“It Does Not Matter How Slowly You Go As Long As You Do Not Stop” – Confucious
Where Are The Deals?
I belong to a few different real estate and investment focused Mastermind Groups and have attended a few real estate conferences this year. I also routinely sort through the data about what’s currently going on in the real estate market.
Some of my investor partners have been asking when there will be another opportunity for them to invest in, but I have been taking things slower (and more cautious) than normal for good reason. I wanted to share why it’s harder to find a good deal in today’s market.
Higher Interest Rates
Interest rates are the lead domino that impacts multiple other facets of investing. In the last year and a half, the Federal Reserve has raised interest rates over 5 percentage points. Also, the big jump in mortgage rates from the 3-5% range to the 6-9% range has produced a large increase in debt-service costs for properties that need new mortgages.
With interest rates so high, it makes it very expensive for buyers to buy a property right now. Because the debt service payments are more than double what they were a year and a half ago, buyers will have next to zero (or even negative) cash left over each month after paying the bills and mortgage payments.
In our business, we strive to find properties that will provide quarterly cash flow distributions to investors, and this means we still need to have cash flow. With current interest rates, most properties simply won’t cash flow.
Higher Overall Expenses
Expenses for multifamily properties nationally grew by 9.3% on average in the trailing 12-month period ending in June 2023, which is 63% higher than the 5.7% increase during the previous 12-month period, according to Yardi Matrix expert data.
Expenses rose in most every category, but the biggest increase was in insurance, which was up 18.8% on average in the 12 months ending in June 2023, per Matrix. Other expense categories with large jumps over the last year include repairs and maintenance (14.2%), administrative (11.8%), and utilities and payroll (both 7.8%). Perhaps surprisingly, taxes increased by only 5.9%. The increase in expenses in the period ending in June 2023 represents $740 in additional costs per unit at the average U.S. multifamily property, with the average property operating expense rising to $8,694 per year per unit, according to Matrix.
Few Properties for Sale
Another factor impacting new purchases is that there aren’t very many properties for sale. Most would-be sellers realize that interest rates would make it difficult for them to attract a buyer, so they would rather wait for interest rates to normalize before making a sale.
The data shows that the number of transactions as of Q2 2023 is actually 80% lower than it was in Q4 2021. So not only is it harder to afford loans right now, there also just aren’t many properties to buy.
Our Conservative Approach
Another reason MSC Capital Partners hasn’t had any recent investment offerings is that our company has a conservative approach for new acquisitions. Rather than simply speculate that prices will go up in the future, we want to make sure that any property we buy is still a smart move right now.
This means that we use realistic, data-backed assumptions in our financial forecasts. Some of these inputs are rent levels, rent growth, vacancy, expense levels, and future sales cap rate (sales price). If we can use realistic numbers and still get strong rent growth and total returns for our investors, then we can feel good about making an offer.
However, with apartment prices still relatively high compared to interest rates, finding conservative, cash flowing properties has been challenging in today’s market.
Path Forward….It’s Not All Bad
Aside from finding a property that is priced attractively (even at current interest rates), one strategy is to find a seller with a low-interest rate loan in place from a few years previously and “assume” their loan. This means that the lender will re-qualify MSC Capital Partners as the borrower and let us take over the loan payments from the Seller.
There is also opportunity with distressed properties. Nationwide there are several thousand apartment buildings that were purchased in 2020-2021 with short term loans and/or variable (floating rate) mortgages. Due to loan maturity and increased interest rates owners will be forced to sell at a discount or face foreclosure. While there have been some examples of these situations in the news lately, there will be much more distress during the remainder of 2023 and 2024.
Due to the current market headwinds, my strategy is to be patient and wait for a strong-performing property that I feel confident about sharing with our investor partners.
Fed Skips September Rate Hike But May Not Be Done Yet
As some anticipated, the Federal Reserve held interest rates steady at its September policy meeting. The Fed had raised its benchmark federal funds rate at their July 2023 meeting to a range between 5.25% and 5.5%, a 22-year high. Fed Chairman Powell suggested that they were prepared to raise rates one more time this year, at either of their two remaining meetings, to combat inflation (WSJ.com, September 20, 2023).
While inflation is well down from its 9.1% peak last year, it’s still higher than the Fed’s target. Their projection for annual core inflation, which excludes volatile food and energy prices, is 3.7% for the fourth quarter, above their 2% target (WSJ.com, September 20, 2023).
Since rates may be raised again, economic pundits have called the Fed’s latest decision to hold rates steady a “skip” instead of a “pause.”
Rates Higher for Longer
The Fed has been lifting rates since March 2022 to cool the economy without causing a recession. It’s a tough act to pull off. In his press conference, Powell said, “a soft landing is our primary objective.” But if inflation remains stubbornly high, he added, “the worst thing we can do is to fail to restore price stability.” With economists lowering their calls for a recession in 2024, Powell may be able to thread the needle (BusinessInsider.com, July 25, 2023).
