Prices, interest rates, rents, they’re all getting higher and higher. There might even be a potential recession at this point. So if you want to thrive in this current market, listen to this episode. Today in Alternative Investor Mindset, we’ll be discussing how real estate is still the safest bet despite the higher interest rates and potential recession in the market. Tune in to learn what’s really going on in the market, and how to know where you can leverage on
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Real Estate Still Safest Bet Even With High Rates/Recession
In this episode, I want to talk about why real estate is still the safest bet even with higher interest rates and a potential recession. The first thing I want to point out is that most multi-millionaires have a much higher allocation of their wealth in real estate and other alternative assets than the stock market. I saw a statistic that roughly 90% of investors are in traditional stocks, index funds, and mutual funds and have very limited exposure to real estate.
Those of you that are accredited investors who have significant net worth should have a much higher percentage of our assets in real estate and alternative assets, especially with some of the coming economic uncertainty we have. I want to say I see a lot of noise or news about real estate prices. It’s the CNBC highlights on the residential housing market. Don’t let the hype of the residential market scare you away.
The residential and commercial real estate markets are drastically different. There’s a great quote by Howard Marks at Oak Tree Capital. He was one of the early investors in the subprime crisis and has a book about market cycles. I’ve tended to repeat this a lot and some of you probably read this ten times from me. “History may not repeat itself, but it does rhyme.” I’m not expecting a 2008-type housing crisis, and the reason is that so many people are locked in fixed-rate debt. There’s not going to be the level of supply that there was.
In 2006 and 2007, most of the people that got in trouble had these option ARMs where they got in with a teaser low rate, and then all of a sudden, 1 year or 2 years later, the rate was doubling or tripling. That’s not the case this time. I locked in 2.88%. Most people I know that bought in the last couple of years are locked in 30-year fixed-rate debt. They’re not going to be for sellers. With inflation going on, rents are also through the roof as well.
Many of them might choose to rent the property out instead of selling for a few years because they’ve got a 30-year fixed rate at 3%, could rent the place out, and make thousands of dollars a month. Again, I don’t expect a housing collapse. There probably needs to be an adjustment in some of these markets that had this crazy bubble during COVID because of a lack of supply.
Commercial real estate is different. When you’re investing in cashflowing properties, everything adjusts as debt increases. What we invest in are cashflowing properties. We have a significant amount of fixed-rate debt. Much of which we locked in 1 year or 2 ago at very low rates. For any debt we have that is a variable rate or floating rate, we have an interest rate cap. Usually, rates are either 1.5% or 2.25% and if it hits a cap, the rates can’t go any higher.
We have a building in Little Rock, Arkansas in our first fund. It was purchased in February 2022 and had a 1.5% interest rate cap. Rates went up over 2.5% this year and that property is in the money. Rents are still increasing like crazy and the rate can’t go up any higher and we’re doing well. Talking about rents, multifamily rents are still increasing significantly along with inflation. There are a couple of reasons for that.
There’s still a shortage of workforce housing with the cost of construction, materials, and building new construction in general. If you’re building new apartments, you’re building higher-end unless there are some tax incentives. You’re generally building a Class A and those are not affordable for the average workforce housing, the Amazon delivery driver, the entry-level plumber, and the fast-food worker to some extent.
There’s very much a shortage of that type of housing and that’s what we focus on. We buy properties that were built in the ‘70s or ‘80s, nice, and relatively occupied but outdated and needed update. We found that for a middle-class professional that is looking for a nice non-luxury place to live, by renovating an apartment and putting in new kitchens, bathrooms, and flooring, we’re getting a premium.
In some cases, 50% higher rent than when we purchased by providing a nice clean place to live that’s not super luxury and going to cost that’s below $2,000 a month. In the hedge against inflation, leverage real estate is one of the best ways to go. You have positive cashflow, it’s completely passive, and in my opinion, it’s much safer than the stock market. Another asset class that is a mainstay of the syndication world that we have some exposure to and will likely continue is self-storage. Self-storage has always been known as recession resistant. In the 2008 crisis, self-storage did wonderfully well.
When you have to downsize a property, you need storage. If you’re moving to a different area, you often need storage. There’s a lot of growth in the Southeast and the Sunbelt with people moving from the North. Often, they’re going to move some stuff. Even if they’re moving into a bigger house down South from the Northeast, they often want the house to be clean. It’s a good way to pare down your stuff but often, it ends up in self-storage.
When you talk about self-storage with inflation, think about how much of a pain in the butt it is to clean your garage or how much you put it off. If you’ve got a storage unit, with inflation, you’re getting a $50-a-month rent increase. What’s the likelihood you’re going to go, clean out, and move your entire storage facility? It’s very low.
