721: Commercial Real Estate Could Crash, But Are Everyday Investors Impacted? w/BiggerPockets CEO Scott Trench

This is the Bigger Pockets podcast show number 721.

Keep in mind, bigger is mentally more daunting, but bigger is easier. It's the same amount of work to take down a 10 unit as it is to take down 100 unit. So my philosophy is go as big as you comfortably can, and I mean, comfortable is without putting you or your investors at financial risk. But just don't, don't be scared by the fact that, well, it's 100 units. I've never done that yet. If you've taken down a 10, you've taken down 100. And it's just the amount of the finances. And it actually gets easier the bigger you go.

What's going on, everybody? This is Scott Trench, temporary guest on the BiggerPockets podcast, here with the host, Dave Meyer. Sorry I stole that from you, Dave.

Oh, no, I don't know if I'm the host of the guest. Whatever it is, we're here together and we're taking over the show today.

Well, yeah, thank you for having me on today, Dave. I appreciate it.

Yeah, of course. I mean, you're very smooth at that intro. You're an old hand at this. And, yeah, we wanted to have you on because we've had a great. A couple of questions. You and I have actually had a lot of great conversations offline about this, and you have some really interesting thoughts and frankly, some concerns about the multifamily commercial space that we're going to talk about here for the first 20 minutes of the show.

Yeah, I do. And I think that the commercial multifamily has enjoyed a really phenomenal run in creating a tremendous amount of wealth over the past 10, 12 years, as rents have really grown almost in an accelerating fashion for the last decade, as interest rates have come ticking down over that time and as cap rates have come down. And that's created an incredible environment for wealth creation that I think.

I worry has run its course and is set for to give a lot of that back in the next 12 to 18 months. I want to voice those concerns, really, and ring the alarm bell here so that investors are very, very wary of this asset class heading into 2023.

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All right, great. Well, this will be a great conversation. I'm looking forward to it. I have a lot of questions for you and just for everyone listening, we're going to talk to Scott for about 20 minutes and then we're going to turn it over to Matt Faircloth and Andrew Cushman, who are going to be answering some mentee and listener questions about the multifamily space. So we have a great show for you today. We're going to cover a lot about commercial and multifamily, so you'll definitely want to stick around for this. So you have some thoughts about what's going on in the multifamily and commercial space. And we'd love to hear what you're thinking.

Yeah, I think the first thing that's concerning me in the.

Multifamily and commercial real estate space is that cap rates are lower than interest rates right now in a lot of the space. What that means is when I'm buying a piece of commercial real estate, I'm buying an income stream. If that's at a 5% cap rate, I might spend $10 million to buy a property that generates $500,000 a year in net operating income. Well, if my interest rate is 5.5% or 6.5% like Freddie Mac, 30 year fixed rate mortgages are averaging 6.42% as at the end of the year, that means that my debt is dilutive. I'm actually going to get a better return by buying all cash or being on the lending side instead of the equity side. Unless I'm really bullish on appreciation. In the case of commercial real estate, that means I'm really bullish on rent growth or I for some reason believe I can reduce operating expenses. And so this is a huge problem. This is not sustainable, in my opinion. And when the average of the market.

Sees cap rates lower than interest rates, that means that the market is going all in on these assumptions for growth. Right. And I don't understand that. I think it's a really risky and scary position. Right. So let's go through what has to be true for this to work out for investors in the commercial space. One is rent growth has to go up. One way that could happen is supply and demand dynamics. On the supply side, we're going to have the most inventory coming online since the 1970s. Ivy Zellman estimates that they're going to be 1.6 million units coming online in the next 12 to 18 months in the backlog here. And builders will complete that inventory and they will monetize it. It's possible that if things get really bad, they can stop construction. But then that just proves the point that there's a big risk in this space and then the other side of this. So I think that's a headwind to that rent growth assumption that the market's going all in on. Right? Lots of supply coming online, lots of construction. All you got to do is peek out the window here in Denver and you see the cranes more prolific than they ever have been. And that's saying something because the city has been booming for a long time now. This will all be regional, right? Some cities will not see this supply coming online. Some cities will see tons of supply coming online and still have no trouble with absorption of those units.

Well, just to, just to reiterate to emphasize that point, Scott, we are already seeing that rents specifically in multifamily are flattening and starting to decline in some areas. And that's even before what you're saying, this increase in supply comes online, because I think that's sort of towards the middle of 2023 when that's intended to happen. So we're already seeing this before the supply glut even starts to impact that dynamic.

Yeah, absolutely. So, I mean, I think a better bet is that rents stay flat or maybe even decline over the next 12 months in the multifamily space versus the implicit assumption, when cap rates are lower than interest rates, that they're going to explode. Right. On the demand side, I think we have a wild card here, and I don't really have any forecasts that I feel really confident in. On demand. Right. One of the big arguments for demand is that there are more people, household formation is accelerating. There's long term trends supporting that. That's true. But there's a whole bunch of volatility from the whole Covid situation. Lots of people moving out, getting divorced, breaking up. That creates household formation, in my opinion, artificially. It's a metric that can move and confuse economists. And so I don't know how to predict household formation in 2023 one way or the other. And I think the safest bet is to assume very little household formation. If there's a mild recession or interest rates keep rising, that's going to put pressure on the economy, it's going to result in less wage growth, and we might give back some of those rent increases. So I think, if anything, there's reason to believe that rents again stay flat or decline year over year. And again, that's problematic.

