Here is the sure-fire way to avoid getting burned at the top of the market. In one word, it’s “discipline.”
Here’s how it works.
- Decide on a target cash on cash return. Let’s just pick 8% for this example, which is hard to achieve in today’s market (but that’s the point).
- Decide on a level of leverage (mortgage debt). I always use 75% leverage on my deals. Not too aggressive, not too conservative.
- Never succumb to the temptation to alter either of these metrics, no matter the state of the market. Use discipline.
- Underwrite deals using your normal assumptions for rent growth, expense growth, expenses, etc. In other words, maintain discipline in your underwriting.
- If you keep all of your metrics constant, your underwriting will tell you whether the market is in opportunity stage or the danger zone. If you are keeping your metrics constant, and you are seeing deal after deal that does not produce your target return at the price you need to pay to buy it, that tells you that the market is at or near the top. If you start to see it easier and easier to make your target return, then you know the market is starting to enter the opportunity phase.
Now, this sounds really OBVIOUS, doesn’t it?
Well, here’s the thing. Most investors are NOT disciplined. As markets get hotter and hotter, two things happen. First, they get dollar signs in their eyes. Second, they start adjusting their metrics to hit the target returns they want. So, they become more aggressive on rent growth. Or they try to add more leverage to the deal to increase the returns.
They convince themselves that the deals “pencil out” and that they will make money. But, in fact, they are just adding more and more risk to the deals.
This happened in 2007 and it’s happening now. My mortgage broker friends tell me that deals are starting to fall out because investors are trying to hit their target returns by increasing the debt on the deals.
But banks are turning them down because the deals do not meet the required debt service coverage ratios.
At least the banks are turning them down, which they did not do in 2007. For that reason,I think we will have a normal property cycle downturn, but not a 2008-style financial meltdown this time around.
But the people who added too much debt to their deals in order to hit their target returns will still get burned.