However, with 2023 economic growth stronger than anticipated, most Fed officials expect they will need to keep interest rates near their current level through next year. The median projections showed the federal funds rate being lowered to around 5% by the end of 2024. That would imply two rate cuts next year if the Fed hikes again this year. Further rate cuts may be pushed into 2025.
Contact Us to Discuss Ongoing Portfolio Strategy
On Wednesday, the stock market reacted negatively to the Fed’s update. But since 1984, when the Fed has stopped its rate-hiking cycles, stock prices have trended higher. The medium returns of the S&P 500 for the 3-, 12- and 30-month periods after the Fed’s tightening cycle ends were +7.7%, +19.1%, and +62%, respectively. Of course, past performance is no guarantee of future results (Investing.com, March 30, 2023)
Climbing 10-Year Treasury Yields Are a Warning Sign
There was a bit of a chill earlier this month in Treasury yields.
“At 4.35% on August 21, the 10-year Treasury rate reached its highest level since 2007 before retreating to 4.24% on August 24,” wrote at the time Richard Barkham, global chief economist for CBRE. “Some economists predict that the 10-year rate could hit 4.75% or higher — more than double the 2.24% average over the past 10 years.”
A few notes. According to the data at the Treasury’s website, the rate at the end of August 21 was 4.34%. It may be that the 4.35% reference was an intraday rate, which would still be worth noting, but even 4.34% is a high point since November 6, 2007. By August 24, the rate was 4.23%, but that was still the highest since November 9, 2007.
“Econometric evidence suggests that every 100-basis-point increase in long-term interest rates results in a 60-basis-point rise in commercial real estate capitalization rates,” Barkham said. “So, a predicted rise in the 10-year rate to 4.75% from 2.2% would cause a 150-basis-point increase in the average cap rate. Under this scenario, a prime asset trading at a 4.5% cap rate would now trade at a 6% rate, equivalent to an approximate 25% fall in capital values. While not a disaster for commercial real estate, it would cause pain for some investors and some losses in the banking sector.”
CBRE projects, however, that when the Fed eventually gets the level of inflation that it wants, the 10-year’s yield will return to about 3.5% over the next five years and then settle at 3.25% by 2027, meaning average cap rates will be 75 basis points higher than during the past decade, which is an asset value reduction of 12.5%.
However, there’s a secondary impact of the 10-year’s activity that could have a shorter-term impact: volatility.
When the 10-year’s yield rises, it puts pressure on financing costs because it is a standard measure of alternative investment value. An investor wants risk-adjusted returns that are better than buying Treasurys. Otherwise, why put money into a different investment when you could pick as close to a risk-free way to make money as possible.
Higher 10-year yields are something that investors, borrowers, and lenders can work around. Sudden shifts, though, throw off everyone’s planning, inducing many to step back and wait.
How to Prepare for Student Loan Payments to Resume
Student loan payments on most federal student loans are scheduled to resume on October 1, 2023. The moratorium on payments has been in place since March 27, 2020, when the Coronavirus Assistance, Relief and Economic Security (CARES) Act was signed into law.
On average, student loan borrowers have $39,032 in debt, according to Experian data. The Consumer Financial Protection Bureau (CFPB) reports roughly 20% of student loan borrowers may experience financial difficulties when payments resume. As a result, it’s important to know what to expect and prepare yourself for the change to your budget.
When Do Student Loan Payments Resume?
The student loan payment pause has been extended eight times since it was first introduced. With the recent debt ceiling deal, Democrats and Republicans agreed that the administration would not seek to extend the student loan payment moratorium again.
As a result, interest will start accruing again on federal loans on September 1 and payments will resume on October 1 (borrower due dates may vary).
Additionally, the Supreme Court struck down the Biden administration’s widespread student loan forgiveness program. Borrowers who were hoping to receive full or partial forgiveness of their debt will need to prepare to start making payments again. The administration is providing a 12-month “onramp” period to allow borrowers to begin repayment while avoiding loan delinquencies or defaults. Still, interest will accrue during the transition period, so it will benefit borrowers to begin making regular payments in October if they’re able.
How to Prepare for Student Loan Repayment
Depending on your situation and budget, there may be several ways you can approach paying down your student loans. Here are some ways you can start thinking about preparing for student loan payments to start up again.
Make a Budget
If you don’t already have a budget in place, now may be a good time to start using one. A budget is a simple way to help you understand exactly where all of your money is going.
To make a budget, start by writing down your income and expenses from the past few months to get an idea of where your money is coming from and where it’s going. Depending on your comfort level, break out your expenses into different categories—the more categories you have, the easier it will be to make decisions about how to allocate your spending. To get started, you can use a budgeting app, your own spreadsheet or whatever works best for you.