I worry that in 2023 we could see cap rates increase, which means multifamily asset valuations decline. That same Property that's generating $500,000 in net operating income goes from being worth $10 million at a 5 cap to 7.7 at a 6.5 cap. That's a 23% crash in the asset value of that property. And if you're levered 70, 30, you used 70% debt, 30% equity, that's going to w the vast majority of your equity. And this is the problem that I see brewing in this space or that I worry could be brewing in the 2023 space.

So do you see this across all multifamily assets and or bigger syndications or smaller multifamily is disproportionately going to be impacted by this.

Yeah, I think that this is a threat to commercial real estate assets across the board, which would include office, office space, retail, multifamily and other assets. I think that you're going to see more pressure on larger assets. You're going to see pressure on assets that are not financed with Freddie Mac loans at 30 year fixed rates.

I think that folks will be disproportionately impacted. I also think you're going to see folks simply not selling in this period. If you're invested in a syndication, your syndicator is probably just not going to sell for the next year or two and hope that prices recover. My worry though is that if interest rates stay high and they don't have to, it can even come down a little bit. I know you're thinking that mortgage rates will actually come down, are probable to come down next year, but as long as they just stay much higher than they were for the last couple of years, I think you're going to see cap rates reset at a higher level, like maybe 6.5%, 7% on a nationwide basis, again varying by region.

Well, and also, you know, ideally most indicators and operators will probably hold on, but given the nature of commercial lending, most of them don't have long term fixed debt and some of them might have balloon payments coming due or an adjustable rate mortgage that's adjusting in the next couple of years and that could potentially force a sale or further negatively impact the cash flow of the properties.

Right?

I think that's true and I think that's a really big unknown in the space. I don't, I don't know anyone who has great data on averages in commercial multifamily real estate debt terms. Right. Like what is the average weighted life of these debts? Is it 5 years? Is it 10 years? Is it 30 years? Is everyone getting fixed rate Freddie Mac loans on this? And we're all set. My guess is there's going to be, there's a big spread in these areas and that different folks are going to get impacted very differently. And my best guess is, is that there's going to be a process rather than an event for this cap rate reset. There's just going to be continual grinding pressure on operators of these assets over 12 to 18 months. But there could always be some sort of event issue where things come to a head at once. By the way, this is not news. Asset values in the space have come down 20 to 30% in many markets already. And for some of those markets it was like a light switch and some of it was, was over time. Right. Brian Burke, I think has some really good detail on this on a previous BP podcast. And then I also want to call out, you had Ben Miller on the on the market podcast, the CEO of Fundrise and he really has a good handle, I think on the timing and credit issues that are coming up in the space and the fact how folks are leveraged and why your lender A borrowed from lender B to finance property C, and everybody needs liquidity at once. That could, that could create problems. I think that's really hard to predict. And I think again that's, that's, that's the space where nobody has great data and there's a big unknown here.

Yeah, that it is, it is really hard to find that information. And if you want to check out that podcast Scott was talking about, it came out around Christmas on the on the market feed, you can check that out. It's called the Great Deleveraging with Ben Miller. But Scott, I think this is fascinating and appreciate your take. I'm curious what you would recommend investors do. And I guess there's two sides of that, right? Like as a operator, multifamily, syndicator, what are you, what would you recommend they do? And then as people like me who invest passively in syndications and multifamily deals, what would your advice be?

Well, you know, I think if you're in a current syndication, you got to just kind of pray and hold. Right? There's not really another option. Right. You're a limited partner and there's nothing, there's nothing to do. So it all comes down to what you can do going forward. And I think that if you're considering investing in a syndication, make sure that it's a huge winner even in a no rent growth environment. Throw out the syndicator's projections right on market rent growth and say if there's no rent growth, does this thing still make sense over the next couple of years for me? And does it make sense where even if I have to sell the property with 150 basis point increase in cap rates and in that market, that's a general rule of thumb, each region will vary, you definitely can modify those assumptions by your region. If you have one of those markets that has a lot of net migration with very little new construction. Another one is instead of getting on the equity side in a syndication Consider being on the debt side. There's preferred equity, which is really consistent with debt in terms of its return profile, although it's junior to the more senior debt at the, the top of the stack.

Or you can just be, you know, get into a debt fund, right. If you're going to earn, if, if the cap rate is 5% and the interest rates are 6.5%, why not just earn 6.5% interest rates or even higher with other debt funds, right. That's, that's a lower risk way to earn better cash flow for a period of time. Right. And, and when things change, or if they change, you can always go back to the being on the equity side or when you have confidence in rent growth. If you're going to go in on an equity deal, maybe consider finding somebody that is going to syndicate with no leverage at all. Again, if the property is going to produce a Yield at a 5% cap rate, consider using no debt at all. That's actually going to increase your returns in a no or low rent growth environment while being lower risk. That's really attractive. So these are super bold opinions that I'm trying to bring in here, but I really want to voice this concern because I feel like folks don't understand this and I feel like they're getting information, if you're getting all of your information from people who syndicate real estate deals, recognize that these syndicators, they're great people, they do a great job in a lot of cases, but this is their livelihood. And it's hard to see perhaps some of the risks in this space. If your livelihood depends on raising large amounts of capital, buying deals and earning money through acquisition fees, management fees, and then, you know, having, having a spin at a carried interest on the, on, on the come.

