If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.
Continued from Part 31 –Forecasting: Here’s another use for NOI and DCR. Rosenberg believes interest rates are going to climb. How will that affect the value of income properties?
Once we know the NOI and DCR, we can begin to estimate what happens to an apartment building’s value at a higher interest rate. Assume current rates are 5% and we’re preparing for a climb to 7.5%. That’s about the middle of what Rosenberg expects in 18 months.
Example: $100,000 annual NOI divided by 12 months equals $8,333 monthly. Divide the monthly NOI by (in this case) a 1.20 DCR to get $6,944.
At 5.0%: $6,944 will support a loan of $1,293,500 (rounded). If the Loan to Value Ratio (the LTV) is 70%, borrower would be required to have 30% equity. A 70% loan plus 30% equity puts the property’s indicated value at $1,848,000 (rounded). That’s the sum of the loan amount plus the down payment.
At 7.5%: The same $6,944 will support a loan of $993,000 (rounded) at 7.5% interest. The required equity (down payment if this is a purchase, or retained equity if a refinance) is still 30% but the dollar amount of the required equity has shrunk to $426,000 (rounded). The property’s value at 7.5% interest is reduced to $1,419,000 (the total of the loan plus the down payment.)
When interest rates are at 5%, the value of the property is estimated at $1,848,000 (loan: $1,293,500 plus equity: $554,500). But now that rates are at 7.5%, the increased interest rate has reduced the property’s value by 24% (rounded), down to $1,419,000 from the earlier $1,848,000. That’s a loss of a little over $400,000.
Summary: Everything else being the same, rising interest rates (as in the example above) will reduce loan values. If loan values decline it is not likely that property values will remain high. In this example, the effects of rising interest rates cut $429,000 off the value of the building.
Emily knew all this but was still unmoved. She recognized that a rate-induced value loss was more than a possibility but she believed it to be less than a certainty. After all, maybe everybody’s wrong and rates won’t go up. Or maybe the value of all buildings will drop – except hers. And besides, 18 months is a long time. She’d been waiting that long for Ralph to call.
In fact, Emily didn’t have to do anything and she would still be okay. Her rentals were all 4-units or less and had 30 year fixed rate loans. But even if she had commercial (adjustable) loans, they would be fully amortized. Once they clicked over into the adjustable rate period principal pay-downs could be made with no pre-payment penalty. At future higher borrowing rates, competition from new apartment construction would be reduced. The limited new competition might allow her to raise rents a little more, over time, than she otherwise could – (Might). If she was hungry for more units she could refinance her properties now (not that rates are as low as they once were, but that forward rates will be higher) and tuck the proceeds away until the time is right. But that seemed like a lot of trouble and she wasn’t ready to do anything … maybe later.
Evening was approaching. She turned on a light and reached first for the fudge brownies, then for that diet book someone told her about, “The Complete Guide to Fasting” by Jason Fung, MD.
Emily started to earn a nice cash flow once her units were renovated and the rents were bumped up to market. If she was careful it was enough to live on and to even save a little. That meant she was now facing a pleasant issue all successful apartment owners sooner or later confront: what to do with her increasing income.
Emily did not know what might happen in coming years. Her future being uncertain, and she felt an urgency to have a liquid reserve. She was a single woman, now approaching middle age, and thought she should keep a portion of her investments liquid. You just never know.
Emily understood that there were many different ways to invest, but she didn’t know what might be best for her. She just knew she had to invest her savings. She couldn’t simply tuck a bunch of cash under the mattress: there would be no return and inflation would eat it up. She wanted to create a reserve of liquid money that had at least a chance at growth.
It was time, she resolved, to learn how the Big Boys invested.
Emily found that Warren Buffett and George Soros, two famous Big Boys, demonstrated very different investment styles yet both men were wonderfully successful. Emily thought that if she could understand how those guys did it she might just piggy-back on their selections. Maybe buy shares of a bunch of stocks Buffett has already bought, or maybe even copy Soros.
Warren Buffett
To Emily’s mind, Buffett seemed to have evolved his selection process over his career. In the early days he bought shares of stock as, someone once joked, a street person might pick up a cigar butt from the sidewalk. It may not be much of a smoke, but there are a couple of puffs left in it and it came cheap. This does not mean he always bought trashy companies. Some of them worked out very well. But back then Buffett bought based more on value than growth. Companies purchased around this time include Nebraska Furniture Mart and See’s Candies.
