This is an LFI episode and LFI is now part of PassivePockets.
I’m thrilled to have Brian Burke with us. He is the CEO and Founder of Praxis Capital. He’s the author of what is the best book on passive investing, especially for people like me and people that are investors. It is The Hands-Off Investor. It is a fantastic book. He started in real estate at age nineteen after reading a real estate book. He’s been in real estate for many years and twenty years as a syndicator. Most importantly, he was guest number three on the show, which was released a couple of years ago. I’m thankful for Brian taking a shot at us when we were on episode three. This will be episode 113. Brian, welcome to the show.
Thanks for having me here. It’s an honor to be guest number three and an honor to be back.
We’re happy to have you back. As we talked offline, we’ve had a lot of people join the community in the past few years and a lot of new readers of the show. If we could start the same way we always start, with your journey, how did you get into real estate and become a syndicator? Give us the story there.
I got into real estate when I was barely twenty years old. I had no money, connections or knowledge. I had nothing. I figured, “I’m perfectly situated to become a real estate investor. I’m fully equipped with everything you need.” I made my first house purchase and never looked back. I’ve started out flipping. I was buying, fixing up and reselling houses. I started with one and then another very slowly at first. It took a few years to get going.
About year 6 or 7, I was doing a dozen houses a year. By year fifteen, I was doing a couple of dozen houses a year and stopped. I was like, “Something’s going to happen badly.” That was the massive recession. I managed to avoid all of that because I slammed on the brakes right before that happened. Right after it happened, I built back up, got jumped right back in and was doing 100 houses a year. It was like a light switch. It was the greatest time of growth for our business.
As I was doing all this, I was thinking, “I’m building up this great base of investors. We’ve got this great engine that we’ve built. In 2 or 3 years, all these foreclosures are going to be gone. What are we going to do?” I figured the best place to turn my focus was going to be multifamily. I had gotten into multifamily several years ago in a 1031 exchange in personal investment and decided that I needed to grow a multifamily business with this great base of investors that I built.
We started in multifamily. My 1st one was in California and then my 2nd one was in New York. I went from one coast to the other and then said, “Let’s go in between.” I was then in Texas. I did a lot of units in Texas for a few years and then went national a few years ago. I bought about 4,000 multifamily units, 3-quarters of which I sold over the last few years.
It’s a great story. I want to back up because things have changed. You’ve been through the ups and the downs. How did you know to stop flipping or reduce what you were doing back in 2008? You did the same thing in 2021 when you were prepping for what was coming. How did you know then? How did you know now to maybe put the brakes on a little bit?
There are a couple of things. I don’t look at it like, “Here’s a data point that’s telling me that it’s time to do something.” I have a feel for the market. It’s a sense of what’s happening. I tend to rely on it pretty well because if I don’t, then I get my hand slapped. Back in ’05 and ‘06, what I was recognizing was the prices had gone astronomically and the price-to-rent ratios made no sense. Every investor I talked to wanted to get in the game. Every property that was listed was getting dozens of offers.
At that time in ‘05, I was also noticing that most of the offers that were being written were by unqualified investors and/or were being financed by shaky loans. I was realizing that all of that can’t end well. I felt, “If everybody wants to buy, this would be a good time to sell or at least stop buying.” That’s what drove me then. In ’09, what drove me to put my both feet back in was that nobody wanted real estate. People were like, “Real estate’s toxic. It’s catching a falling knife. Don’t buy real estate.” I was like, “This is great. This is the perfect time to buy.” That’s when I got back into it.
In 2021, it was the same thing I saw in ‘05 minus the financing part. Everybody wanted to get in. Everybody was suddenly an apartment syndicator. Every property that was listed was getting 1 dozen or 2 dozen offers going for astronomical prices that made no sense. When I saw that, it was like, “Here we go again. It’s time.” We started aggressively selling in 2021. The last one we intended to sell in early 2022. The timing couldn’t have been more perfect because, in mid-2022, multifamily values dropped at least 20%, even though most people didn’t recognize it initially. Our timing probably couldn’t have been much better.
It sounds like from 2005 to 2009, you weren’t much of a buyer. You can tell me but from 2021 until 2023, maybe you’re not much of a buyer. How do you stop yourself from investing? You’re an investor. You go out and buy apartments. How do you take a two-year hiatus? I’m still allocating capital. Sometimes, I question whether that’s a smart thing to do or not but I’m dollar-cost averaging. A lot of operators think, “I have these investors. If I don’t invest in something or give them something to invest in, they’re going to go away.” You seem to have that discipline. Where does that come from?