That's great advice, Scott. Thank you. Do you, do you see this, this potential downturn in commercial real estate? And from what you're saying, it sounds like, you know, I personally believe we'll see a modest downturn in residential real estate, but this commercial one has more downside. According to your analysis, do you see it spilling over into residential or any other parts of the real estate industry?

This is not good news for real estate in a general sense. So look, I think that you have a really good handle on the residential market in particular. You have a good handle on all the markets. I don't think you spend quite as much time in the commercial space, I would say. By the way, you should take some of my opinions here with a grain of salt because I'm an amateur, aspiring journeyman in understanding the commercial real estate markets here. But in the residential space, I think we've got a reasonable handle on that. There's a whole variety of outcomes, but no commercial real estate asset values declining will likely be.

Hand in hand with residential real estate asset values declining. We already predict that. I think 3% to 10% declines are the ballpark that you've been discussing for residential, depending on where interest rates end up at the end of the year, next year.

Yeah.

Okay. Well, that's super helpful.

By the way, if you're considering investing in residential real estate, put it on the bigger pockets calculator and look at the property with a 30 year mortgage and reasonable appreciation and rent growth assumptions and put it on there without a mortgage and see what the returns look like. In a lot of cases, the returns are going to be bigger, better without a mortgage on the property. Which again is something that is really interesting and something that should.

Get the wheels turning. You need to really find some good deals right now in order for this to work and you might want to consider being on the debt side.

Awesome. Well, Scott, we really appreciate this very sober and thoughtful analysis and it's clearly something our audience and anyone considering investing in real estate should be thinking about and learning more about.

Well, Dave, one question I have for you is what do you think? I'm coming in hot with some, you know, some a little bit of doom and gloom here, worrying that there's a really big risk factor brewing in the commercial real estate space. Do you think I'm, I'm reasonable with that or do you think I'm way off?

No, I do. I think that it's, it's, it's a serious concern there. I really have a hard time envisioning cap rates staying where they are. You know, it just, I can't imagine a world where they don't expand. And as you illustrated really well, just modest increases in cap rates have really significant detrimental impacts on asset values. And we're just seeing conditions reverse in a way that cap rates have been extremely low for a very long time and economic conditions, I don't think really support that anymore. And so I think the, what you said about rent growth is accurate. The party that we've all seen over the last couple of years where rent growth has been exploding, the economic conditions don't really support it anymore. And I think it's time to be very cautious and conservative. I don't see any downside in being really conservative. And if you're wrong and if I'm wrong, then it's just a bonus for you if you invest really conservatively and rent growth does increase and cap rates stay low.

Good for you.

But as you said, I think that the most sober and appropriate advice both in commercial and residential right now is assume very modest rent growth, if any at all. Assume very little appreciation. And if deals still work, then that makes sense. But I don't think hoping for improving conditions is a wise course of action, at least for the next year and maybe two years.

Well, great. You know, again, I feel very, I feel a little nervous, you know, voicing this concern. Right. I'm essentially coming on the show and saying I'm predicting a pretty, I'm not predicting. I'm worried about an up to 30% decline in asset values in commercial multifamily. Right. And that's one area where I really enjoyed Ben Miller's podcast where he talked about the credit risks in here. But I really think multifamily is not insulated from this. His risk was for the commercial, like a retail office. There's other asset classes I think multifamily is very exposed to right now and that I worry that some of these things have not been priced in appropriately in the market. Again, it just comes back down to the simple fact of we're trying to make money as investors. And how can you make money if rents aren't going to grow and your debt is more expensive than the cash flow that you're buying? That has to change. And I think that a reasonable spread between cap rates and interest rates on a national average is about 150 basis points. And that, that amounts to a, a very large increase. That's, that's going from about five on a national average right now to six and a half percent cap rates. And again that, that destroys a lot of value. So hopefully this is helpful.

The only alternative there is that interest rates go down.

Right.

Cap rate, like if you're saying you need this spread, but I think personally think mortgage rates might go down by the end of 2023, but not a lot of, you know, I don't think by 100 basis points from where they are right now. And it's, that's, that's a, that is my thought, but I don't believe that very strongly. I think there's a lot of different ways that this could go. And so I think that the more probable outcome, as you've said, is that cap rates go up to, to get to that historic healthy spread rather than interest rates coming down.

Yeah. And there may be a combination. Right. That could be a mitigating factor. They could come down some and cap rates could still go up a portion of this. Right. But I'm very fearful of this space over the next year.

All right, Scott, Will, we really appreciate this honest assessment and you sharing your feelings with us. It's super helpful for everyone listening to this and given me a lot to think about before we let you get out of here. What is your quick tip for today?

My quick tip is if you're analyzing commercial real estate or any other real estate in today's environment, try analyzing it with and without debt first and then second. If you're looking at syndicated opportunities, if you're still interested in syndicated opportunities, make sure that the sponsor is buying deep, buying at a steep discount to market value, that there's significant opportunities for rent increases just to bring current rents to market, and that the property can still generate an acceptable profit when the syndicator needs to sell it three to five years later, even if that is at a 6 and a, you know, a cap rate that is 151.5% higher, 150 basis points higher than what it was purchased at today.

