wonder – do even?they?buy what they are selling??

Inflation

CPI has shown tremendous improvement in just 9 months, falling from 9.1% to 5.0%, the lowest reading in two years. Unfortunately, a lot of that has to do with oil.

Core readings are proving far stickier. The Fed’s new preferred measure, aka "supercore", has only improved from 6.4% to 5.8% over the same time period.

Core PCE peaked at 5.4% twelve months ago. It is down to 4.6% - an improvement of just 0.8%.?

Consumer inflation expectations climbed again, likely a result of conceding inflation is far stickier than originally expected. Here’s one year forward inflation expectations.?

Recession odds continue climbing. Wells is calling for -0.5% GDP this year, while Bloomberg is down to 0.2%.

Rates

Futures put a 78% probability of a hike on May 3rd?(5.25%)?

• Then a pause in June
• Then a coin toss between a pause and a cut in July
• Then a 70% probability of a cut in September
• And an 80% probability of Fed Funds at or below 4.50% by year end

The 10 Year Treasury may not plunge when the Fed starts cutting. Ahead of an expected tightening cycle, the 10T climbs and then waits for FF to catch up. The same is true in reverse - the 10T is already pricing in cuts and is waiting for FF to catch up.?

The 10T is at 3.4% as I write this.

Short Video: Be Present During Your "Gold Time."

Have you sat right next to someone in a conversation but felt a million miles away?

If you are going through life constantly distracted, chances are you need a reset.

"Gold Time" is THE MOST critical time in your day; it is your top priority.

It can be quality time with your family or the tasks that will move the needle in life.

I am most present with my family when we get out of town.

I speak a little about it, coming from Green Valley Lake, California.???

Thanks for tuning in.

See you next month.

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