Updated: Apr 23, 2020
No investment is without risk. Whether you’re investing in a stock, a bond, a rental property, gold or a business...every investment on earth carries a degree of risk. Even your FDIC insured savings account has risk associated with the solvency of the U.S. Federal Reserve. It is up to you, the investor to understand what these risks are and determine if an investment is suitable for you. In this article I will tell you what the risks are associated with a fyre CAPITAL investment and our strategy to mitigate them so that you are better prepared to determine whether or not our investments are for you.
The risks associated with commercial multifamily investing are unique when compared to residential rental properties.
A common misconception from prospective investors is that commercial properties react to market forces in the same way as residential properties do. While it is true that commercial properties are affected by markets, how and to what extent they react is different. Residential properties are consumer level, retail investments and as such are much more susceptible to the ups and downs of the market. Buyer behavior is a huge determinant of what a single family home will sell for. Because of this, there are large swings in residential home prices as prices are largely based on what an individual buyer is willing to pay for their ideal home...and in turn affect comps. While comps do impact what a commercial multifamily property will sell for, it is not the primary force affecting sale price:
Commercial multifamily properties are valued based on their Cash Flow.
Sale prices are a function not so much of buyer behavior, but on overall market condition and cash flow. Rents and expenses largely determine sale prices. In this way commercial multifamily valuation behaves less like residential real estate, and more like common business valuation. Kitchens and bathrooms are less influential on what a seller is asking for, it's more about what that property is producing on the bottom line. A great example of this is the reaction of occupancy and rental rates to the 2008 financial crisis. In the residential real estate market, home prices lost on average 40% of their value. Foreclosures and short sales created a real estate market downturn not seen in recent history. But what happened to commercial multifamily?
In 2008, homeowners left their single family homes in favor of apartments: Commercial multifamily demand went up, and rental premiums increased.
Occupancy rates increased and in turn rental premiums went up, all while in the middle of the 2nd largest recession in US history. Commercial real estate survived and even thrived in most markets across the country. An interested investor should take the time to understand the unique economic environment in which commercial multifamily operates.
Market Risk Mitigation Strategies
As you’re aware, every asset whether a stock or a single family home is only worth what somebody is willing to pay for it. Buyers and sellers come together to form a market and the potential of either side leaving, although remote, is a possibility. Once we purchase a property, we are participating in a market. Macroeconomic forces converge to influence the price of that property and if they are unfavorable, the price could be negatively impacted when it comes time to sell. Fortunately there are ways in which we mitigate that risk and minimize exposure should there be a market correction. Those strategies include:
Buying in the right markets at the right price
Properties are Cash Flow Positive Day 1
Securing long term debt
Having adequate cash reserves
Typically when we source a property, the goal is to pay as little as we can for a property which we identify as having a high upside once we reposition it. A property worth 10M for example will receive our offer of 6M-7M as we negotiate with the seller on terms and price. Once we get a property under contract, raise capital for the purchase and close, we’ve bought a great property for a great price. That price is always below market, part of that stems from our ability to source and close great deals, and part of that stems from unrealized equity gain on a value-add property. What this means for the investor is that we are able to withstand a change in the market. Should that 10M price tag drop to 9M, we are still in a position to receive a good return.
Cash Flow Positive Day 1
There are essentially 3 ways to make money in real estate: Cash flow, appreciation and principal pay down. We focus on properties that are cash flow positive day 1, meaning that even if we didn’t implement our business plan, the property would still make money. Purchasing assets in cities like Los Angeles or Boston, is akin to speculating on a stock. Properties in those locations are highly susceptible to market corrections and downturns. While an investor may make money through appreciation, we feel this is an extremely risky way to invest in real estate. We rely on the underlying fundamental financial picture when choosing our investments. That being said, we purchase properties in markets showing the highest potential for growth and appreciation. We simply don’t rely on it to make a return, instead its gravy on an already good deal.
Securing Long Term Debt
Securing long term debt is extremely important when looking at exposure to long term market risk. Commercial loan terms are very different from residential loan terms, and usually come with shorter terms such as 5,7 and 10 years yet have amortization schedules of 20, 25 or 30 years. We seek commercial loan terms with a time horizon that is beyond our anticipated hold time as a hedge against risk should markets turn. For example we may have a projected 3 year hold for a project, but our loan will have an 8 or 10 year term. Should a correction occur in year 3, it wouldn’t be in the best interests of our investors to buy high and sell low. Instead we secure a grace period where we can sell when markets are more favorable in year 5 or 6. This way we can return as much as possible to our investors and aren’t as susceptible to the ups and downs of interest rates.
Having Adequate Cash Reserves
Our acquisitions and asset management team have decades of experience and have seen quite a few unforeseen events as they relate to investing in commercial multifamily. Nevertheless, it is impossible to foresee every possible adverse situation we may be presented with. The way we hedge against that risk is to have cash reserves available to deploy should an unforeseen event impact the property’s solvency or financial position. If a major employer suddenly leaves our immediate market, a decrease in occupancy is possible. Our cash reserves serve to cover expenses while we implement a marketing campaign to counter that expected drop in occupancy. One of the great advantages of investing in commercial properties versus residential, is that even if a commercial property were to experience an adverse move in the markets which negativity impacted occupancy to say 85% for example, 85% of the revenue is still being collected. In a single family home rental, if that tenant loses their job or moves, revenue drops to zero while the unit is turned and a new tenant is found. That exposes rental property owners to significant risk when compared with commercial property investors.
In conclusion, there are always risks associated with investing. Just as prevalent as those risks are, we deploy numerous strategies to mitigate and address those risks. Blindly investing in a property located in a market based on appreciation is not a business practice, it's gambling and unfortunately commonplace in rental property investing. Buying in the right markets, which are cash flowing Day 1, securing long term debt and having adequate cash reserves are some of the strategies we deploy to mitigate risk and ensure great returns for our investors.
Invest with fyre CAPITAL
fyre CAPITAL is a commercial multifamily investment firm. We purchase and/or partner in 150-600 unit, value-add apartment communities in fast-growing Tier 1 & 2 U.S. markets. Together with our strategic partners, fyre CAPITAL represents over 500 Million Dollars of successful real estate acquisitions. Our developers, sponsors and capital partners have amassed a network of over 1,500 unique investors. We provide new opportunities to invest in projects targeting a 14%-21% Internal Rate of Return . If you would like to join us on our next project, your first step is to Submit an Interest Card. We look forward to partnering with you.