Are Multi-family Properties Recession-Proof???

It’s been just barely over a month ago that a new international financial crisis was averted following the US government 2-week lockdown and the raising of the debt ceiling until early next year when once again Congress has to raise the debt ceiling.

THE CRISIS HAS BEEN AVERTED, AT LEAST FOR NOW…  BUT FOR HOW LONG?

I got to tell you I don’t consider myself a worry wart but I’m concerned about what I’m seeing with regard to the international financial system and I’m darn happy I chose to invest in apartment buildings because if done right it can be an excellent hedge against financial volatility.

And I sure am no economist either, although I have always found macroeconomics quite fascinating.  But somehow, it just does seem right for the US whose currency is the world’s reserve currency, to keep printing money at will, which is what economists call ‘quantitative easing’, to keep their economy afloat.

I hate to say it but my 87-year old dad who has little education (he was a lumberjack) was right! He’s been asking for years where is all this money coming from? What value is there to back up this money? The subprime mortgage crisis and ensuing deep recession certainly proved him right!

And then, if you look at the sovereign debt issue in Europe, it’s anything but resolved.  Bottom line is that there are a lot of dark clouds in the financial world that could turn into a storm at any moment.

So yes! I’m worried somewhat! The truth is I did not particularly enjoy the real estate ride during the 2009 recession, which, as you will recall, was the worst since the Great Depression of the 1930s.

In December 2008, just a few weeks prior to the beginning of the recession I took possession of 24-unit apartment building.   2008 was certainly a bad, bad time to get into multi-family investing.  The first thing that hit me in my market was the City of Edmonton increased property taxes by a whopping 34% within months. There was the first hole in my cash flow.  Then of course as the recession worsened oil-related jobs fled the province and oil workers went back to Nova Scotia or Ontario or wherever they came from and vacancies increased drastically overnight. There’s another hole in my cash flow. Of course with higher vacancies come higher repair and maintenance expenses because when your suites become vacant, well that’s the time to fix ‘em up a little to attract tenants. Third hole in my cash flow and 2009 and the recession had just begun.  Oh yes and when the vacancy rate doubled, then the large, and often times institutional landlords such as REITs (Real Estate Investment Trusts) with significantly bigger financial means than me, started giving rent discounts to attract tenants to their vacant suites.  So I had no choice but to follow suit and start lowering my rents too as an incentive to tenants to rent my own vacant suites. What’s that? Fourth hole in my cash flow now… That nice positive cash flowing multi-family property is now looking like a Swiss cheese big time now!

OUCH!!!

I forget to tell you that if I had closed on that 24-suiter only a few weeks later, around the end January 2009, the interest rate on my loan might have been perhaps close to 2.0% lower than the 4.76% rate (5-year term) I ended up getting.  You may remember that within weeks of the beginning of the recession, interest rates dropped significantly.  (See graph below, courtesy of Calum Ross)  The additional cash flow that I could have had from a lower interest rate sure would have been nice and plugged up a few holes in my Swiss cheese cash flow.

I’m not going to lie to you, 2009 and 2010 were not much fun. But looking back, I now realize the very important lessons I learned and I’d like to share the key ones with you in today. I’m actually very grateful for that challenging experience because it’s made me a much better real estate investor and if my concerns over the international financial situation ever materialize, I feel my investors and I are well protected as a result of implementing those lessons.

LESSONS LEARNED

1)   Don’t over pay for the property

OK! This goes for any real estate asset you purchase and, although I put it down as a lesson, I cannot say I have overpaid for this property. As a matter of fact, I obtained financing for 84.4% of the purchase price, which is very rare for a CMHC-insured loan where the maximum LTV is 85% of the lending valueas determined by CMHC’. The emphasis is on the fact that CMHC practically always uses a value that’s lower than market value in calculating the LTV.   You always end up having to put down somewhere between 20% to 30% down.  As we’ll see below in lesson #2, more money down is not necessarily a bad thing. On the contrary. The point here is that if you overpay and there is a market correction in terms of values, it might be a while before you recover the over-paid portion.  We certainly experienced a market correction as values definitely decreased during the recession, although not much. You really need to know your market well.

I’m personally aware of a few investors that have defaulted and lost their properties because they speculated on the value and they bought based on future value that never materialized instead of current value.

2)   Lesson #2:    Don’t over-leverage your financingI’m not sure this was necessarily a mistake I made, that is to take a loan a close to 85% LTV. However it’s certainly not something I intend to do again.  Right now, my average LTV on all my properties is around 70% and I don’t intent to ever exceed 75%.  This is a much more comfortable position to be in in the event of market volatility.  A lower LTV means you have a lower loan amount, therefore a higher risk tolerance for higher vacancies and a greater cash flow to carry you through tougher economic times.  I like a break-even vacancy rate of at least 20%. The worst vacancy rate I suffered during the recession was around 9%. This means 91% of my suites were still generating an income. I like to sleep at night…

3)   Lesson #3:    Be ready to intervene as needed

When I faced higher vacancies I have to admit I may have been a little slow in reacting at first.  My suites were in good condition and yet I wondered why they did not get leased up more quickly. Then I started looking at the marketing my property manager was doing. As part of the management fee, it is his responsibility to advertise vacant suites. I soon discovered that my manager’s ads were not very good.  You cannot blame him because managing properties is a very tough job. The ads contained very brief property descriptions that did not mention the surrounding amenities or the walking score (http://www.walkscore.com), and especially the ads had no pictures…  So I then yanked away the marketing from my property manager and took it over. I started writing detailed ads myself on various online websites and included lots of pictures. The result was an immediate decrease in  vacancy rates by almost half.