All right, well, thank you, Scott Trench, the CEO of BiggerPockets. We appreciate you being on here. And with that we are going to turn it over to Matt Faircloth and Andrew Cushman, who are going to be doing some answering some mentee questions about getting into multifam investing.

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Philip Hernandez, welcome to the Bigger Pockets podcast. How are you doing, sir?

I'm doing well. I am super stoked to be here. Yeah, thank you so much. Andrew.

You are part of the inaugural group of the Bigger Pockets Mentee program and you're here with a few questions that hopefully we can help out with today. Is that correct?

Yeah, yeah, that's right. Yeah. No, super stoked and yeah, thank you guys so much for your time. Yeah. So my question, so in the multifamily world, but also just in the regular, the real estate world in general, a lot of times when we're starting out, the advice is given to partner with somebody that has more experience than you by providing them with some value, like either finding the deal or managing the deal or somehow making it easier for the person that has more experience than you?

What if the thing that you're able to do to add value is raise capital? So I'm starting to find some.

My network is starting to be interested in investing with me more and you know, I what if I don't have the deal? What if somebody else has a deal, but I'm just starting to get to know them? How would you vet the person that you're thinking of, you know, bringing your friends and family's money into a deal for. Yeah, what would your checklist look like? So you do that in a good way.

Important topic. So just to make sure we've got that right. So your question is basically, if I'm kind of starting out as a capital raiser, how do I, what's the checklist look like to pick the right partner or co sponsor to invest that money with?

Yeah, exactly. Because I feel like I, you know, like vetting a deal. As far as doing my own due diligence, I feel like reasonably competent at that. But that's if I'm in control of everything. So what if I'm not in control of everything?

So.

Yeah, no, you're right on. And Matt's probably got a lot to say on this, so I'm going to roll off a few things and then I'll let him take over. Number one is I would say go read Brian Burke's book, the Hands Off Investor because it is written towards LP passive investors, but it is the most detailed in depth manual for how to vet an operator that I've ever seen in my life. So if you are looking at raising money and putting that money with somebody else, you need to be an expert in that book. That's the first thing that I would do. And I even as someone who's been doing this for a decade and a half, I read every page of his book and there's a lot to learn in there. So do that. Second of all, if you're going to raise other people's money and then put it in someone else's deal, do not be just in a limited partner. Make sure that you are either part of the general partnership or at bare minimum have some level of input or control in the deal. I unfortunately just last week a friend of mine raised money, put it with another sponsor in a deal in Texas. They had a fire, the deal is going bad, 100% of the equity is going to be lost in the. One of the biggest frustrations with the friend of mine who raised the money is he has no control.

He can't even get all of the information into what's going on. So make sure that you have some level of input, some level of control. I would also recommend when you're looking at a specific deal, underwrite the deal and do due diligence on the deal as if it was your own deal and you found it.

You're basically duplicating.

The underwriting and the research that the sponsor is supposed to be doing. Hopefully everything lines up and you're like, wow, this guy's great. But if not, you're gonna find that and you're gonna save yourself. A lot of you save your investors risk and save your own reputation. And then, you know, also realize you are really betting more on that operator than you are in any specific deal, especially as the market is now shifting. Asset management and good operations is where the money is truly made. We've all been riding a huge wave for the last 10 years that has crested. And the good operators are going to be the differentiating factor going forward. And then also, really, from your perspective, Philip, just understand that no matter what, you to some degree are placing your reputation in somebody else's hands and, you know, go through that vetting process, do it slow and make sure and if you do it right, it can be a wonderful thing for growing and scaling and being and focusing on what you're good at. But just keep, keep that in mind. So, Matt, I'll toss it over. You see what, see what you have to add.

Well, I could just say, you know, hey, I agree with Andrew, which I do most of the time. So everything Andrew said is 100% COR. Yes, vet that. Vet them as if you were investing your own capital. And that's how you should look at it. Above everything else, Philip, is look at this as if this were your money going into this other operator's deal. Do what you would do if you were writing this check. Because in essence, the person investing is not investing in that deal. They're investing in you. They're coming to you. Look to help them find a place to park their capital. They're not so much like, oh, they could just go to that operator direct. Why would they need to go through, you know, the reason why they have to go through you is because they trust you, right? And they, they're try, they're investing with Philip Hernandez and his network and his underwriting prowess and his market knowledge. So do that and, you know, go, go through and vet the market. You know, find out why the market's amazing. Don't just listen to the, to the syndicator or the operator or the, the, the organizer. Come up with your own homework as to why. Get, don't just, and don't just rely on these syndicators, you know, PDF documents that show financials, get their real numbers in Excel, underwrite the deal yourself, get the rent roll and profit and loss statements from the current owner that they're buying the property from, and do your own analysis of the property, maybe come up with your own, your own vetting, your own underwriting and, you know, and stress test the deal too. All these things are done by good LP investors that want to invest in a deal. And you need to act as if it's your powder going into this deal, not your investors. That's number one. I can also offer you some thoughts, if you're looking for it, on how you can protect yourself in raising money for someone else. Because my guess is you're a great guy. I happen to know that. But you're not doing this for a hobby, right? You're doing this because you would like to get some sort of compensation in exchange for placing one of your investors in the deal, correct?

