I recently shared my thoughts on why I believe a new real estate bubble is being formed. Click here to read the article. To be more specific a bubble occurs when the asset – in this case real estate – is experiencing an unusual appreciation during a stage when economic conditions – stagflation – don’t justify healthy growth in the specific sector.
Regardless of whether we’re half way into the bubble or close to the top I believe you should not fear acquiring a property today provided you secure it at a good price, good cap rate and a solid DSCR, in a market which has a positive forecast for local economic growth, and if you depend on financing, you secure it at a fixed low rate.
So let’s say you’re closing on a property today and the end of 2014 surprises us (even though we wouldn’t be surprised because we knew a bubble was developing) with a deflationary event. A rise in interest rates could trigger a bubble to burst. Many property owners’ inability to renew their maturing loans could also trigger an event of such magnitude. Regardless of that you can evaluate your asset and its circumstances. Yes, there is panic which is usually amplified by the media. Banks tend to go through their ritual of begging the government for bailouts. Small banks vanish while large banks are saved by the government’s moral hazard attitude. But unless you have to sell the property why worry its value is lower than before? Value is subjective and if you’re in this for long term it is the residual income that you should be most concerned with.
When a real estate bubble bursts not all areas of the country are affected equally. Some areas will be more impacted and some will be less. Your homework prior to purchasing a property is to learn everything there is to know about the local market. Unemployment is dictated by the local industries players. If there is only one or two then it may not be an ideal place to invest in it. The more employers the better for your investment.
Your property should reach its full potential with the highest level of occupancy, which is determined by the caliber of tenants you have and the condition in which you keep the property. If you buy on the wrong side of the tracks what good does a current high cap rate do if your tenants stop paying rent because they’re disposable in their jobs?
If you’re buying an under-performing property then you have even more work to do. You have to be even more accurate with your projections. You must get it a better discounted price today and be sure to be conservative when budgeting for the cost to cure.
Finally, if you secure financing you must be sure you get a fixed rate so that you don’t experience the volatility of an adjustable one. Permanent long term commercial real estate financing comes with options of five, ten, and possibly longer terms (in certain types of financing).
If you’re getting an under-performing property long term financing is not viable. A bridge loan might be the way to go. The property must be well discounted to start with and I can’t emphasize enough how important the local economy is. If the market crashes while you’re stabilizing the property you must be able to fill out its occupancy even if you have to rent at lower than anticipated rent values. You must anticipate a higher permanent rate when analyzing your deal. If the rates stay low then it would be a bonus but if they happen to rise then you’re prepared. Don’t underestimate the importance of building reserves. They may be needed in case the cost to renovate ends up being higher than projected. They may be needed to meet the LTV requirements when it’s time to refinance into a permanent loan in case the property doesn’t appraise at the anticipated price.
I would recommend all of the above regardless of whether the bubble will burst anytime soon or not. It’s just smart practice. But I believe you already knew all this. The bottom line is to follow your inner instincts, be proactionary rather then reactionary, do your thing and do not let the media frenzy get the best of you. Stay cool.