As I read headlines about sponsors with deals drowning in high leverage and high interest floating rate debt that are now making capital calls on investors or, worse, losing their properties to foreclosure, I’ve reflected on some decisions we’ve made (or not made) this year that have put us in a very different position. While we don’t consider ourselves market timers, per se, the fact is we have recently taken actions that have turned out to be extremely propitious and which reflect our worldview and discipline around real estate investing. Having now eliminated our capital markets exposure, we are in the fortunate position to be able to focus our efforts on the forthcoming arbitrage in this volatile multifamily market while our peers are spending all their energy on how best to save their investors’ capital.
I can think of no market I was more excited to buy in than Seattle. We bought our first property, CityZen Commons in Kent, a 177-unit 1983 vintage garden style asset, in February 2018, for $28,100,000. We bought a 172 unit, 2006 mid-rise in South Lake Union (downtown Seattle), Alley 24, for $72,000,000 in 2019. We ended up selling CityZen in 2022 for $52,000,000 (close to double what we paid), and also sold Alley 24 last year for $90,000,000, a 25% increase in value, only two years later.
We signed contracts with large non-refundable deposits in February 2022, at what was literally the peak of the market. If we were selling today, each asset would be worth 30%-40% less, based on what other assets are now selling for.
While that certainly looks pretty clever, the truth is what prompted us to sell were 1) a spate of ordinances/laws in Seattle and Washington State that were very unfriendly to landlords (e.g.; giving tenants 180 day notices of rent increases greater than 10%), and, 2) nauseatingly high delinquency in Kent that was more akin to a dystopian Mad Max movie than a property investment in a major metropolitan suburb.
What this illustrates is one of the core tenets of real estate investing, namely that investors need to get paid for the risks, or headaches, they assume when buying an asset. Government policies passed under the guise of protecting tenants during a global pandemic, that ultimately translated to unjust losses to landlords far after the effects of said pandemic had subsided, require a much higher risk premium than we felt we were receiving were we to hold these already appreciated assets. Note, I didn’t say we would never own in Seattle again. Many of the fundamentals that initially drove us to invest in the market still remain, and there may be light on the horizon in the local political landscape. In fact, as prices have come down so dramatically, we are again looking surgically in certain areas where we feel there is a better equilibrium in the pricing vs. risk calculus.
There are two types of buying decisions a real estate investor makes: what to buy and what not to buy. We have always structured our acquisitions to target high quality assets in excellent locations that we intend to hold long term, meaning 7-10 years. Many others in our industry pay less attention to long term fundamentals and focus their business plan on acquiring Value Add properties (mostly 80’s vintage), with the intent to execute a renovation strategy and sell the asset within three years. In order to achieve higher IRR hurdles, this strategy is typically executed with high leverage floating rate loans. This can be a lucrative strategy, but there is substantially higher inherent risk. If interest rates shoot up, as they have, and the market essentially freezes, the buyer is stuck with debt service payments that in some cases are not covered by in place cash flows, and even worse their building is now worth less than the note on the property. Many of these deals should simply never have been purchased.
We buy deals we want to own.
During the past few years, we bid on – and lost – many deals where the winning buyer needed to make what we felt were unrealistic and aggressive assumptions about long term rent growth, or take on high LTV floating rate debt to make a deal pencil. Now, we are glad we didn’t pay the freight. We have had many conversations with brokers in the past few weeks where the broker starts the conversation by saying, “wow, I’m sure glad you ended up not buying (fill in the name of property we passed on)”. In one such case, a seller wanted $100,000,000, we balked and they are now hoping to get $68,000,000 for a property likely worth only $62,000,000.
I don’t think this suggests our brilliance as much as it does our discipline or, perhaps, our stubbornness. We like to buy deals as much as the next guy, but our financial models include a disaster scenario where we attempt to game out what it would take to lose a deal (i.e.; how much NOI would have to drop). We always make the decision that helps us sleep at night, which is the decision where we believe we have not put investor capital at undue risk (there is always some risk).
Since the Great Financial Crisis, which spurred the historically low interest rate environment we have recently exited, high leverage floating rate interest made a lot of sense. Today, interest rates have skyrocketed and rents nationally are trending flat or even down. That is an often fatal combination that is causing others to lose deals or make capital calls on their investors.
Our typical LTV is 55%-65% at acquisition and most of our loans are fixed with low or moderate interest rate debt. While this meant we were often the bridesmaid and not the bride when chasing a deal due to our unwillingness to get as aggressive as our peers were in their financing, we are in a very different position today than many others. Our deals are safe, we are able to meet market rents to maintain occupancy and our investors continue to receive distributions (and sleep at night knowing their capital is secure). This is why we have always preached the value of risk-adjusted returns.
We have also made timely decisions of late regarding the few floating rate loans we did have. While our leverage was always low, we also bought long dated (2-3 years) interest rate caps at very low strikes (.75%, 1.0%) rather than the minimum strike required by the lender (e.g., 3.0%). We bought our caps when the cost of doing so was very cheap as we viewed rate caps as a tool to protect our investors’ cash flow rather than to simply hedge the lender’s downside. The effect of these favorable caps was that our investors have continued to enjoy virtually unimpaired cash flow even as rates have shot up. By comparison, there are many deals today with fully indexed, uncapped interest rates of 8%-10%, and Debt Service Coverage Ratios well below 1.
This past spring and summer we began to feel that interest rates could continue to climb further than the market anticipated, so we elected to refinance two of our floating rate deals (at 5.05% and 5.48%) and then bought an interest rate swap on one deal which fixed our floating rate loan at 5.25% until 2026. It turned out that we were right to take action when we did, as the 10-year Treasury shot up to 4.9% (as of this writing) and the forward curve flattened to reflect the market’s belief (and Jerome Powell’s words) that rates will stay higher for longer. Had we waited, one of two things would have happened: either the cost of the cap for these deals would be over $1,000,000 each or the interest rate to refinance would be 6.5%.
While these turned out to be wise decisions, it is critical to understand they would not have been possible were it not for our conservative use of leverage and preventative use of interest rate derivatives, furthering our stalwart belief in the philosophy of risk-adjusted returns.
There are times when managing a property is a lay-up. Rents are up, supply is down, everything is great. Those times are not the test of a company’s mettle. Rather, it is during an economic downturn or, as we are seeing in certain markets now, times of oversupply that strength in property management becomes essential. To some extent this is a function of experience and having great people. But it’s more than that. Running a property during more challenging times is also about an obsessive focus on results. At most companies, property management is handled by a separate division and that is true for us as well. What differentiates us, though, is our policy that “you buy it, you run it”, meaning that acquisitions executives must asset manage the properties they acquire. This means overzealous deal junkies (like all of us) are less likely to incorporate unrealistic income and expense assumptions into financial models just to make a deal look good. It also means everyone on our team knows how to run a building. It’s why our properties thrive even during difficult times.
The bottom line of all this is not that we are brilliant market timers or more astute investors than everyone else. Rather, it’s that we have a well-defined world view that is no more complicated than buying great properties in strong markets using conservative leverage, expecting to hold on to them long term and being committed to excellence in our operation of those properties during the holding period. This approach insulates us from the buffeting winds of economic change and allows us to deliver strong returns while protecting principal. To be sure, no investment is without risk and past performance is no guarantee of similar future performance. But after a half century, past performance has given us guardrails to stay within to give us, and our investors, the best probability of success.