The tenant base in self-storage is very sticky, very high renewal rate on average multi-year leases, and is not very sensitive to rent increases. That’s a great asset class. For many others, we track the mobile home park space. We’ve done some student housing generally in SCC country. Big universities that pretty much stayed for the most part open and people rented for most of COVID that are going to continue to be mainstays and a very stable occupancy with real simple cashflow. We love those asset classes.
As far as where we are in the stock market, a lot of people preach index funds. I’m certainly not advocating anyone to panic and sell the bottom but keep in mind that we’ve had a twenty-year run of generally low-interest rates, the Fed buying bonds, doing whatever it could to prop up the markets. There are some larger shifts happening right now. There have been some periods of time through the ‘60s and ‘70s where we’ve had 5- to 10-year runs where the market hasn’t automatically bounced back the next year like it did in 2020.
For example, there are sectors in Japan that haven’t reached their peak since the ‘90s. Japan, if you look at macroeconomics and follow guys like Peter Zeihan, they have some demographic issues of an aging population that is very similar to what’s happening here. Our average Baby Boomer turned 65 in 2022. That means a lot of money that’s been in 401(k)s, passive, coming out of people’s paychecks likely in stocks, and more types of growth sectors are shifting more into protective mode.
For example, bonds, especially with interest rates up. A lot of that money is going to get more conservative and there’s less money to prop up the stock market. More than ever now, it’s important to be diversified and have more assets in real estate secured by real assets rather than the casino of the stock market. A lot of people have also asked me or mentioned that only 1% or 2% of fund managers beat the stock market consistently. For the stock market, I completely agree. The stats speak for themselves.
However, private real estate funds and private syndications are different. It’s not exactly apples to apples. If you run the numbers on Warren Buffett’s returns, he publishes these in his annual letters. Throughout the ‘60s and ‘70s, he made higher returns through publicly traded stocks. You’ll see headlines of him buying Coca-Cola and Apple and doing well on some public stocks now. In reality, he’s made a much higher annual return on his private deals buying Geico. There’s a number of private companies he owns and the private equity deals over the last twenty-plus years have been a higher return for Berkshire.
You can beat the market because you’re buying. When you invest in private funds and syndications, you’re buying a piece of a business. There are plenty of businesses that have 15%, 20%, and 25% profit margins. When you look at beating the stock market average of 8% or 9% annual return with some exposure to private real estate, if you don’t think that there are businesses that can earn 10%, 15%, or more a year, then certainly don’t do it.
If you do your research, you’ll realize that there are plenty of private businesses that are consistently earning that. The question is, are you considering a stock return in the stock market or do you consider that more of a margin or a profitable business itself? With our series of funds, what we look for is limited partners and passive investors but I do think of them as business partners.
With that said, the market is adjusting slightly. We are seeing some better pricing and some great opportunities right now to buy all of these asset classes, like multifamily self-storage, mobile home parks, and student housing. With interest rates rising, the sellers know the numbers and a buyer is going to have a slightly higher cost because there’s a higher borrowing cost. Pretty much everyone buying a larger real estate property is going to use some leverage, even with rates at 5%, 6%, and 7%. It’s still cheaper than equity. Smart, conservative leverage is what pretty much every sophisticated buyer is going to use.
With that said, we’re getting better pricing and essentially priced in at this point. Our thesis is that pretty much everything we buy has a value-add component. For the properties we target, we could add more value by renovating units, raising rents from $800 to $1,200, and 40% to 50% on renovated units. That value increase is going to outpace inflation across the board.
That’s why I mentioned there’s a lot of noise out there right now. It’s very simple. You buy right and your dollar cost average, you consistently buy into new opportunities that are the best available at the time, and then over a 5- or 10-year period, we’re continually adding value to sell. We expect that we’re going to do very well on our investments. I have a case study on real property. This is a 94-unit in Fort Lauderdale that we closed on in July 2022.
We were fortunate we locked in 4% fixed-rate debt on this property. It was from a local bank and it was largely due to the relationship our partner has with the bank. He’s a high-net-worth individual and he owns a number of the properties in that bank. Even though rates had been moving, they locked in an interest rate. We’ve got at least five-year fixed-rate debt. This is a 94-unit. It was owned for a long time by an owner that was collecting rent and not doing much with the building.