Yeah, definitely.

The problem is, unless I'm wrong, you don't hold a Series 7 license. You're not a licensed securities equities broker, are you?

You.

Correct.

Okay, so it's that operator can't compensate you for raising capital because what you're doing is you're selling a security for them.

Right.

And I can't cut. I can't cut you a check in dollars in equity that you raise in exchange for raising capital because that would be compensating you as an equity broker for selling a security. And you need a license to do that, which you don't have. So you need to be. But. But, you know, rest assured, I got you covered. So the. The way that you do that is you become a member of the gp, the general partnership, as Andrew had said. Now there's a carve out there. You can't just become a GP as a capital raiser. You need to have an active role in the company. And a capital raiser's job pretty much is over after the. After the company gets formed. You know what I'm saying? It's not like you need more capital forever. You raise the capital and the deal closes, and then you're done. So what your. What the SEC will want to see if there's ever scrutiny on the deal. And to be straight, not what your investor is going to want to see is do you remain an active partner in the deal. So Philip's job does not end once the capital is raised, because that gets you an active role in the company as an owner. And if you're an owner of a company, any size owner, you're allowed to sell equity. You don't need a securities license if you own a portion of the company. You follow me? Yeah, you own a portion of the company, but you also need to do something more than just raising capital. So you could sit on the asset management team. You could, as we do at darosa. For my company, what we do is we form a board of directors, you know, and that board of directors. That board of directors has a voice. They have say we do regular board of directors meetings. We keep minutes. We even are total dorks and do the Roberts rules of order, where there's motions and seconds and eyes and that whole thing. So you can do all that as a board of directors with the capital raisers having a regular voice on the company. If the operator is willing to play ball with you and set things up that way, then that's a great way for you to become a member of the gp for you to have a say and have control. Right. And also for you to become a member of the GP so that the, the, the main organizer can legally compensate you in whatever form or fashion you negotiate for yourself.

Yeah.

So if it's a smaller deal and you know, if there's like three people on the deal, four people on the deal, what is, you know, Andrew, you said make sure you have a certain level of control. What does that actually look like? Like control as far as in the dis. Like the dispo or control. Like what would I say? Oh, this is how I want that to look. Look as far as control.

Control in as much as possible. Right. So you get to vote on, like you said on disposition. When, how approval of price you get to approve. Does it get refinanced? Are you going to fire the property manager and hire a new one? You should have some input into that. You get input on whether or not to make large capital expenditures, should they be held back or should you go forward with them. You get to have input on should distributions be made or should they be held back to preserve the financial position of the property, to get through potential rough times. So the more input you have, the better that is for your investors. And then also you're going to learn more too, especially if you're on the capital raising side. You're not going to be spending as much time in operations. You're going to learn more by doing that as well.

So what's interesting, Philip, is that you had talked about this is a small deal. Right. There's only three to four of you involved in this project. Correct. And I didn't want to scare you or anybody else thinking about like a board of directors. Well, geez, you know, Microsoft has a board of directors, but this is like a little however many size, you know, deal. It doesn't need a board of directors. Well, yes and no. Right. You don't have to let terms like that scare you or anyone else. There are ways that just, there's just ways to operate real estate that involves, you know, a couple of partners that involves, involves private capital coming into the deal and every partner having a say, as Andrew said in the project is imperative. Every partner having a vote. And by the way, it doesn't have to be what Philip says Goes. It has to be. Philip has a vote, Philip has a voice. And in all these things, it's typically a consensus or even a, you know, I say, I naysay, nay kind of thing to determine whether or not you take the offer, whether or not you decide to replace the roof. This is how semi complex real estate happens. And this could be a four unit property or a 10 unit property. Whatever it is, it doesn't. I don't want people to view this as any more complex than it need, than it needs to be. This could be a very up and down quick zoom call that, that you just make record that the zoom call happened and, and maybe every here and again, put yourself on an airplane, Philip, and go out and look at the property. The last thing I'll leave you with. And everybody else, too many folks do real estate like real estate do real estate investing like this as a dabble, right? If you're raising private capital for an operator, you should not raise capital for that operator unless you're planning on doing it 10 times for their next 10 deals or, you know, maybe growing into your own thing eventually. But you shouldn't dabble in raising capital for an operator. You should do it over and over and over again so your brand gets attached to them and so that people view you as a capital source for them. And it's something you can do over and over and over again. It's not something you can try on one time because a typical real estate project could last five years and if the economy changes a bit, it could be a bit longer than five years in these projects to take. So you got to make sure that you, you know, like working with these folks and you want to do a lot more work with them.

That's great advice. Thank you guys so much. I really appreciate it.

Philip, before, before you split, man, I want to let you know you were an awesome, awesome, awesome juggernaut in the multifamily boot camp that we had in the one that we, that we kicked off a few months ago. And I want to thank you for bringing the, for bringing the sauce you brought to that. It sounds like you're doing just the same for the Mentee program and, and I am really grateful to see you here, saw you be pecon and that, and I just, I love your vibe, love your energy even though you're bundled up there in, in Los Angeles.

Thank you. Appreciate it.

Appreciate you guys. All right, take care.

Phil, Andrew, we got another, another question lined up here. I want to bring in. I got Danny, Danny Zapata, Danny, welcome to the Bigger Pockets podcast, man. How are you today?