Let them go away. My job isn’t to invest people’s money. My job is to not lose their money. That’s what drives me. My very first syndication deal was money I raised from my ex-coworkers. Mind you, I was in law enforcement when I was working a full-time job to earn an income when my house-flipping business was small. When I put in my two weeks’ notice to quit my job, I told all the guys at the station I was going to have a real estate presentation come down. They all come down and I give this dog and pony show about real estate. 28 guys invested with me. I raised $500,000 in a blind pool that I could use to go and flip houses. With a $5,000 investment minimum, it was nuts.
All of my investors were cops. I used to say, “I have 28 investors that carry guns so I cannot lose their money. If I lose their money, I’m a dead man. Not only do they know how to kill me but they know how to get away with it.” That experience has driven me throughout my entire career that my first job is to not lose people’s money.
If the market isn’t conducive to me making investments, I don’t make investments. I don’t need to. We’re well-capitalized enough. I don’t have to do another thing for the rest of my life and I’ll still be fine. I’m working on my golf game. I’m building a new house. I’ve got other things I can focus my attention on. I don’t need to go out and buy apartment buildings to earn fees so that I can keep the lights on here at the office.
Can you talk about the state of the multifamily market? I’m sure you’re still looking at things. What are you seeing, what do you think and where do you think we’re headed? Those are broad questions.
We bought our last apartment building in December 2021 on a semi-distress sale, which seems a little odd but it was a unique circumstance where this guy had to sell. We got a good deal on that and then that was it. In December 2021, we shut it off. We haven’t bought anything since. For about ten months, we didn’t even look at deals. A deal would come in my inbox like, “Value add. This and that. Everything’s great.” Every time I would get an email on a new deal, it went straight to the delete button.
We started underwriting deals again. At first, we were doing a couple here and there. We’re underwriting most stuff that’s coming in that fits in our buy box but we’re not doing it with the understanding that we’re going to buy any of this stuff. It’s our way of staying in tune with what the market is doing so that we can get a read on when the next signals are going to tell us that it’s time to buy.
Prices have fallen. They have more to fall. A lot of that has not been recognized yet because transaction velocity has dropped so dramatically. Some people don’t understand how much less their properties are worth than they think they are because there’s been nothing to sell to prove otherwise. Until we see a little bit more transaction velocity, we’re probably not going to see that in reality. The cap rates have decompressed. It’s time for people to recognize that.
What’s going to be the trigger? What’s going to cause the velocity of buying and selling to increase to get back out there? Do interest rates need to stabilize? They don’t necessarily need to go down. You can still make money at these interest rates. Is it that there’s an imbalance between buyers and sellers and no one knows where interest rates are going to end up?
You can make money in any interest rate environment because it depends on the purchase price. The problem that we’ve had over the last couple of years is if there’s a standoff. Nobody wants to flinch. The sellers don’t want to sell it at a lower price than they think their property is worth. The buyers can’t pay what the sellers want because the numbers don’t work. Nobody’s doing anything.
Sooner or later, somebody has to flinch. Either the buyers have to pony up and pay, which would be a big mistake or the sellers have to get real and sell at the prices. There is going to be a confluence of factors that are going to cause that to happen. Some of it will be distress. There could be loan maturities. A lot of people were buying these three-year bridge loans years ago. Someone’s knocking at the door and saying, “It’s time to pay up.”
A refinance may not be feasible. If it is feasible, they might have to go to their investors for money. Their investors might not want to pony that money up and might be forced to sell. In some cases, they might be forced to sell at a loss but certainly, they’ll be forced to sell it at market value. That’s one thing. Another one could be simply lifecycle. If you had an 8-year fund and it’s been 8 years and your investment mandates are to sell and you don’t have extension options and you go to a vote to the members and the members don’t vote to extend, you have to sell.
A lot of people were buying with what I call so-called hot equity. They go to, let’s say, private equity, JV equity or pref equity. Those equity tranches have life cycles where they say, “You will sell in three years, whether it’s come hell or high water. You can wipe out your common equity. We don’t care. You have to sell.”
Those dates are going to come knocking. Eventually, people are going to have to sell. That’s what’s going to stimulate things to happen again. Some are holding off thinking, “Things are going to get better quickly. We’ll push it back six months,” but six months later if things aren’t better, they’re going to have to get real and sell.
What does get better mean? I know that the sellers are hoping prices rise but you think and it makes sense, that prices have to fall. Is this all because of inflation interest rates or it was built up and we had this big bubble because interest rates were so low for so long? What do you think the underlying cause of where we are is?