In his second iteration, thanks largely to Charlie Munger’s influence, Buffett began accumulating interests in “better” companies that were “surrounded by a moat”.
Emily took the moat reference to indicate that barriers to entry existed: it would be hard for a competing company to significantly encroach on the castle’s market share. During this period, Buffett accumulated stock in American Express and Coca-Cola.
More recently, in the current (third) iteration, it seemed to Emily that the single-moat had morphed into multiple concentric moats surrounding the castle. The desideratum changed from limited competition to no (effective) competition. In 1999 Berkshire Hathaway bought a controlling interest in MidAmerican Energy Holdings. In 2010 Berkshire bought 100% of Burlington Northern Santa Fe railroad.
Emily was pretty sure the multiple legal, regulatory, and environmental barriers (i.e., the concentric moats) protecting BNSF or MidAmerican made it impossible to duplicate either of those two businesses in the current regulatory climate. And she didn’t see that changing in the future. If there are no competing businesses now and none likely to appear in the future, that’s a pretty strong moat, isn’t it?
The Teachings of Warren
When both are elastic, supply and demand have an equal importance in the marketplace. But the “supply” side is more profitable. Supply is what people pay for. And big bucks can be made when you’re the only, or perhaps one of the top two suppliers.
MidAmerican Energy supplies electricity and natural gas to two million residential and industrial customers covering almost 11,000 square miles of Iowa, Illinois, Nebraska, and South Dakota. You’re too cold? MidAmerican gets paid. You’re too warm? You need to light the sign that says your motel has a vacancy? Your town has street lights? “I’ll take MidAmerican for $1,000, Alex.”
Burlington Northern Santa Fe is the second largest freight railroad in the United States (after Union Pacific). It has over 32,000 miles of track in 28 states, three transcontinental routes, and in combination with Union Pacific shares a duopoly on all transcontinental freight lines in the western U.S. You need to ship to the western states? You need to ship from the western states? Guess who gets paid.
The similarities are critical: There are huge barriers to entry relative to MidAmerican’s or BNSF’s businesses. MidAmerican has a monopoly on electricity and natural gas in its market area. Burlington Northern shares a duopoly on freight traffic moving to or from the western United States.
Monopoly and duopoly companies are wonderful things, if you own them.
George Soros
This is the man who shorted the British pound in 1992 and “broke the Bank of England”. His profit was reported at 1 Billion USD. Soros is a private man and it’s typically hard to discover with any confidence what his financial dealings might be at the moment. Nevertheless, it has been made public that he has been shorting the American market. It is said that he’s bought Put options in the S&P 500 (large cap stocks), and the iShares Russell 2000 (small cap stocks). A Put option is the right to sell 100 shares of a given stock at a predetermined price during a stipulated period of time. They are heavily leveraged derivatives, and can be unusually profitable – or not.
Emily thought she might, if the market goes down sufficiently, use some of her savings to buy stock in a few of the public companies Buffett holds minority interests in. But this Soros fellow and his Put options introduced an entirely different approach.
The Lessons of George
The Principle of Supply and Demand requires elasticity for the lubrication necessary for an efficient market. But there are times when either supply or demand is not, for a period, elastic. It may, for example, take a little while for the supply chain to ramp up enough to satisfy the new demand. So there’s sometimes a timing problem: almost everybody knows it will happen, but nobody knows exactly when. These moments are recognized by their volatility, and Soros turns some of them into profit centers.
Buffett vs. Soros
These are at opposing types of investments. The Buffett approach is biased towards safety of principal and the compounding of dividends. His desire is to control a meaningful portion of the supply chain: buy for a reasonable price (you seldom get moated companies “cheaply”) and keep it as population and demand grows. Let the dividends compound while you’re waiting.
Soros takes another approach. There is no stream of income with Put options, all the gain (if there is any) is made at the end, so Soros is not really an investor. A better term might be “speculator”. He’s speculating that the S&P and Russell 2000 will dramatically decline while his Puts are in place. If that happens, he can achieve extraordinary gains. There is a place for both. Remember the Bank of England.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker – BRE: 00957107 MLO: 249261. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much loan the building will support. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]. This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.