4)   Lesson #4:   Be realistic about your return projections

Right up until the recession, that is during the preceding economic boom, we had extraordinary returns in excess of 30% per year. In Alberta, rents increased by close to 40% between 2004 and 2008.  That’s right! There’s no rent control! Rent increases, though, are limited to once per year to whatever the market can bear. Because of the multiplier effect whereby the value of multi-family properties is directly derived from the ‘income approach’, which means that for every dollar in increased net operating income (NOI), the value of the property appreciates in value by approximately $15, our returns were fantastic. Frankly, I went in into this deal with expectations of high returns and because of the recession these high returns did not materialize.  The good news is that our tenants kept paying the mortgage down and the property appreciated in value. Not all was lost. Still though, the property generated around a 12% annual return, albeit mostly a combination of mortgage pay down and appreciation. Not a bad return when considering it occurred a deep economic slump. Imagine what the return will be when times are good like now…

5)   Lesson # 5:     Be patient!

Well, I guess that’s it hey! Success does not happen overnight and patience is a virtue! This is probably the biggest lesson of all.

I stuck with it and I just renewed the mortgage on this 24-unit property for another 5-year term at interest rate of 2.62%.  A drop of 2.14% from the 4.76% rate I got just before the recession began.  Needless to say the impact is significant. Basically, this means an instant increased in net cash flow of $2,100 per month. Plus, the annual principal pay down will double.

Patience pays off, indeed…

Not only that, but since I purchase this property a new LRT (Light Rail Train, or subway) has been built within a few blocks of it and it will come into operation in the spring.  According to studies, the proximity of the LRT could lead to a value appreciation of 10% to 15%.  In addition, a new arena for the hockey team the Oilers will be built over the next 5 years, along with a huge retail and condo development attached to the arena. In all, it is expected that perhaps as much as 5 billion dollars will be spent in redevelopment in the area causing a significant revitalization of the area and further value appreciation and drawing quality tenants looking for a great urban lifestyle.

The current vacancy rate is extremely low. I figure it must be around the 1% mark. In other words, we’re fully leased and just in the last few months I’ve been increasing my rents, some suites by as much as 7%.

SO ARE MULTI-FAMILY PROPERTIES RECESSION-PROOF?

I personally believe so if they’re structured properly using a risk assessment and mitigation approach. For sure, my training as former CMHC underwriter come in handy.  You cannot completely eliminate risks, but you certainly can manage them to a great extent.

Yup! I’m definitely worried about the possibility of another financial crisis.  But no matter what happens, my investors and I are well protected because at the end of the day, if done right, apartment buildings remain a low risk and safe investment asset, and I like this! It may not be a get rich quick scheme but every now and then as the real estate market cycles go up and down you get a big lift (multiplier effect) and it more than makes up for lost time.

I hope this post has been insightful. Please, feel free to leave me some comments  and/or ask me questions.

Cheers!

6 Responses to Are Multi-family Properties Recession-Proof???

  1. Jim Elson says:

    One quick observation. Perhaps we should all invest only in Alberta and avoid rent controls? 7% increase in one year, now that’s nice
    Jim

    • admin says:

      Hey Jim! I hear you! I think everybody is investing in Alberta now because I have a hard time finding properties to buy. The word is out and the market is very very hot.

      Thanks for your comment.

  2. Jeff says:

    One market a portfolio doesn’t make- Spread your asset base across emerging economies. Alberta goes sour then what ?

    • admin says:

      Jeff,

      Thank you for your comment. I agree that spreading your investing risks across different markets sounds like a good idea. However, I’m very comfortable sticking to Alberta in the long run because, although there’ll be up and down cycles over time, I cannot see you and I stop using our cars to get around in such a large country such as ours. I also don’t see other emerging economies needing less of our oil over the long run either. Proof of this are the foreigners investing in the oil sector in Alberta. Let me give you some examples: Warren Buffet, known as the most smartest investor of the 20th century, last summer bought a $500M stake in Suncor Energy Inc., Canada’s largest integrated oil company. Also earlier this year, Chinese state-owned entity CN00C Ltd bought out Canadian oil and gas company Nexen for $15.1 billion as a means to meet its energy needs. I could easily go on with more examples of such investments by the billions. These investments are long term and they would not materialize if the big picture and long term prospects were not very promising.

      Cheers!

  3. Darren Smurthwaite says:

    Great article Pierre-Paul

    Darren

Leave a Reply

Hide me
Get the FREE Blueprint Report
First Name Email Address
Show me