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Empty invoice for Real Estate

The best real estate deals in 2025 will all have the exact same issue. So every single real estate deal that's in distress has a long term sheet. And there are five main things in the term sheet, and I've outlined them here. The first one is the term there's a beginning and an end. And that's going to be very, very important. The second one is the rate. We all hear about the rate, the federal funds rate and the what the Federal Reserve is doing. But the interest rate is extremely important. The type is either fixed or variable. The ones we're going to talk about in this video are the variable loans the fixed rate debt. They're going to be probably fine. Then the next one is loan to value. So this is leverage. How much will the bank give you against the collateral of the property that you're actually pledging? And the fifth one which nobody really talks about is debt service coverage. And this is actually what's disrupting the entire real estate industry. So let's take a snapshot of what the interest rates did since 2019. So as you guys can see here, they were in the low 4% range in 2019. And they've gone all the way up over 7%. Now they've come down a little bit, but they're basically still let's call it in the high sixes. Mid sixes to low sevens. That represents about a 3 to 4% interest rate jump. Now why is that important. It's important because if you bought a piece of real estate in 2021 when rates were, let's say, 3 to 4% and now they're 7%, because you had a variable loan, that means that whatever the loan payment was in 2021, what up? A lot. When you first got the loan, the interest rate would have been 3 or 4%, but it's gone up each and every year. That exact same loan could be in the 6% range and in construction loans it's even higher. The next piece that I want to focus on is what we call the debt service coverage. And this is typically buried inside of the loan documents. This is simply the net operating income divided by the total annual debt service. You can calculate the property's discard by dividing its annual NOI by the annual debt service, which includes principal and interest. For instance, this a property was generated $450,000 of NOI with 250 and debt service. It would have a debt service coverage of 1.8. That means that there's $1.80 of income for every dollar of debt service. That's really important. That lessens what the banks looking at when they size every loan. Is this debt service coverage. They look at this as insurance. So what they want is $1.80 of income for every dollar of debt service. Which means that the operator should have $0.80 left after that one dollars paid. That's essentially what the debt service coverage means. And as these interest rates went up, it significantly changed the debt service coverages, which I'm going to show you in a minute. Now, it's important to understand that this could be any kind of commercial property. It could be an office building, a self stores, a multifamily and industrial. It doesn't really matter in this particular case. It's important to see that as hasn't $1 million NOI. Now for those of you, you might not remember what an NOI is. It's simply income minus expenses. So in the apartment world, the income would be all the renters paying each and every month. And the expenses would be things like taxes, insurance and utilities and all those things on the expense side. And so it's simply income minus expenses. It does not include debt. That's very important. So when a bank is looking at what they're going to lend on a property like this, they're looking at the NOI because essentially this is the net income that they're going to lend against. This is the amount of money that the bank is going to lend you against, because this is how it's going to be paid back. This is a very typical deal. $25 million deal with 75% debt, 75% leverage, or 75% loan to value with 25% equity, a very, very common deal. What this would mean would be the people would tie this building up for $25 million. It would go source the debt at 17.5, and then they would go raise the money or put their own money in of 7.5 million. And of course, hoping that the property produces a $1 million and a why. Now, typically what was going on, let's say, in 2021 is these were value add. So they were raising the money by saying we're going to value add. We're going to grow the NOI by, let's say 100 or $200,000 in a period of a couple of years. And over here we're going to sell the property for more money than we bought it for. That was the typical strategy. This is a typical value add strategy with an NOI growth from 1 million to 1 point 1 or 1.2. At the time in 2021, interest rates were in the 3 or 4%, let's say. So 4% simple interest. Now, I'm not doing this on a fully amortized loan, but 4% of 17.5 equals a payment of about $700,000. So now the bank's looking at this. This $1 million is is about a 1.3 debt coverage ratio. In other words, for every dollar of loan there's 1.3 in income. Exactly like the example I just showed you. So this is a $300,000 cash flow on this property. This is about a 4% cash on cash. So what you do is you take your 300,000 and you divide it into your 7.5, and that is your cash on cash. And a lot of people look at that because they're like, I can just keep my money in a high interest bank account and make 4%. But this is what people are doing back in the day, because they were trying to create the value and get the capital gain that they were hoping to get. The debt service coverages were fine here, and the cap rate is 4%. The cap rate is simply a 4% into the 1 to 1 million and a Y, which equates to a $25 million value. So that's how that works. Now the cap rates, they do move based on the values of property that move from year to year to year. So cap rates go up and down based on what people pay. So and based of course on what the NOI is. So you'll see cap rates going up and down. So typically cap rates are quite low in markets that are super competitive. You'll see the higher cap rates in markets where there's not as many buyers. And you'll see the lower cap rates where it's super competitive. So now let's go to 2024. And the reason this is important because in the first slide I showed you that every loan has a beginning and an end. And so in every kind of value add property, people typically took out about a three year bridge loan with two one year extensions. So let's say this was 2020 or 2021. 