With that information in mind, you can start planning how you want to spend your money for the upcoming month, including your student loan payment. Check with your loan servicer to confirm your payment amount in advance, as it’s possible it may have changed.
Once student loan payments start up again, your budget will help you make sure you have enough cash flow for that expense, along with all of your other ones.
It’s been a long time since student loan payments were required, and your budget may have changed significantly since then. If you’ve started using the money that would have otherwise gone to student loan payments for other purposes, you may have to cut back in certain areas of your budget.
If you’ve improved your financial footing, however, you could consider putting more toward your student loans than is required. Even a little extra every month can shave off months of repayment and hundreds or even thousands of dollars in interest.
As you look for areas to cut back, be honest with yourself but also reasonable, so you can achieve your debt payoff goals while also being able to pay your other bills on time.
Earn More Income
If you have the time, you may also look into opportunities to earn more income. This may include working overtime at your current job, taking on a second, part-time job or starting a side hustle.
If you’re thinking about getting a side hustle, opportunities are plentiful, so do some research based on what you enjoy doing or what you’re good at to find the right fit.
Some common side hustle options include:
- Driving for Uber or Lyft
- Delivering food or groceries for apps like DoorDash and Instacart
- Buying and selling used items online
- Renting a room on a short-term rental website
- Performing odd jobs on Craigslist, Mechanical Turk or Thumbtack
- Tutoring young students
- Becoming a mystery shopper
- Walking dogs
Take some time to consider several options, including the time requirement, flexibility and pay, to find the best one for you.
What to Do if You Can’t Afford Your Student Loan Payments
If you believe you might still have trouble paying your student loans once the federal student loan payment pause ends, here are some potential solutions:
- Request forbearance or deferment. The federal government offers forbearance and deferment for people experiencing financial difficulties. Your options may depend on your situation, so contact your student loan servicer directly for more information.
- Get on an income-driven repayment plan. The Department of Education offers four different income-driven repayment plans, all of which can reduce your monthly payment to 10% to 20% of your discretionary income. That way, you don’t have to worry about the end of a forbearance plan creeping up on you and being right back where you started. Income-driven repayment plans also extend your repayment plan up to 20 or 25 years, after which any remaining balance is forgiven.
These options can provide immediate relief and potentially help you get to where you need to be financially to continue paying down your student loan debt.
Student loan refinancing can be another way to reduce your monthly payments, but private lenders typically don’t offer income-driven repayment plans, and their forbearance options are often less generous than what the federal government provides.
Structuring a Self-Directed IRA Real Estate Investment in 2023
Looking to make a Self-Directed IRA Real Estate Investment? Many real estate experts believe real estate prices will become more moderate in 2023. With mortgage rates increasing, home prices should moderate, but low inventory will continue to keep pressure on the real estate marketplace.
2021 was a great year for selling a home but not such a great year if you were looking to buy a home. Home prices rose significantly and at the same time, the number of homes for sale dropped. This led to a very hot real estate marketplace in 2021. The market cooled off in 2022 as available homes began to dry up, but there’s been an upwards trend this year for real estate investors. What 2021 taught us is that cash is king and that is good news for Self-Directed IRA investors.
Before we examine the best ways to use retirement funds to buy real estate, it is important to understand what a Self-Directed IRA is and how it works.
What is a Self-Directed IRA?
The Self-Directed IRA is a retirement account vehicle that is best known for allowing investors to use retirement funds to buy alternative assets, such as real estate. It is not a legal term, and you will not find it anywhere in the Internal Revenue Code; it simply refers to an IRA account that is permitted to be invested in traditional assets, such as stocks, but also alternative assets, such as real estate.
One major advantage of purchasing real estate with a Self-Directed IRA is that all income and gains are tax-deferred until the time when the IRA holder (you) takes a distribution. In addition, for many Americans, it is their largest source of savings and capital, which can help get a real estate transaction done in a competitive market.
Self-Directed IRA Real Estate Rules
The Internal Revenue Code does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits the IRA holder and his or her lineal descendants (“disqualified persons”) from engaging in certain types of transactions that would directly or indirectly personally benefit a “disqualified person.” In other words, a Self-Directed IRA can, generally, make any investment except for collectibles, insurance, or any transaction that does not exclusively benefit the IRA.
