September 2024 Newsletter

Anatomy of a Portland Refinance

As September comes to a close, I celebrated turning 38, which was a memorable milestone for me and my neighborhood. But the real cause for celebration is our successful navigation of a complex refinance on a September 2021 deal, originally funded with a 3-year bridge loan. Despite the challenges, we achieved a positive outcome for our investors, avoided a forced sale, and now stand in a much more stable debt position as we wait for better market conditions to sell.

If we compare our performance to the many 2021 multifamily deals financed with similar 3-year bridge loans (many of which have since gone back to lenders, wiping out investor equity), we did remarkably well. We preserved investor equity, maintained ownership of the asset, and positioned ourselves to benefit from a market rebound. In these tough times, preserving capital is a win—and we did just that, and more.

Key Lessons from the Process

Even with a positive result, it wasn’t an unmitigated success—after all, nothing ever is (except maybe the birth of a child!). Here are a few candid lessons we took away from this experience:

1. Avoid 3-Year Debt Structures in the Future: On paper, these deals can look promising, but they come with significant risks for everyone involved.?
2. Stabilizing a Deal in Under 3 Years Is Tough: With only about 2.25 years to execute a business plan, followed by a minimum of 6 months of stable performance to qualify for agency take-out financing, this structure leaves little room for error—especially in a rising interest rate environment.

Our success came down to two key factors: First, we bought the property at a reasonably conservative price. Although you might be able to buy the asset cheaper today, for the market conditions in 2021, it wasn’t a “stretch” purchase. Second, we exceeded expectations on rent growth for our renovated units, given our conservative underwriting, which helped drive solid returns.

Many deals that have gone under—particularly those in Southeast and other "hot" COVID markets —fell victim to overly optimistic underwriting. In our case, we took a more conservative approach, which shielded us from the worst of these risks.

Conservative Underwriting Saves the Day

Here’s why our underwriting approach worked: When presenting a deal to a lender, the key question is your “terminal outcome”—the amount of NOI (Net Operating Income) you expect to generate by the end of the business plan. This projection hinges on three variables: projected rents post-renovation, anticipated expense growth, and broader market rent trends.

We exceeded our rent projections by 10–15%, though we faced some challenges with rising expenses, especially from inflationary pressures like insurance. Crucially, we resisted the temptation to overestimate market rent growth, which protected us when the market didn’t perform as expected.

In 2021, real estate was booming, but not all markets were equal. For this Portland deal, we conservatively projected rent growth of 1–2% annually, and the lender accepted this. Had we been working in a market like Texas at the time, we could have projected 5% annual rent growth, and the lender would likely have approved it. However, many Texas deals are now underwater due to that very optimism.

Our Portland deal held steady. We forecasted a 5.25% cap rate at exit, and we ultimately achieved a 5.5% cap rate at refinance—mostly in line with our projections.

Real Estate as an Inflation Hedge

Let’s shift gears briefly to talk about inflation. Real estate is often viewed as an "inflation hedge," but it’s important to understand what that really means. Real estate encompasses a wide variety of assets, from single-family homes to multifamily investments, and each behaves differently.

For example, despite rising interest rates, U.S. home prices increased by 4.7% from June 2023 to June 2024, according to CoreLogic. Why? Homes are a finite resource, and when more money chases fewer goods, prices rise—even as borrowing costs go up. Leverage plays a significant role here, too. If you owe 50% on your home and its value increases by 4.7%, your equity appreciation is actually double that percentage.

In the multifamily sector, real estate can still be a strong inflation hedge as well, though it’s not always straightforward. Here’s why multifamily real estate often fares well in inflationary environments:

• Frequent Rent Adjustments: Multifamily leases are typically 12 months long, which allows rents to be adjusted more frequently to match inflation. Compare this to industrial or commercial real estate, where leases may be locked in for up to 10 years.
• Construction Cost Increases: As inflation drives up the cost of new construction, existing properties become more valuable due to higher replacement costs.

However, multifamily real estate isn’t immune to the challenges of inflation. Here are a few factors to consider:

1. Rising Expenses: Inflation doesn’t just push rents up—it also drives up operating costs like labor, materials, and utilities, which can squeeze margins.
2. Interest Rate Sensitivity: Higher interest rates—often a side effect of inflation—can negatively impact real estate, particularly properties financed with variable or short-term debt.
3. Lag in Rent Adjustments: Although multifamily leases allow for yearly rent increases, there’s still a delay. If your loan matures before rents catch up, you could face financial difficulties.
4. Cap Rate Expansion: As interest rates rise, cap rates tend to follow, which can reduce property values and offset the benefits of higher rents.

Final Takeaway: Conservative Stewardship Wins

While multifamily real estate can serve as an effective inflation hedge, especially over the long term, it’s important to recognize that the relationship isn’t immediate or linear. Success in the short term requires careful management of debt maturities and conservative stewardship of the asset. This approach has helped us weather recent challenges, and we’ll continue to prioritize it in future investments.

Good Reads from the Month

1.??????? First Wave for Multifamily

2.??????? Argentina Rent Control - WSJ

3.??????? Oakland – Former Sports Capital of the Nation

4.??????? Transitory was “right”