2024 would be about the third or fourth year. So maybe they expire that a one year extension. But now things are a little more disruptive. As we all know, interest rates went up to 7%. So this is the first thing to note. So they went from 4% to 7%. So right out of the gate, what that does is it raises your payment from $700,000 to 1.225. That's again just simple interest. That's just having the interest rates go from 4 to 7% on the exact same loan amount. This is the biggest issue that you're going to see in as a theme as to why these properties are in distress. Hopefully, you are immediately seeing that this property now has about $125,000 negative cash flow a year. So we went from positive $300,000 cash flow to a -$125,000 cash flow. This is a red alert for the bank. Now what I also want you to note is that the the person who got this deal and bought this property actually did raise the NOI. They actually did increase the net operating income. So they were able to do it by let's say 100,000 or $200,000. So this is all positive, but it immediately was lost because the interest rates went up from this period to this period. So what they've done, even though they've performed, is that the interest rates have wiped away all their progress. And so now they're in a negative cash flow situation. So the lender is now taking a look at this low in this same Holy cow. This property now is in jeopardy. We are out of bounds with the debt service coverage piece of the loan terms. That's the first thing. There's no cash on cash. So your investors are upset. It's a negative cash flow situation. So this sponsor these people that own this building, they either have to fund this out of their pocket. They have to go get another partner. They have to go to their existing partners perhaps, and get more money. And they're trying to do anything and everything they can to save this deal. So this is the state of many, many commercial real estate deals right now. Doesn't matter if it's office, self storage, new construction, multifamily with bridge loans it doesn't matter. But this is the debt maturity issue that's facing us right now. And it's going to hit in a big way in 2025 now. So now let's go to the end of their term. Because remember all of these have a beginning and an end. So the end is what do we do now. They either turn it back to the lender or they try to find a buyer. They can't do a cash out refinance because here's why. Remember the NOI is still $1.1 million as you size this property. It's actually probably worth somewhere around $17 million. So the value of the property has gone down $8 million. When they originally bought it, they thought it was going to go up significantly more so, but it's gone the other way. And precisely because of the interest rates. So now then, if there's a new buyer, for example, the buyer is going to look at the 1.1 million and so is the lender. And the lender is going to say our interest rates are 7%. Going back to debt service coverages again, the most that they're going to be able to land on it is about $892,000 a year in simple interest, which produces about $208,000 a year in cash flow, back to about a 4% cash on cash return, kind of like we started their debt service coverages are back in order, and now it's about a 6% cap, taking the 1.1 and dividing it into the two. The actual price. So as you can see in this situation cap rates are going up. So let's sum up what's happened here. Interest rates have gone up from 4 to 7%. Cap rates have gone up from 4 to 6%. However, they're not directly a result of the interest rates, but people are actually willing to pay less for a property because it doesn't have any cash flow, even at the existing price. So that means the properties were repriced from 25 to 17. So now these sponsors and these lenders are in big trouble because here's why. If the properties were 17 million today, that means that it's not even worth the original loan. So that's actually what it means. So if you have this property three years, four years later, a buyer is not even going to pay you here. So so let's say somebody makes you an offer at 17 million. That means these people have to write a check for at least a half $1 million just to get rid of the property. And of course, all the equity that they raised in the beginning is completely gone. In this particular example, this would be a very good deal to buy. And this is precisely what people are looking for right now. They're looking for deals that have been repriced because of the interest rates have gone up, and they're out of bounds with the debt service coverages. And of course the cap rates are going up. So now you would buy this property with fixed rate debt. So you would buy this property with a 7% loan let's say. And you would produce about a 4% cash on cash return. It would produce about $208,000 on a $4.25 million in equity. And what you would do is you if you could, let's say you can increase the NOI even more, perhaps, or you wait for these cap rates to go back down because of these cap rates. Go back down from, let's say 6 to 5. Then this value of this property goes back up. So at a 5%, this property is probably up over $20 million. So you buy something for 17. And now the property potentially could be up over $20 million. So this is precisely what's going on in the real estate market. A lot of the lenders are actually taking back these projects and scraping the equity completely gone. So a lot of the limited partners, the LPs are out of these deals now. And these are sitting on a lot of lender balance sheets. And again, these are office buildings. These are industrial buildings. These are multifamily buildings. And this is what everybody's watching for 2025. Because they can step in and clean up all of these issues with these lenders that are now holding some of these assets on their balance sheets and are not yet released to the market. But I can assure you, this wave of debt maturity is coming. It's going to hit us in 2025, and it's going to spill over all the way into 2026. So this is what everyone's raising money for right now in the form of rescue or distressed funds. So be on the lookout for these in 2025. This is going to be the year to buy up properties like this. If you want to see an exclusive behind the scenes look at one of my properties. I just walked through this deal with my partner Ross. We went over some tips for buying and managing real estate. You can watch this video now.