There are 3 things and 1 of the things are caused by the other 2. The three things are interest rates. That’s the one that’s on everybody’s minds. Interest rates are rising. Therefore, debt service is rising and then that sucks cashflow. Therefore, value has to fall to make up for it. That’s true. That is part of it to some extent.
The other part of it is rent growth. When people were buying at so-called crazy prices in 2021, they were buying on the thesis that rents were growing astronomically. If you look at the Phoenix market in 2021, they were getting 20% to 30% annual rent growth. You’re underwriting an acquisition and you’ve got a rent growth forecast that says 20% next year, 15% the year after that and 10% the year after that. This isn’t necessarily apartment syndicators making it up. Although many of them did. There were actual legitimate third-party economists that were predicting rent growth at those levels.
As long as that worked out, then the values that some of these buyers were paying were justified. Granted, it results in a 3.5% cap but in 2 years, you’re at a 6% stabilized yield on cost. The investment works out quite well, especially at 3% interest rates. Rent growth has plateaued. Phoenix has had month-over-month rent declines for nine straight months and finally seeing a positive uptick. That blows that rent growth thesis out of the water.
Let’s face it. When you’re buying a multifamily asset, you’re buying an income stream. Forget about real estate. That’s what underwrites it. If you believe that the income stream is growing, you can pay more for it. That means a lower cap rate. If the income stream is not growing, you have to pay less. When the borrowing costs for that income stream go up, you have to pay less. Those two factors are influencing cap rates.
The third variable that I would mention is the exit cap. How does a buyer underwrite an exit? What cap rate are you using to underwrite your exit? No one knows what that is. Until you can get some clarity on the direction of interest rate movement and rent growth movement, it’s impossible to quantify exit cap rates with any degree of certainty. Therefore, exit cap rates are expanding. All three of those factors are causing prices to fall.
I want to go back to your book, The Hands-Off Investor. In that book, there are a lot of metrics to look at when analyzing a deal. That was one of the things I loved about that book. It spells it out, “Here’s what a metric is.” It tells you all about it. It then gives you some ranges like, “Here are some things that maybe it’s in this range that you should think about.” It may be cap rates, economic vacancy and all that stuff.
It’s certainly cap rates but what has changed or how have you seen some of those metrics change? For passive investors that are still looking at deals and analyzing, how should they change their analysis of a deal when cap rates and interest rates are in a different place and rent growth isn’t going up again? Can we still look at those same metrics or do we need to reevaluate and change our metrics?
The metrics are still valid. Those metrics will serve you in any market and any conditions going up, going down. All those measurements that are included in the book will always be relevant. What will change is what might be considered a normal range for each of those measurements. Here are some examples. I included some examples of costs of maintenance, insurance and personnel or payroll.
Inflation has driven the cost of repairs up. The numbers are probably trending to the higher side of what I included in the book as a reasonable range. Maybe they even might blow through that a little bit. The competition for human resources has driven wages up. Payroll expenses are going to be higher. Natural disasters have caused insurance to skyrocket. In many cases, they’re doubling. If you’re in Alabama, Florida or right along the coast, forget about it. Insurance costs have gone through the roof. We’ve experienced that ourselves. Being cognizant of what actual costs are is helpful.
It’s important to compare cost estimates included with syndicators’ projections to the ranges that I have in the book. It’s also relevant to compare that to the property’s historical performance. Don’t always assume, “The new operator’s going to do better and those costs are going to go down.” That doesn’t happen. The costs don’t go down. They go up. You need to be realistic about that.
In this market, what do you think passive investors should focus on that maybe wasn’t as critical a couple of years ago in their analysis? I’m looking closer at debt and maybe rent increases. Are there other things or other metrics that maybe it wasn’t as important back then but this is something you should focus on?
They were always important. I was stressing the importance. That was one of the reasons I wrote that book. People just ignore it. They’re like, “Everything’s going great. I don’t have to worry about this stuff. We’ll buy it and it’ll go up.” This time, they’re like, “I have to look at this stuff.” There are a number of things. First of all, it’s very important, if not more so than ever, to make sure that the groups that you’re investing with have experience, especially market cycle experience.
Has anybody been through tough times or are you looking to allocate capital with someone that’s only been investing on a sunny day? Get with groups and people who have navigated some storms. If they survive that, that’s a huge leg up for you in your investment partner selection. That would probably be the biggest one.
The second one is going right back to what I always preach. Look at those assumptions. It’s garbage in, garbage out. If the sponsor is filling up the projections with a bunch of trash, anything that they project to you that might happen is hogwash. Look at their projected interest rates, expense assumptions and rent growth assumptions. Get a bit of a pessimistic view of your own to the market and recognize those rosy rent growth assumptions may be too rosy.
