I’m constantly on the lookout for great deals to buy, new strategies to improve management and information so that I can analyze the market.  Always on my mind is whether the timing is right to purchase the next deal.

A number of Observations have given me pause and I’ll share them with you:

1.      Prices of buildings by any measure in Southern California, Las Vegas, Austin and Atlanta have gone up at a faster pace than rent increases.

a.       At the same time, interest rates on mortgages have moved up.

2.      The volume of letters and calls directly from buyers who are targeting properties which I’ve purchased over the last 3 years has increased dramatically (I receive calls from brokers on a continual basis so that is almost impossible to use as a measurement).

3.      Properties being sold prior to be fully repositioned and/or with financing that must be assumed (in other words, many sellers are rushing buildings to market earlier than planned).

4.      Offers from equity lenders.

 While the first three observations in and of themselves do not necessarily mean that we are at a point of going to the sidelines, the fourth point caused me to re-evaluate my strategy very carefully.  The person who met with me works at a very large debt and equity group with a nationwide footprint.  They provide all levels of debt including a portion of the managing partners down payment which is loaned against the managing partner’s equity and also fees for operating the partnership.

He said that institutional equity (majority of the down payment) is still demanding an Internal Rate of Return (IRR) in the mid to high teens (typically 15-18%).  I asked how one could achieve this as I thought about observation #1 and #1 a. above.  He said that my fellow property syndicators had abandoned fixed rate debt and instead went with “structured adjustable rate mortgages (ARM’s) which initially would lower the interest rate by as much as 3% (in comparison to a 10 year fixed rate loan).

They also moved their buying to tertiary markets where they could achieve another 1 – 2% in Capitalization rate (Cap Rate).  Instead of Atlanta, deals were being bought in Selma, Alabama.  Instead of buying in Charlotte, North Carolina, deals were being bought in Winston Salem.  In California, buyers were passing on Los Angeles and San Jose and were pursing buildings in Fresno and Bakersfield.

Lastly, a syndicator could leverage their own down payment (a portion of the equity invested typically comes from the General Partner) by borrowing half of what they were going to put in.  The cost of this loan would be a hurdle rate (a guaranteed rate of return of 10%), a portion of the profit at refinance and/or sale and also a portion of the fees charged by the General Partner.

If everything goes right in the deal (interest rates stay low, the tertiary market stays strong, income is raised through a reposition and/or market rent growth and the property is sold at a higher price), the General Partner and the investors will do very well in this structure.  If one or two of these factors goes wrong, the margin for error is slim.

That is the point of observation #4, the risk / reward ratio has become more risky.  Given all of the factors, I am deeply concerned and made the decision to avoid tertiary markets.  I still favor fixed rate loans as an insurance policy against a rising interest rates so with my risk aversion, it would make hitting 15-18% IRR’s far more difficult.

While I am still bidding on properties to purchase, it feels like we are getting into the late innings when investors throw more and more caution to the wind.  I hope buyers lower their risk profile organically but people and markets rarely work that way.  It won’t take much to go askew for many of the latest purchases to go wrong which should be a reminder that real estate is a cyclical business.