I'm doing excellent. Thank you for having me on.

You are, you are quite welcome. What, what is on your mind? How can Andrew and I brighten your day a bit? What is your real estate question you want to bring for, for Andrew and I to answer and for the masses to hear our thoughts on?

Yeah, yeah. Let me give you a little context. So I'm a small multifamily investor currently. I have some properties in Sacramento and I'm looking to take that next big step to scale. So.

Really great opportunity to pick both of your brains here. Right now the question I have is around, you know, besides differences in lending between small and larger multi families, what are some of the other things you look, you look out for when you're scaling from, you know that less than 5 units to 10 to 20 unit properties?

Well, I know Andrew, I know you and I have friendly debates on which is better. Andrew got pretty much right into big multifamily real estate because he's a superhero and he's able to do that. Commoners like myself have to climb their way up from like 5 to 10 to unit to 30 to 40 and, and, and, and scale up in that. But here's, and I'm sure, Andrew, I know you have thoughts on this as well, but I'll, I'll give you my thoughts briefly, Danny, in that when you the, the, the profit and loss statement's still the same, right? There is still profit and there's still losses in that there's still income and expenses. The, so you're still going to have an income stream. But as multifamily gets, as you get to bigger and bigger deals and it perhaps becomes a few more income streams. Perhaps it's not just rental income. Perhaps it's your, your PNL is going to show laundry fees and all kinds of other fun things like trash valet or charging the tenants for cable or other things that come in so that it gets more complex on the revenue side. Additionally, things like late fees and that I got scrutinized for showing late fee as income on a four unit property because, well, you know, you're, you're showing that as revenue. You're kind of trying to stretch it. But guess what? On bigger multifamily it becomes more common and it becomes expected for that to be part of revenue. Additionally, on the expense side, that can get very big on the expenses on multifamily. Not big in the dollars but big in number of line items. You may have like On a five unit property, you could have, what do you got? You know, real estate taxes, insurance, maintenance, maybe four or five other line items. For a larger multifamily property, you could have 30 or 40 line items on an expense sheet that, and you've got a big one that a lot of people on small multifamily don't think about. And that is payroll. Right. And the reason, and here's what that means, right. For a four unit property that you own. Like give me a really a real life example, Danny, of a small multi that you own right now.

So yeah, I have a fourplex in West Sacramento, mix of two bedrooms and one studio.

Who's managing it?

We have a property manager for that.

Okay. Do you, you don't write a check, a W2 check to that property manager's salary that collects your rent and runs that property for you, do you?

Correct.

Okay.

For larger multifamily you will charge a pro, you will get a, you'll see a property management fee, but you're also going to see staffing charges. And, and it's a good to bad thing because that means that you've got full time personnel. And the rule of thumb is somewhere over around 80 units a property can afford full time personnel. And that's awesome because that means that person's career, their job is based on making your multifamily property, you know, meet its goals. Correct. So that could be a leasing agent, that could be a maintenance tech, those kinds of things. But you do not have those line Items in your 4 unit or in your 10 unit or in your 30 unit doesn't have those things. And so you need to budget for full time staff whose job it is to make that multifamily sing the song you want it to. Leasing agents, perhaps. Larger units may, larger properties may have a site manager, larger properties may have multiple maintenance technicians whose job is to repair things that come up on the property big and small. That is far and away the line item that a lot of smaller investors, as I did, get surprised to say, oh wow, I have to budget for that. But also exciting. I now can give these people job descriptions and give them task lists and use software or whatever to make them fully optimized it, help them fully optimize their product positions and in what they do and help that bring along my property. So it's a good thing, but just to get a budget for it. Andrew, do you care to. John, what. What other. I know you've thought of this too, but what other things do you see in the buckets on bigger multifamily that are maybe not in the buckets on smaller multifamily income or expense wise.

Yeah. And you know your comments. So I, I jumped straight to 92 units because of one of the things you said is that the bigger properties will hire, will be able to support their own full time staff. Because I was like I don't want to manage a 30 unit from out of state. That's really difficult. So you know, you really mentioned quite a few of them and a lot of the really important ones, some of the other ones that are actually not necessarily line items on the, on the P and L. But some of the other differences, Danny, one, keep in mind bigger is mentally more daunting, but bigger is easier. It's the same amount of work to take down a 10 unit as it is to take down 100 unit. So you know, my philosophy is just go as big as you comfortably can. And I mean comfortable is without putting you or your investors at financial risk. But just don't, don't be scared by the fact that, well, it's 100 units. I've never done that yet. If you've taken down a 10, you've taken down 100. And it's just amount of the finances and it actually gets easier the bigger you go. The other difference when you're starting to scale from like 4 Plexes to 10 units and 20 units is demographics become that much more important. If you have a four plex and it's in a market that's flat or maybe even declining a little bit and it's not that hard to fill a vacancy or two. Right. Because you don't need that many people to stay full. But if you've got a 20 unit and people are moving out of the area and you start getting two, three, four vacancies, it's actually, it's going to get harder and harder to keep that property full and it's less and less likely for rents to go up. So as you scale up, demographics becomes more and more important because you're not, you're becoming a bigger fish in the pond. Right. When you're, when you're a fourplex in an MSA with a million people, you can kind of swim your own direction and get away with it. As you collect 10 and 20, 30 unit properties, you're a little bit more subject to the currents that are flowing around you. And then also another thing to keep in mind when you get to 10 and 20 units is if you buy a fourplex, let's say you house hack it, you get FHA loan, you move in, you get a vacancy, you probably have the reserves to cover that vacancy for a month or two or three. When you start going to 10 and 20 units.