The key thing is the financing structure. What does the financing structure look like? To me, the things I would look to avoid at all costs would be short-term maturities and high loan-to-value ratios. Those two things together, which is what a lot of these deals had been financed on over the last few years which is short-term and high-leverage bridge debt, could be a death sentence to a syndication investment. It’s because that due date can come and you can be in a world of hurt.
I would watch for those things. I would look for lower-leverage financing and longer-term financing. There’s this fixed versus floating argument that will probably never get resolved. I’ve made it no secret that I’m a big proponent of agency floating rate debt, not bridge floating rate debt. For ten years, I was laughing at the fixed-rate guys as they were getting killed by yield maintenance penalties when they sold their deals early. This time, they’re all laughing at me going, “Your interest rate went up. Your rate cap replacement costs are high.”
I wouldn’t want to be locking in a fixed-rate loan at the peak of the interest rate cycle. That would be a little scary because if interest rates fall, the yield maintenance on that would be astronomical. It would be prohibitive to seller refinance if interest rates were to fall and you had a fixed-rate loan locked in. Financing structure’s very important. There’s a lot to look at and for some of that, you have to make sure it aligns with your beliefs and where the market is going.
[bctt tweet=”When doing financing structure, there’s a lot to look at. You have to make sure it aligns with your beliefs and where the market is going.” via=”no”]
To make sure everyone’s on the same page, can you talk about the difference between agency and bridge debt on the floating rate? Can you then also talk about, for the fixed rate, what yield maintenance means, what it costs and what the downside is? I assume those are the penalties you pay to get out of fixed-rate debt. Can you talk about that so everyone’s understanding what we’re talking about here?
Agency debt is Fannie Mae and Freddie Mac. These are the government-sponsored enterprises that back multifamily lending. Agency debt is the gold standard for multifamily lending. Bridge debt is usually done by debt funds. They are privately-held funds that loan money to real estate investors on an interim basis. They’re usually used if you have a property that doesn’t qualify for agency debt, for example. Maybe the occupancy isn’t high enough and there’s a turnaround story. You say, “It’s a 2-year loan but we’re going to be able to refinance in 2 years after we shore this place up, get the occupancy up, fix it up and this and that.” The ultimate goal would be to end up in agency debt down the line but the time you have in that bridge debt is a big risk.
A bridge debt generally has a three-year maturity. Oftentimes, it has 2 or 1-year extension options. The challenge is that oftentimes those extension options come with some kind of loan covenant that must be met. If it’s not met, you don’t qualify for the extension of the loan that can be called at the three-year period. You have to pay that loan off. That’s risky. Three years go by in the blink of an eye.
Agency floating rate debt is different. It has longer maturities. It’s not designed for those so-called deep value add heavy lift-type business plans. Generally, the maturities are 5, 7 or 10 years. You can pay it off any time after the first year by paying one point. That’s it. That’s your whole exit penalty. It’s 1% of the loan amount.
I tend to favor ten-year floating rate agency debt because I’ve got no problem. It has no maturity risk. Ten years is a long time. The rate does float but I can pay it off at any time by paying a 1% exit fee. That’s it. It has lots of flexibility and we use that flexibility heavily. There were properties we owned for twenty months. We sold them at double their value that had we had a fixed rate debt, we would’ve paid millions of dollars in yield maintenance.
What is yield maintenance? It’s a pre-payment penalty. Fixed-rate debt in the commercial space is different from the fixed-rate debt you would get to buy a home. A 30-year fix is a gold standard for residential mortgages. That’s no problem. You can pay that off anytime you want. In the commercial real estate space, that’s not the case. Here, the loans are ultimately sold into mortgage-backed security pools and those investors are guaranteed that they’re going to receive a certain interest rate for ten years. If you pay the loan off in 2 years, they still get their 8 years of interest.
[bctt tweet=”Fixed-rate debt in the commercial space is different from the fixed-rate debt you would get to buy a home.” via=”no”]
In simplest terms, you’re paying ten years of interest on that loan regardless of when you pay it off. If you pay it off at ten years, the fixed rate penalty doesn’t cost you a thing. If two years from now you go, “This would be a good time to sell because the market’s about to tank. I want to get out at the top,” you’re going to have to pay eight years of interest on that loan that could amount to millions and millions of dollars. You might elect to either, A) Pay it off and not make nearly as much as you would like to have made or, B) Hold on and hope that maybe you are wrong and the market stays good. You’re going to wait it out for ten years and have lost out on an opportunity to sell at the top. A fixed rate may seem as though it’s risk-free but it has its own set of risks.
