I know, I know. That’s a long title for this post. Plus there’s a pretty bad pun involved. And if you don’t get the pun, you will by the end of the post. Regardless, I feel like this is an important topic to touch on. And to kind of serve as a PSA of sorts for potential physician investors in passive real estate deals.
But first some background…
The year was 2020
We were in the middle of the COVID pandemic. Stimulus packages were flying out. And interest rates were rock bottom.
Meanwhile, many physicians were discovering that they were expendable cogs in the healthcare machinery, much to our dismay and disheartenment. This led to a massive surge of doctors looking to:
- Accelerate their path to financial freedom and retirement
- Establish alternative streams of income so as not to rely solely on their doctor income
- Or combination of the two
Given the flux of money into our monetary system both via stimuli and low interest rates, real estate (rightfully so) became a very popular medium for doctors to achieve the goals I just mentioned above. In fact, this was the time that Selenid and I learned about and decided to invest in real estate. Fast forward 3 years and 8 properties and this was a great decision for us.
And while Selenid and I chose to invest in real estate actively, a majority of physician investors decided that active investing was not right for them (This post will help you determine if you are a better active or passive real estate investor). Thus, they decided to invest largely into “passive” – or at least time leveraged – real estate deals.
What are passive real estate deals? – a quick aside
For a full breakdown of passive real estate investing, check out this comprehensive post.
But in the meantime, as a quick refresher, passive real estate deals come in two main forms – syndications and funds.
In a syndication, there is a deal sponsor, also known as a general partner, who puts together the deal. They line up to purchase usually one large multifamily investment property. Then, they seek out limited partners – investors like you – to contribute money to buy the property. So, essentially you and a bunch of other investors are buying a large property along with the general partner, who will also run the day-to-day operations and financials of the property.
In a fund, you contribute towards many properties, not just one like in a syndication.
So, bottom line, you contribute money towards the deal and that’s it. Of course you should always due very deep due diligence on the deal sponsor and the deal itself. Because you are basically handing your money to someone else and trusting them to invest it wisely…
And now back to the story
So, it’s 2020. Interest rates are low. Cash is being fluxed into our economy. Real estate prices are rising because people have more money to buy. But interest rates are low so buyers aren’t particularly worried about the high price points.
And doctors are eagerly seeking passive ways to establish new streams of income on the road to financial freedom.
As a result, passive real estate deals begin to sprout up like daisies. Everyone is now a syndicator. The market flourishes!
Flash forward to 2023
The real estate market hits a big slow down. Interest rates rise (and seem poised to keep rising) due to record breaking inflation. All of a sudden borrowing money to buy investment properties is a lot more expensive.
Deals begin to dry up. So do would-be deal sponsors.
But something even worse is happening
A lot of passive real estate deals and investments made years earlier are going sour. Large investment properties are going under. Limited partners – the money only investors – are receiving messages from their general partners asking for capital calls. They want more money to keep the deal afloat.
Suddenly, these investments aren’t just not making money, they are losing money while asking investors to cough up more. Many deals go under. And it’s not just small-timers, even big fish ran into trouble by falling into bad habits – like happened here.
That’s not good.
How can this be?
It seems like this shouldn’t be able to happen. A good deal in 2020 is still a good deal in 2023, right?
Well, that only holds true if all of the variables of the deal hold steady. Variables like rents, vacancy, maintenance costs, and…mortgage interest rate.
And it was the mortgage interest rate that is responsible is the overwhelming majority of these busted deals. Because the general partners/deal sponsors accepted an Adjustable Rate Mortgage or ARM (there’s that pun!) for the mortgage. As opposed to a fixed rate mortgage, which always stays at the same rate, a ARM stays the same for a pre-determined time period (usually 1, 5 or 10 years) after which the rate adjusts to the current interest rate based on some benchmark.
And suddenly we are starting to see a problem…
Let’s use a case example
Take a look at this pretend example that I made up below.
The numbers themselves are just made up and totally arbitrary. But let’s say that you invested in this $1 million, 20 unit property. In 2020, these properties could be obtained with interest rates of 3.5%. And with that interest rate this deal is good, if not great with 5% cash-on-cash return.
Now, let’s say this was bought with an ARM and the interest rate only was adjusted in 2023. All other variables stay the same…
All of a sudden, this deal doesn’t look so hot. In fact, the investors – all of them – are coming out of pocket every month to just keep the deal afloat. That means things like capital calls.
So we can see just how quickly these things can turn, especially fi you are not prepared for it.
But why would any deal sponsors buy with an ARM?
It’s a fair question to ask.
And the reason why is simple. Because you can often get a slightly lower interest rate or more favorable mortgage terms initially by accepting an ARM.
But the juice isn’t worth the squeeze here. Especially in 2020. Because these deal sponsors took an adjustable rate mortgage at exactly the wrong time. If interest rates are at historic lows, where should we expect them to go in the future? Well, up obviously. However, rosy colored glasses and the excitement of the potential opportunity overtook too many (often less experienced) deal sponsors.
The slightly more favorable, but temporary rate, with an ARM just isn’t worth the much greater potential risk to all investors in the future.
And that, my friends, is why so many passive real estate deal sponsors got into trouble with variable rate mortgages!
But we are missing one important piece of this discussion.
What can you, the investor, do to avoid something like this? And are ARMs always a bad thing?
I’ll give my take on the second question, first.
No, I don’t think ARMs are always necessary a bad thing. ARMs with long periods of fixed interest rates may have a place for investments with a short time to sell horizon. And it always depends on the details.
But a fixed rate mortgage is certainly always safer than a variable rate one.
Ok, now on to the first question.
What can investors do to make sure they don’t get involved in bad deals like this?
Here are the most important tips that I have:
- Learn how to analyze deals on your own so you can vet them and not just rely on a biased deal sponsor’s answer
- Become familiar with the process of how investing in passive real estate deals actually works
- Listen to experienced deal sponsors and how they source, vet, and close on deals (this webinar with Colony Hills Capital is a great place to start!)
- And lastly but most importantly, you shouldn’t be considering any of this without first having a written financial plan to help guide your investment choices. This is my written plan which you can use as a template for yours if you’d like!
What do you think? Have you invested in a passive real estate deal recently? What was your experience like? Did your sponsor have an ARM or fixed rate mortgage? Let me know in the comments below!