Three Strikes and You’re Out - The Real Estate Investment Version
Currently, almost every media comment concerning real estate refers to the word bubble. By inference, this indicates a collapse of real estate value that is out of the buyer’s control. Well, the facts are that most collapses of real estate value are the fault of the buyer. Avoiding loss of real estate value is what this Blog’s first article is all about.
“Three strikes and you’re out” is a popular phrase that has been applied to criminal activity. It means enough! No more! It’s over! There’s no future in this type of behavior!
The phrase “three strikes and you’re out” has a similar meaning for some aspects of real estate investing and lending. When this phrase is applied to ending a criminal’s career, it refers to a criminal who is convicted of breaking the law three times. The three strikes in real estate investing and lending are (1) negative spread, (2) negative debt service coverage, and (3) negative cash flow.
Any one of real estate’s three strikes can terminate a real estate investment and its loan (mortgage). If all three real estate strikes converge on the same real estate, the result is the same as the criminal being convicted of committing a third crime: a cessation of continuing activity. Real estate investors and lenders should be cautious when one of these strikes exists. They should be very cautious when two exist. When all three real estate strikes exist, the likelihood of failure is so high that investors should not invest, and lenders should not lend.
Even though most real estate investors and lenders are aware of the serious consequences of such activity, some still invest in or lend to real estate when one or more strikes apply. Why do these investors and lenders expose their money to this risk? If logic drove the decision-making process, they wouldn’t place their money on real estate that has one or more strikes. When greed, hope, fear and/or other people’s money are the characteristics that drive business decisions, one or more of these dangerous real estate strikes is usually ignored.
Why are real estate strikes so dangerous to investors and lenders? Brief descriptions of each real estate strike follow:
Negative Spread (NS)
Negative spread is created when the cost of borrowing is more than the yield generated from the investment. A real estate example is when the capitalization rate is 5% and the coupon rate of the mortgage is 6%. That is a 100 basis point negative spread. The result of NS is a mathematical loss of money. The more money you borrow, the more money you lose. Losses increase when NS widens.
The reduction or elimination of NS is based on the real estate’s ability to increase occupancy, increase rent, or reduce expenses. Higher leverage and wider spreads require larger rental increases, higher occupancy rates, and/or greater expense reductions. If NS is not eliminated, the investor’s equity and the lender’s security will erode.
