Bond Fans: Rates Skyrocket, But Lag Far Behind Real Estate Investment Yields

James BondGreat news for you Bond Fans, or “Bondies“!  (While I am a fan of spy movies…by “Bondies” I mean folks that prefer to invest in Bonds.)  The current yield for 10-year T-Bills is 1.8%.  Expert economists are forecasting bond rates to skyrocket by 60% to 2.85%/year by the end of Q4-2014. (Keep your champagne corked.)

Remember that T-bills are tax exempt…so a year later you will have 2.85% more after taxes.  $1,000,000 invested in bonds at the higher rate would yield a profit of $28,500 after 1 year.  Based on current inflation rates hovering around 3%/year, that means that Bond holders actual buying power will go from “lose every year” to “break even”.  The rate on 10-year Treasuries is the benchmark for all investments.  Betting on the US Government is widely regarded is the safest, most conservative move you can make.  Where “Bondies” make their mistake is that they assume that risk levels for all other investments must be much, much higher. 

If taking a conservative approach is what is preferred, real estate investments can be tailored with that in mind. In this article and my next I will discuss how balancing differing debt amounts with downpayment amounts produces different results.  In essence the two extremes are “fast” and “strong”.

FAST: (Little or no equity down)

I have one client that is always looking for the very minimum amount he can put down.  He would buy an investment property with 5% down if he could.  Financing 95% means that if the economy goes well and there are no bumps you can make a huge profit on sale.  Having a huge loan to pay off means you will not have any monthly cash flow, and that all of your profits will come at the end. Of course the slightest bump in the economy and any event such as rents falling, expenses rising, vacancy rising will cause a catastrophe.  Huge leverage can turn what you hoped would be a cash cow into an alligator.  Note: Banks have eased their lending requirements some; sub 19% equity multifamily loans are being made (81% LTV.) We are also seeing some commercial investment loans at 25% equity (75% LTV.) In the extreme, the “fast” approach is a bit like “letting it ride” in roulette when you win.  Or buying penny-stocks based on 15 minutes of research on an up and comming enterprise.  Fast is high risk…but it will build equity at a much faster pace than other methods.  If it works.  “Fast” works best at the beginning of a cycle, when prices are depressed.  My prediction is that in 2 years there will be very low requirement loans available for multifamily acquisitions.  I also predict that in 2 years there will be newbies that will take out those low downpayment loans…and some of them will even say:  “The apartment market is going so well…what could possibly go wrong?!”   A lot of FAST investors do fine and prosper.  But when we’re talking about 5, 6,  7, and even 8 figure equity investments that’s simply not good enough.  At first blush you would think that as an Oregon Licensed Principle Real Estate Broker that I would prefer clients that want to invest as little as possible…that way they buy larger properties and I get paid more.  Not so.  I get paid enough for what I do that being able to sleep well at night is much more valuable than an additional commission check.

Don’t get me wrong.  I’m a huge fan of using debt to expand equity.  I’m also fan of garlic…but too much is a problem there, too.  What I recommend typically is a minimum of a 30% down payment…using a 70% LTV loan to cover the rest of the acquisition costs.  A 70% LTV loan will typically satisfy the lender’s DSCR (Debt Service Coverage Ratio).  On a well bought property financed at this ratio you should have some insulation from the vagaries of the economy.  While a 30% down acquisition strategy is less risk intense than buying with only pennies on the dollar down, it is far from highly conservative.

In my next post I’ll discuss the STRONG acquisition strategy favored by investors ranging from conservative to very conservative.  Hint: this approach is also favored by those that want to maximize cash flow.

 

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