Ep 70: When operational fundamentals come under pressure

Everybody can make money in a bull market. In a bear market, when things get shaky, it’s the operators who will survive. If you just bought real estate, you make think that based on the three-year average market trends you can raise your revenue by 25% in the first year, and that’s probably what you’re banking on when you sign the papers. You bought a property at a 5-cap and hope to raise it to a 7-cap. But what happens if your operations come under pressure? Interest rates rise, your loans mature, and cash gets harder to come by. We haven’t seen it this cycle yet, but we may be on the cusp of a real bear market.

Going broke as a real estate investor happens in what feels like slow motion. First, the interest rates rise, then vacancy increases, and suddenly you have higher expenses and lower revenue. You may have been operating at $100K revenue with $50K expenses, a healthy 50% profit margin. Well, a 20% hit to revenue would drop your profit from $50K to $30K, a full 40% decrease in NOI. Now, if you have a 1.4X debt service coverage ratio, you’re breaking even, and lower coverage than that means you’re in the red, and suddenly you’re really struggling to make your payments. All over what felt like a minor revenue drop.

It sounds bad to say it, but being operationally sound during a downturn is a way to make a lot of money. The operators that were in over their heads will be the ones suffering, while you can capitalize on the fear in the market. There’s no joy in this, but it’s true, and it makes the industry stronger as a whole when strong managers outlast bad managers.

Real estate has been relatively easy lately. Everybody has won, and everybody has made money. There’s a chance now that the poor operators start to fold in the next few years, and we’ll see resources move from bad allocators of capital to good allocators of capital, which for society is a net positive.

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I started the Sweaty Startup in December of 2018 because I believe the Shark Tank and Tech Crunch culture is ruining the real spirit of low-risk entrepreneurship.