Most Overlooked Risk Reduction in Multifamily Real Estate Investing

"Focus on the downside and the upside will take care of itself."

- John Sellers, hedge fund manager

"Protect the downside and the upside will take care of itself."

- President Donald J Trump

"My dad used to say, worry about the downside and the upside will take care of itself."

- Barry Sternlicht, Starwood Capital, $60B AUM

Yesterday, Sept. 28, 2023, I was looking at the underwriting of a friend who put in an offer for a 77 unit deal in Texas.

He was underwriting a loan assumption assuming a 4.6% fixed rate interest rate with 8 years left on the term, 30 year amortization.

Based on his underwriting, he could get 5.61% cash flow for his investors across the hold period.

Here's the risk reduction people overlook!

Because he has a runway of 8 years and a projected average cash flow of 5.61% with conservative assumptions, he's distributing around 45% of the investment back in cash if he keeps the asset the whole loan period.

( 5.61% annual cash flow distributed x 8 years on the loan term. = 44.88% )

So how does this reduce the downside?

Well if you get 45% back with a very high probability, you're only risking 55% of what you invested.

To lose the full 55%, the asset would have to sell for what you paid, minus all the equity you have in the deal.

For example, let's say you bought an asset for $10M and put $3M into it.

The asset would have to sell for $7M eight years after you bought it and after you did renovations.

If you invest with a good operator, the likelihood of this is very low across an 8 year time frame.

Commercial Loans Types Accounting For This Risk Reduction:

Let's look at different loan types and how much cash we would be able to pull out of them across the hold period.

For the examples, let's say the purchase price is $10M, $3M down and the deal cash flows 5.6% annually.

2 Year Bridge Loan:

Can pull out 11.2% maximum. 88.8% of your investment is still at risk.

3 Year Bridge Loan:

Can pull out 16.8% maximum. 83.2% of your investment is still at risk.

5 Year Balloon (5 years on the term, usually 30 year amortization schedule) :

Can pull out 28% maximum. 72% of your investment is still at risk.

7 Year Balloon:

Can pull out 39.2% maximum. 60.8% of your investment is still at risk.

10 Year Balloon:

Can pull out 56% maximum. 44% of your investment is still at risk.

12 Year Balloon:

Can pull out 67.2% maximum. 32.8% of your investment is still at risk.

35 Year HUD Loan (35 year term, 35 year amortization) :

Can pull out 196%, no risk other than operational risk

40 Year FHA Loan (40 year term, 40 year amortization) :

Can pull out 224%, no risk other than operational risk

How would the upside take care of itself?

Well if real estate follows it's historical trends, you're probably going to double your money every 5-7 years.

The questions is whether you want to be risking 88.8% of your money to get that return like the 2 year bridge, or if you want to be risking 0% like with a HUD or FHA loan.

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