People get confused about rate caps and cap rates. We’re going to talk about the rate cap. The rate caps that people are buying, are they the same for the agency debt as they are for bridge debt or are there differences?
There are some differences. A rate cap is different from a cap rate. Whenever you take out floating rate debt, the lender wants to know that if interest rates rise, the rate can’t rise too high. You want to have some limit to how high the rate will go. In residential lending, if you do a variable rate, usually, they’ll have a maximum rate built into it. It’s a feature of the loan where they say, “The rate’s 3%. It’s variable off of the SOFR rate with a maximum of 11%,” let’s say.
In the commercial space, they don’t do that. In the commercial space, to cap the interest rate, you have to buy a derivative. That’s bought from a bank that underwrites these investments. It costs you money. To them, it’s a financial investment. They sell this derivative to you so you can transfer interest rate risk to them which costs money. A few years ago, an interest rate cap on a $20 million loan might have cost you $10,000. It wasn’t a lot of money. An interest rate cap in 2023 would be about 500 times that amount, quite surprisingly. Rate cap costs have gone up through the roof.
The way that this works with bridge debt or I should say agency versus bridge is agency will underwrite to a one-to-one debt coverage ratio. They’re looking at what interest rate the property breaks even based on historical financials. It’s not the financials you’re going to have 1 year from now or 2 years from now, which are likely to be better but historical financials. What’s the rate that gets to that breaking point? That’s where they’ll set what they call the strike rate. Generally speaking, the strike rate is 1% or 2% higher, maybe as much as 2.5% or 3% higher than the current rates. That rate cap is pretty reasonable in that rates don’t go up very much on these floating-rate loans.
On a bridge debt, they don’t underwrite it the same way. They set their caps based on their tolerance level or by a debt yield. That cap might be a lot higher strike and could be a lot more expensive. Your rate can run a lot more out of control on bridge debt with a rate cap and the rate cap can cost you even more. That’s the downside that you find. Whereas for agency debt, it doesn’t cost as much and your rate doesn’t go up as much.
I have one more question on rate caps. You said it’s gone up 500 times or a lot. It’s not because the interest rate is higher than it used to be. It’s because interest rates are in a period of movement. Is that accurate? If the interest rates stabilize and everyone’s comfortable that they’re like, “The interest rates are going to be 5% for the next 3 years,” then rate cap costs will go down. Am I understanding that correctly?
Yeah. Two things drive the price of the rate cap. The first is the rate strike. Depending upon your price, the historical income and all that, the strike that’s being set is going to influence the rate cap costs some. Strikes have probably tightened a little bit because prices were still artificially high, people were still borrowing a lot and all that stuff. The strikes ended up coming in a little bit tight.
The real driver for rate cap costs is interest rate volatility. You remember what the transaction is. You’re paying a bank to accept the risk of interest rate movement. The more volatile interest rates are, the scarier that investment is for that bank and the more rate cap premium they’re going to want to charge to assume that risk. When interest rate volatility declines, rate cap costs will decline dramatically. When interest rates start to fall, rate cap costs will decline even further.
Let’s say there’s a deal that looks like it could be in trouble because their interest rate keeps going up and the cap price keeps going up. The bank makes them escrow a bunch of money to pay for those future interest rate caps that they’re going to have to buy. These companies that maybe stop distributions are thinking, “I’m going to have to sell and distress or a capital call.” Let’s say interest rates stabilize and they stop going up. Will all of that escrow money be released and then that effectively might save some of these deals or some of these deals are going to go bad regardless?
First of all, let’s talk about a deal going bad. Cutting off distributions is not the worst outcome. The worst outcome is I’m getting stuck into foreclosure and having a loss of principal. This is a distinction that investors need to be very cognizant of. “Has cashflow stopped or are we at risk of losing our investment?” Those are two entirely different things.
Being at risk of losing your investment is the worst-case scenario. The interest rate cap is unlikely to be the cause of that. There are going to be other things or other factors like a loan maturity that could cause you to lose principal if you end up forced to sell. Having distributions cut off is part of the deal. People have been very accustomed to regular distributions because everything has been going very well. In the commercial real estate space, variability of income and distributions is common. It’s part of the drill.
It’s true that interest rate cap replacement costs have become a big issue in distributions. Where this becomes very problematic is for groups that don’t have the money. Let me give you an example. We have a property where when we purchased it, our interest rate cap replacement reserve escrow was $1,000 a month. We got notified that they have increased it to $89,000 a month. To go from $1,000 a month to $89,000 a month tells you a lot about the cost of interest rate cap replacement estimates.