It'S a mental shift of no, I am not personally going to be able to cover all of these properties as I add them to my portfolio. Because if you buy 5, 20 units now you're talking about 100 units. And so you have to shift the mentality to really running them each as a business and that means capitalizing it well up front. So yeah, you're not going to be able to float that $30,000 a month mortgage, but that's okay because you brought an extra $250,000 to the table when you bought it and you set that as a reserve account. So those are also some of the differences that I would keep in mind as you shift from like smaller 4 Plexes to 10, 20 and then on up from there.

It's a great perspective because I've always kind of looked at, you know, the, the larger scale in terms of, you know, if you have 20 plus units, one vacancy doesn't hurt you nearly as much as a small multi family. But at the same time you got to consider all those other things and you know, declining areas and demographics that can affect you and make it super hard to fill and keep it that way.

Yeah, it's, it's a double edged sword, Danny. Meaning, like it can be very difficult to take a larger property and bring, I mean I've brought a 200 unit from 30% occupancy up to 95% occupancy. And I can tell you that was a grind. It's where I got most of my gray hair. It was, it was tough because each time you lease one unit, well, great, that's a half a percent occupancy. You just move the needle. Whereas you lease an apartment on a four unit that's 25% occupancy. Occupancy is move the needle. And leasing one apartment could take you from the red, you know, from being in the red into the black. You might have to lease 30, 40, 50 units in a, in a larger multi family to really make significant cash flow differences. The good side is that it can take a properties like that can take a bit of a hit from the market with regards to occupancy. Maybe 5%. Whatever's not going to put you underwater, you know, and so you lose a couple of apartments, it's not the end of the World, your budget is going to have vacancy baked into it. Whereas for a few four unit, you're either vacant or you're not. You know, I mean it's, it's not like you can bake. You're either 75% occupied or you're 100% occupied. Whereas for a 100 unit apartment building, you could be 85% occupied and be doing okay. So other, other questions, other thoughts? Danny, what, how else can we, what other light can we shine for you here?

Yeah, that's great. Thank you. So, you know, when, when I look, look, as I mentioned, I have a few small multi families that, you know, they do okay cash flow wise and I've actually budgeted some of that stuff that you've talked about in terms of the larger units and kind of keeping accounts for vacancy and different, different line items there. But when you know what, I understand I've gotten some good advice or some interesting advice recently around balancing cash flowing versus appreciating properties. So I'd like to get kind of your, your advice on is how do you balance those because you have cash flow properties that kind of pay the bills. And then you may invest in appreciating properties where you see a lot of potential, but they may not necessarily pay the bills or barely break even. So is there kind of a calculus that you do in terms of how much of each do you have in your portfolio?

Yeah, Danny, I can jump in. I've got a few thoughts on that. I know David talks a lot about this kind of thing on the podcast as well. And it changes when you move from like, you know, this kind of smaller stuff into the bigger stuff. Number one, it also changes with the market. Right. So like David's talked about a lot of times, he would buy stuff the last few years with almost sometimes negative cash flow. And you know, he, because he knows in three, four years it's me worth a lot more. And that was a great multifamily strategy for the last seven years as well. You could buy a value add that had negative cash flow, get it fixed up nice. Like Matt was saying, he took something from 30 to 95% occupied. Well, it was negative cash flow at 30, but it probably was cash flowing pretty well and worth a lot more at 95%. We're in a different part of the market. So if you're looking at a 10 unit, 20 unit, I would stick with something that at least cash flows so that in a worst case scenario, if you can't, if the market shifts against you or the rent doesn't grow or you can't exit, or you can't execute your value add yet, or whatever your business plan is, your worst case scenario is you hold it and you wait. Right? We're at a point now where the greater focus is hedging against downside risk. And then once that's hedged, now you focus on, okay, what can I do for upside? The other beautiful thing about multifamily compared to single family is with single family, you really are at the whim of the market. It's the sales computer. With multifamily, if you are a good operator, you can execute a plan that increases net operating income and you can force value increase of that property by increasing the net operating income. So for me, if I'm looking at a 10 unit property, the current cash flow is important in terms of hedging downside risk and then future cash flow. By executing a business plan and buying in the right markets, that is important in terms of creating equity. So multifamily, you really can have the best of both worlds. You don't have to say, well, I'm going to stack, I'm going to get no cash flow just so I can get appreciation. The multifamily to me is one of the best investments out there because you can do both.

Also take a global view. Can you carry it personally or within your business? We talked a bit ago about, well, if I've got a 20 unit and I got one vacancy, that's probably not going to affect me. Okay, that's correct. And again, that's one of the advantages. If you're going to buy a 20 unit that's almost completely vacant, how are you going to cover that until it is not vacant? Are you going, can you do it personally? Are you going to raise a big interest reserve up front before you buy it? There are ways to mitigate that, but just make sure that you have it covered and in today's market environment.

