The real estate investing environment looks like a world in which trees grow to the sky. Capital flows into real estate have soared, taking cap rates to historically low levels. Great debt terms help justify record asset prices. Everyone seems to love it.
In 2019, lenders are offering great terms. Loan-to-value opportunities are high, interest-only periods are long, interest rates are low, and financing comes somewhat easily. As a result, many fools are relying on cheap debt to make expensive deals work.
With such high asset prices, people feel rich. Rookies feel smart and many have become self-proclaimed gurus. The herd feels comfortable and is buying into the hype. Historically high prices should cause investors to take extra caution, but I’m not seeing it.
Rather, I see investors paying record prices and justifying it with unprecedented debt terms. I get that debt boosts cash-on-cash returns. However, I don’t think a deal is justified because of favorable debt. Overpaying for investments because of great debt still leaves investors with assets that they overpaid for. Overpaying now with great debt, a decent yield, and speculation on perpetually low cap rates is foolish. It’s happening all around us though.
Favorable debt seems to give investors a false sense of security that they can earn their way out of trouble in future markets. The attention paid to the risks of softening rents, rising interest rates, rising cap rates, and recession is close to nil. Most offering memorandums I see assume rent growth, occupancy growth, and perpetually low exit cap rates. I can’t see the future any better than real estate market optimists, but I can clearly see a flaw in their principles.
Here is my primary investment principle: buy assets for less than they are worth. Investing is not about making a deal work because debt is favorable. Investing is about finding bargains. I believe that real estate investments should have some debt. I also believe that a satisfactory yield without any debt is an important consideration. I don’t believe that a 5% cap rate (very common in 2019) for an apartment complex or office building is an attractive unlevered yield. Those assets require a lot of work and risk for a 5% yield. So how are investors accepting those pathetic yields? With debt and foolish optimism.
I think favorable debt is positioning real estate investors for a destruction of capital. Debt levels are high enough that cap rate expansion could wipe out equity, which would be worse than sitting on cash today. Even if I’m wrong and trees actually do grow to the sky, I still don’t want investments that are justified by unusually favorable debt. Justifying expensive deals with cheap debt is the way of the fool.