Here’s where the distinction comes in. If we didn’t have cash and cashflow and things were tight and $89,000 a month for this interest rate cap reserve, we would be in a lot of trouble. What kind of trouble? Could it mean that we end up defaulting on the payments? Supposedly. That could be a potential outcome and that could result in a loss of principal.
Fortunately, we are very well-capitalized and we have no issue with making this payment but it does affect distributions. What happens is, let’s say, that cap doesn’t expire nine months from now. In that period, interest rates may come down. They may stabilize. Volatility may come down. A lot of things could happen that would cause the rate cap replacement to cost far less. Other things are I might make a tactical decision and do a 1-year rate cap instead of a 3-year rate cap. Hopefully, within the year after that, then volatility would improve. There are some ways to manage it.
When you get to that point where the rate cap is purchased, if there’s surplus money in the rate cap reserve escrow and it’s not needed for the next rate cap replacement, those funds can be released by the lender back to the borrower, i.e. the partnership. The partners can then in turn distribute that to investors. It might mean that this is simply a delay of distributions or those costs do get sucked up in the cost of a rate cap replacement. That is possible.
A lot of it depends on the experience of the operator and making sure they know what they’re doing in buying the rate caps, structuring the loans and all of that. That makes complete sense to me. We talked about this a few years ago. In your book, you say the goal of an investor is to eliminate any single point of failure. One way to do that is by diversifying among various sponsors, locations, property types and I assume asset classes. Has that changed or has it solidified when we’re in a different type of market?
A lot of people in our community, myself included, we’re not going to take two years off from investing. I think of it as dollar-cost averaging. I’m much more careful. I’m taking smaller swings but I’m still allocating capital. Should I have the same strategy I had before of eliminating that single point of failure and keep diversifying or should I concentrate on the experienced operators in certain locations and property types?
You’re doing both. You’re concentrating on the most experienced operators but not focusing solely on one. You are spreading your risk around to more than one operator. A friend of mine lost her entire life savings in a syndicated real estate investment. She put it all with one sponsor who turned out to be a crook and stole all the money. He was in prison and she was broke. She would’ve only been half broke if she would’ve broken up into two syndicators.
[bctt tweet=”When investing, concentrate on the most experienced operators, but don’t focus solely on one. You are spreading your risk around to more than one operator.” via=”no”]
It’s important for people to spread their risk around. In times like this, it’s even more important to make sure you’re spreading your risk around. It doesn’t mean you have to be in 100 different deals and you’re going to put money with everybody that comes along and asks for it. It means that you’re going to take smart tactical allocations to make sure that if one of these syndicators goes belly up, you’re not wiped out. You’ll still have something left.
For asset classes, the same goes. If you find an opportunity in other asset classes, you should look at it. We’re standing down and we are. One of the things that I’ve always done is I’ve always looked at where the opportunity is. I’ve found the opportunity is in real estate debt. We’ve launched a debt fund, which is something I couldn’t imagine having done several years ago. I wouldn’t have even considered doing that. I’m always looking at, “Where do I see an opportunity to make money? As an investor, where do I see the opportunity to allocate my dollars and have the best chance for a positive outcome?” That might mean shifting your strategy or focus to what is working in the market or what’s a defensive play in the market.
I was going to ask you about a different asset class. I see a lot of multifamily operators. Multifamily has changed into a more difficult market. Maybe they’re in self-storage. RV parks are becoming popular. There’s a carwash and all these different things. You’re not looking at any of that but debt is where you’re going. Talk about the debt. What kind of fund is this?
I did all those things in my younger years too. I was like, “I’ll go do self-storage or a hotel. I’ll do this and that and the other thing.” Every time I stepped outside of my lane, my hand got slapped so I decided that I wouldn’t do that anymore. Unfortunately, I never lost investor money. After many years in this business, I can still say that I’ve never lost a dime of investor principal. I have no intention of starting that but I sure got my slaps on the wrist for venturing outside of my box.
They can go and diversify into other asset classes. Some of those ventures might be wildly successful. For others, maybe not as much. I’m always looking at the experience of the sponsor. When they start doing things they aren’t experienced in, it increases the risk. That’s all. Real estate debt was a new field for me. I started up a bridge lending company a couple of years ago. I don’t even know if I ever told you about it. We were making loans to real estate investors. I thought, “We’ll do $30 million a year. Maybe we could loan out to real estate house flippers.”