The IRS is essentially saying that when you use your IRA or 401(k) plan funds to make the investment, the investment should be made for the sole purpose of benefiting the retirement account and not the IRA holder personally or any of his or her lineal descendants or controlled entities. Therefore, in the case of a real estate investment using a Self-Directed IRA, you should not:
- Use the real estate for personal use
- Provide any active services personally, whether paid or not
- Hire any disqualified person to provide services to the real estate asset
- Use any personal funds in the real estate transaction that will be deemed self-dealing or a conflict of interest
- All income and gains from the real estate transaction should flow back to the IRA or respective partners pro rata
Best Ways to Structure a Self-Directed IRA Real Estate Investment
There are two ways to fund a Self-Directed IRA: (i) contribution, and a rollover from another IRA or 401(k) plan. For 2023, the maximum IRA contribution is $6,500 or $7,500 if you are at least age 50. Alternatively, if you have access to a former employer 401(k) plan, you can roll those funds tax-free to a Self-Directed IRA. It’s important to note that you cannot move funds out of a current 401(k) plan; you generally can’t touch those funds until you separate from that job.
Now that you know how you can fund your Self-Directed IRA, let’s discuss the two options for buying real estate.
A Self-Directed IRA is a type of IRA that offers an IRA investor more investment options than an IRA with a traditional financial institution. With a Self-Directed IRA, IRA Financial Trust, a regulated trust company, will serve as the custodian of the IRA. The IRA funds are held with the custodian. At the IRA holder’s direction, the custodian will then invest the IRA funds into alternative asset investments, such as real estate.
Unlike a bank or brokerage firm, a Self-Directed IRA with IRA Financial will allow you to invest in alternative asset investments. It is appropriate for Real Estate IRA investors with either one-off investments or investments that do not involve a high number of transactions.
Self-Directed IRA LLC
The Self-Directed IRA LLC with “checkbook control” is essentially the same as described above, but it involves a limited liability company (“LLC”) that is created which is funded and owned by the IRA and managed by the IRA holder.
In other words, the IRA would own the LLC, and the IRA owner or any third party would serve as the manager of the LLC. The Self-Directed IRA LLC offers the IRA investor limited liability protection on the real estate investments inside the LLC. In addition, the LLC offers the IRA owner more control over the assets so investments can be made quickly, and expenses can be paid easily without involving the IRA custodian.
The Self-Directed IRA LLC is best for Real Estate IRA owners that want more control and expect to have frequent transactions, such as rental properties or fix and flips. Because you have checkbook control of your IRA funds, transactions can be performed without consulting your custodian.
Why Does Using a Self-Directed IRA to Buy Real Estate Make Sense?
There are a number of reasons why using a Self-Directed IRA to buy real estate makes so much sense.
- Tax Advantage: By using a Self-Directed IRA to invest in real estate, in general, all income and gains generated by the real estate investment would flow back into the plan without tax. For example, if a Self-Directed IRA invested in a home and paid $200,000, and later sold the home for $300,000, that $100,000 of gain would go back to the IRA tax-free.
- Follow the Cash. For most Americans, their retirement funds are their greatest source of capital. With the cost of living increasing and inflation impacting our personal savings, using an IRA to invest in real estate is the only option for many Americans. Accordingly, using a Self-Directed IRA is the primary way many Americans can gain the opportunity to invest in real estate.
- Diversification Approximately 90% of retirement assets are invested in financial markets, such as stocks, mutual funds, and ETFs. Investing an IRA into real estate offers a form of investment diversification from the equity markets. In general, the more diversified your portfolio, the greater chance that your assets will offer lower correlation, meaning they are less likely to move in the same direction. Stocks may go down, while real estate, and other asset classes, may go up.
- Hedge Against Inflation: Rising food and energy prices caused by an influx of trillions of dollars into the economy by the Federal Reserve over the last several years have caused core consumer prices to rise. As a result, many investors are looking for ways to protect their portfolios from the ravages of inflation. In general, having the ability to invest in certain hard assets, such as real estate, is viewed as a smart way to protect your retirement assets from inflation
A Hidden Real Estate Tax You Should Know About
If an IRA uses a non-recourse loan to purchase real estate, a tax called the unrelated business taxable income (UBTI) tax could apply to a portion of the net income associated with the leverage. A non-recourse loan is a loan not personally guaranteed by the individual, which is not permitted under Internal Revenue Service Section 4975(c).
The maximum UBTI tax rate is 37%, so it is important to keep that tax in mind if you plan to use an IRA to buy real estate with leverage. For example, if you borrow 50% of the purchase price of a piece of property, then half the gains generated would be taxable.
2023 will likely shape up to be another great year for real estate investors. However, having access to cash will be key to securing a real estate transaction. Learning how to use your retirement funds, in a tax-advantageous manner to invest in real estate, can help many Americans better diversify their retirement portfolios, as well as hedge against inflation.
The Self-Directed IRA is the best way to invest in real estate. So long as the real estate property is held by your retirement account, you don’t pay taxes on the income it generates. Of course, if you do need to borrow to make an investment, make sure you are aware of the UBTI rules. That tax could turn a dream investment into a nightmare.