It was 90% to 95% occupied but he would paint and re-rent units without doing much work. We took over the property with the plan of doing renovations as units became vacant. We also did a lot of work on painting the exterior and cleaning up the courtyard. It’s got a great courtyard and a great pool in the center. It’s about five minutes from Las Olas, the main strip in Fort Lauderdale.
What’s been happening in Fort Lauderdale is that a lot of people are moving from the North and can work remotely and are moving to Florida. The higher-end apartments and the single-family houses, everything else is shot up in value like crazy. Where do the waiters live? Where do the housekeepers and the middle class live down in Florida right now? They’re largely living in these types of apartment buildings and there’s a big shortage. What we’re seeing is that rents are increasing. The prior owner wasn’t paying attention. He wasn’t tracking the market. He might raise the rent to $25 or $50. He wanted to keep the place occupied and didn’t run it as a true business.
Rents are moving up to the market. We have a choice between renovating the units or re-renting them. What we’re finding is that there’s such a shortage that we’re getting $300-plus more in rent without doing a full renovation. Normally, the plan is kitchens, baths, and flooring, but in most cases, light renovation or paint and clean up. There’s such a demand right now that we’re delaying the full renovations and renting. Rents are up 20% to 30% per unit without re-renting. We’re still going to have long-term work through that business plan, but as of now, we’re getting the same rents without having to renovate. The questions come up a lot. How much more can rents go up?
I had a great conversation with Danny Kattan, who were a partner with them on a number of deals in Jacksonville and Fayetteville North Carolina, and a few other ones. He made an interesting point to me. I don’t know how many of you have seen the help-wanted ads that are out and about. I remember seeing one on one of my recent trips. In-N-Out Burger was offering $20 an hour. If you talk about minimum wage and some of the political stuff, I’ll stay out of but the fact is $20 an hour to flip burgers and that’s happening. There’s a shortage of across the board of workers. Some of that has to do with the average Baby Boomer turning 65 in 2022. That was the largest generation.
There are a lot of people leaving the workforce and there are not enough workers for many of the jobs. Wages are increasing regardless. If you think about what it takes to raise the rent by $100, if an average worker works 40 hours a week to cover a $100 rent increase, they need to make an extra $0.62 an hour to cover a $100 rent increase. I think and I hope most of you agree, especially on the workforce housing, that the hourly worker’s wages are up well more than $0.62 over a couple of years. With continued inflation, that is likely to continue. I feel good about our thesis that rents are not going to take a dive here, not on the middle-class workforce housing or apartment renter side of the business. I don’t think that’s going to happen with the worker shortages.
I want to talk a bit about taxes and then we’ll finish up for this episode. We are in the middle of October 2022. We’ve got two months left before the end of 2022. This is the time to do your planning for 2022 moving forward in 2023. This is the last year of bonus depreciation. That means that when you invest in syndicated projects, they generally will do what’s called Cost Segregation and they will look at the life of the windows, the roof, the air conditioning units, and the kitchen cabinets.
Instead of taking them over 27 years, which is the way that standard depreciation works, you’re allowed to accelerate that. Anything with less than fifteen years left in its life can be taken in year one. What that generally means for passive investors is for every $100 you put into a deal, you’re getting between 50% and 100% tax loss on paper year one so this could offset other passive income you have.
If you own other properties or pieces of other businesses and you have other passive income, the losses from passive real estate can offset all of your other passive losses. If you’re a high earning professional and you have a high W-2, in most cases, you cannot offset your W-2, although there are some great scenarios where that can work. That’s more of a one-on-one conversation about becoming a real estate professional, which doesn’t mean you need to be a real estate broker.
It means the number of hours you spend on renting properties, and that could include your spouse as well. If you want to have a one-on-one conversation, we’d love to strategize on that. We’d love to hear what our investors are doing, what they’re working on, and what their goals are. My main point is that you have about a month to figure out if you can save money on taxes by investing in properties this 2022.
In addition, we’ve had a bit of a price adjustment on new acquisitions so we’re getting much better deals. If you’ve been worried about the interest rate rise and catching the falling knife, we’ve got great deals all along, especially now. We’re seeing some great opportunities with the shift in rates. Now is a great time to be actively shopping to buy and invest. If you have money sitting in cash, inflation is likely to continue. You’re losing money every day if your money is in cash.
That’s it for this episode. Please follow us. If you’re on iTunes, please give us a review, or if Spotify is your platform of choice. We are on YouTube as well, so if you’d like YouTube, please subscribe and leave a comment. If you have topics you’d like us to address, please let us know. You could also subscribe to our newsletter at JKAMInvestments.com and feel free to reach out if you have any questions or are interested in investing passively. Thanks a lot. Have a great day.