The business took off beyond my wildest expectations and we did $2 billion in loans. We did $1 billion in our last year, which was 2021 into the first half of 2022. When you do $1 billion in a year, you don’t do that and do not get noticed. We got noticed. Somebody came along and made us an offer we couldn’t refuse. I could have the opportunity to semi-retire. We sold that company. It got me a good intro into the debt world.
I started this fund. We’re buying loans from our old company. These are performing short-term bridge loans made to real estate investors. It is mostly house flippers but a little bit of a small balance of residential-commercial like multifamily fourplex, fiveplex, 10-unit, 20-unit and that smaller-type stuff. We’re buying those loans. It’s a great business for us. It’s a good steady income.
Our investors have been frustrated by the apartment syndication world where distributions are getting cut off and all that. That’s part of it. That will come back. If they do want cashflow, debt is a place to do it because you get cashflow on day one. In apartment syndication, you’re probably not going to get that. The downside is there is no big upside. There’s no big payday. This isn’t a 2X multiple investments. It’s a cashflow play but it’s a low-risk cashflow play relative to the risk that you take in owning real estate. If things fall 30%, it’s somebody else’s 30% that gets lost, not ours. That’s where I want to be.
I want to understand this a little bit more. The previous company was loaning to bridge borrowers or real estate flippers. As I remember it, you would then sell those loans pretty quickly after you initiated them. Thereby, it felt like reducing the risk almost to nothing because you would initiate the loan and then be done with it. Your old company is initiating the loan and they’re selling it to whom you used to sell it to, which is yourself. Are you in a riskier position on these loans than you were before? It doesn’t make it bad to recognize the difference. Can you talk about that?
That business was probably the greatest business model I ever created because there was almost zero risk. We were in and out of those loans for a number of days. It was the best business we ever did. We did $2 billion with $50 million. That’s hard to do. You got to be turning quickly but when you turn, you also eliminate your risk. It was a great business model.
The capital that we raised, that $50 million, was an extraordinarily low risk but it was also a lower return. Low risk begets lower return. This time, we have more risk because we have borrower default risk. We didn’t have borrower default risk, not very much in the old company. Here, we do have borrower default risk. We have some backstops to deal with that like equity, borrower balance sheets, track record, historical experience requirements, FICO and all that different stuff.
We do have that risk although the return that we can deliver to our investors is higher than the return that we were delivering to investors in the other company that had a lot lower risk. Everything in this business is all about risk-adjusted return. People always want to focus on, “What’s the number? Is it 6%, 8%, 12% or 20%,” but it’s, “What’s the number? What’s the risk? How do those two interplay with one another? What’s reasonable?”
There is one more topic. We’re going long here but this is great stuff. I appreciate you staying on. When we talked before, you were just starting your fund. You had single-asset deals and then moved into the fund model. Part of that was because, at the time, the market was very competitive. You explained that when you are negotiating and have a bucket of cash, it’s easier to close a deal than when you go have to go raise it. That was one of the reasons for switching to a fund model. As the market continues to change, are you going to go back to the single asset deals if you can ever find a deal that pencils or are you going to continue in the fund model?
That’s a tough question to answer because if I find a deal that pencils and it’s the only one we’re ever going to find or at least for a while, doing a single asset deal might make sense. If we find one and think that there’s a reasonable likelihood that we’re going to find others, I would far rather go the fund route. The fund route provides us the advantage of being a stronger buyer to get deals.
The deals that we have in our fund, if we did not have a fund structure, the opportunity would not have been there for us. Case in point, the last deal that we closed was a $150 million 3-property portfolio. We closed that deal in 26 days. We never could have done that if we didn’t have a fund and we never would’ve got the deal if we couldn’t close it in 26 days. That’s where the fund comes in. That’s the advantage for us.
The advantage for the investor is to remember the single point of failure discussion that I keep bringing up. We can provide a portion of that single point of failure reduction internally by using the fund structure because we can buy multiple assets in different places. We may not do the multiple asset type diversification because we’re not going to go out and buy an office building with our multifamilies. We can’t provide sponsor diversification but we can at least satisfy some of the diversification with a single point of failure elimination by using the fund structure. I would far rather remain in the fund structure if we can but we’re open to single-asset deals if the situation proves that that’s most warranted.
I hope that you find some deals soon. I’ve invested with you and had a good experience. I’d like to do that again but we might have to wait a little bit longer. This has been fantastic. I appreciate you being on the show. If people want to get in touch with you and learn more about Praxis Capital, what’s the best way to do that?