Factor that in much more than we have the last five to seven years. So just kind of as a quick recap, multifamily, my approach is to try to get both cash flow and then be able to force appreciation. If you forgo the cash flow to try to get even more appreciation, make sure you bring lots of reserves to the table, whether it's yours, whether it's, it's investors, whether it's partners to carry you through that period and, and get you out, get you out to the other side. Matt, got anything else you want to add or.

Yeah, man, I'll throw Just Andrew, you and I are both old enough to be able to say we both invested in 2007, 2008 when the, when the bottom fell out. Right. And I'm not, I do not believe that's what's going to happen again to the market, but I do certainly believe the market's going to change. You know, it's going to go somewhere in 2023. Right. And I would not be banking on appreciation. Appreciation has made a lot of people look like geniuses and over the last 10 years, but really what they did was they picked the right markets and they made a lot of money on appreciation that they had no control over. Meaning like just cap rates went down, property values went up, certain markets, you know, blew up off the charts. And a lot of people have made a lot of money on, on activities that they had no real control over. And, but they, but they were able to tout that they did. And so I think you're going to see a shift. And I personally today from just given what I learned in 2007, 2008, cash flow is king. And I think it'll become more king, you know, over the next couple of years. The properties that I owned in 2007, 2008 did just fine during that recession. If they were cash flowing, the properties that were cash flowing, they might not have been worth what I paid for them a year or two ago, but if they were cash flowing, you can weather the storm. You're not just having to throw money at them to keep them going. I personally did. My investment strategy would be invest in nothing that doesn't cash for the very first day that I own it. I'm not doing negative appreciation stuff. I don't judge anybody that does. That's just not our strategy. And I would be investing in cash flow because cash flow gives you time, right? Cash flow will give you time to hold it for a while until, and cash flow with fixed interest rate debt will give you time to hold it if things get funky in the market for a little bit. Just keep, you know, keep cash flowing it until, until you can sell at some point in the near future, at this point, buying a proper, with a goal of appreciation to meet your long term investment goals for yourself or for your investors is really investing in something you can't control. You know. And yeah, you can push a forced appreciation by increasing rents, by increasing noi on the property. But the other thing that the, the other factor in forced appreciation is cap rate and cap rate is how a property gets valued. It's you Know, noi divided by that cap rate is the value at the time. Right. So if cap rates can expand a bit, if interest rates stay high for a while, cap rates may start going up in the multifamily that was worth X today could be worth X minus 10% a year or two from now if cap rates continue to stay. If cap rates come up and investors aren't able to pay for properties what they're able to pay today. So I can't control what cap rates do. I can control. No, I can control, you know, the way I operate my property in that. So I'm investing 100 in things I can control over the next couple of years. I've got no faith in the market delivery, you know, taking me to the promised land anymore.

I concur with Matt. I do not buy personally. I don't buy negative cash flow anymore. We did that in the beginning. I don't do it anymore. And I think 2023, a lot of the, let's say motivated sellers are going to be people who bought in the last year or two and don't have the cash flow they need to hold on to the property.

Unfortunately, I 100% concur. Again, I don't think a bubble is going to burst and the bottom is going to drop out. But I do think you're going to see properties on the market for people that, as Andrew said, they just need to get out so that. Just to stop the bleeding or whatever it may be.

Yeah, quick follow up here. So it's really interesting you mentioned kind of how the market's changing and you have all these folks who have properties which don't cash flow, which, you know, may present an opportunity for, you know, investors who want to get more in the market. So how do you. And then you both kind of mentioned, you know, we don't invest in things or don't want to invest in things where it doesn't cash flow on day one. But I also live in California, which has some really interesting tenant laws, pretty restrictive. So I look at some of these properties and from my experience from the smaller ones, the tenants that you acquire the property with aren't always the ones that you want to keep long term when you reposition. So from that perspective, I've been thinking lower occupancy is actually better because it helps you accelerate the repositioning. But if I'm listening to you folks correctly, it's not an ideal for this kind of market situation. So maybe get a couple thoughts on that.

I'll throw quick thoughts on that one. Andrew. Remember, Danny, when I, when I talk about negative cash flow, properties or properties aren't performing occupancy, you can solve is 70%. Again, I, you know, we got into a property that was performing economically at 30%. I probably would do that deal again today. I would. Because if a deal gets brought to market and whatever market rate occupancy is 90, 95% and it's still lean on cash flow, that's not a good deal. But if I can do what I can control, I can lease up, I can run leasing specials, I can put in beautiful kitchens and beautiful bathrooms and those kinds of things, and I can do what I can control to get a property to cash flow, I'm all in, right? And if you're talking about a property that's maybe, you know, 70% occupied in a market where there's a lot of rent control and those kinds of things, that's perhaps an opportun where Those, the other 20% of units that you can put back on the market, you can put back on at market. I like that. You know, Andrew, what do you think? 60, 75% occupied property in today's market.

You know, again, just, just make sure you can cover it and make sure you can cover it for longer than you would have planned last year or the year before. There is opportunity there. There's just greater risk. And so risk, you know, there's ways to mitigate it. And if you're going to take on that risk, just make sure you're doing that.

Danny, this has been an awesome conversation and, and hopefully, hopefully relatable to everyone here. I appreciate you, man. Thanks for coming on the show today.

Good talking with you, Danny.

All right, thank you very.

Much.

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