They can do that through our website, PraxCap.com. That’s the best way to get in touch with us if you’re interested in investing. If you’re curious about following the things that are on our minds, you can follow me on Instagram @InvestorBrianBurke. You can catch me on BiggerPockets.com in the forums answering questions. If you want to know everything that’s in this brain, which it’s only real estate because it’s the only thing that’s in there, you could get a copy of The Hands-Off Investor. There are 350 pages of everything I know in there.
I say this all the time but if you haven’t bought that book yet, then you’re missing out. You shouldn’t be investing in multifamily until you buy that book. Thank you for being on the show, Brian. We always appreciate you. We’ll get you on sooner than two years for the next one.
I look forward to it.
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I could talk real estate with Brian all day. That guy knows his stuff. It’s fascinating listening to him. Every time I listen, I learn a whole bunch. He nailed it when he said, “My job isn’t to invest people’s money. My job is to not lose their money.” That says all you need to know. He is more conservative than others but where do you want to put your money? It is someplace where you’re not going to lose it. Hopefully, you get some cashflow and gains but you’re not going to lose money. That is critical and he said it so well.
There are a couple of other things he talked about. Prices for properties are still falling. A lot of the sellers don’t realize that they have a little bit further to go. There’s a standoff between sellers and buyers and that is why there isn’t as much deal flow. That’s why probably what you’re seeing are mostly distressed deals because the buyers and sellers haven’t matched up their intentions or where they think things are going to be.
We talked about why we are where we are and why didn’t things go up forever. Things can’t go up forever. We live in a finite world. You can’t have infinite returns and rent increases forever. What Brian was saying is we have three things going on. We have rising interest rates and rent growth that are not continuing to increase because they can’t go up forever.
One of the biggest ones he mentioned was exit cap rates. They’re unknown. No one knows what the exit cap rates will be. There’s no good way to estimate what the exit cap rates will be. When you’re trying to do your proforma and figure out how this deal will pencil, if you don’t know what the exit cap rate is, you’re going to have some problems trying to figure out how to exit the deal. That is a problem for people that are trying to buy real estate.
Brian also talked about volatility in the interest rate that causes the cost of the rate caps to go up. It’s not high-interest rates that are causing the rate caps to be so expensive. This is something that I talked to somebody else about and it’s the volatility. If interest rates stabilize, start retreating, stop going up or become more predictable and stabilized, then these huge rate cap costs will go down and some of the money might be released out of escrow. It might not all happen right away. It might take a while. It might be that distributions are slowed down for some deals rather than terminated.
That’s one thing that Brian also said. Stopping the cashflow is different from a deal being in trouble. An operator that stops the cashflow distributions is protecting your investment. Brian said in the years that have gone by before everything was boom times, it wasn’t always consistent. We have to get used to the fact that sometimes, operators will hold back cashflow and distributions to protect your investment. We have to be okay with that as long as we understand, “The underlying investment is still going as it should. It has little hiccups because interest rates went through the roof unexpectedly,” or however else this happens.
A couple of things to avoid that Brian mentioned are short-term maturities and high LTVs. Those are a couple of things to look at when you’re looking at deals. You got to take a second look and maybe analyze if that’s a deal you want to get into and they have those high LTVs and short-term maturities on their debt.
This is fantastic information from Brian. I apologize to the audience that it took me years to get him on again because he’s so great. He came on when Left Field Investors was CPIG and we had twenty members. He came on a Zoom call and talked with us. It was phenomenal. He was on episode three of the show when I didn’t think we’d get more than 50 readers.
He was willing to take a chance on us and I appreciate that. He’s been a great partner. He has so much knowledge. He’s promised to come on anytime we want him. I am going to pledge here publicly that we will not wait for years before getting Brian back on. He is awesome. I love talking to him. That’s all we have for this episode. We’ll catch you next time in the left field.
Important Links
- Praxis Capital
- The Hands-Off Investor
- Episode Three – Past Episode
- @InvestorBrianBurke – Instagram
- BiggerPockets.com
- www.LinkedIn.com/company/PraxCap
- www.LinkedIn.com/in/PraxisCapital
- https://www.Facebook.com/PraxCap/
- https://Twitter.com/PraxCap
- https://www.Instagram.com/PraxCap/
About Brian Burke
Brian Burke is President / CEO of Praxis Capital Inc, a vertically integrated real estate private equity investment firm. Brian has acquired over 800 million dollars’ worth of real estate over a 30-year career including over 4,000 multifamily units and more than 700 single-family homes, with the assistance of proprietary software that he wrote himself. Brian has subdivided land, built homes, and constructed self-storage, but really prefers to reposition existing multifamily properties. Brian is the author of The Hands-Off Investor: An Insider’s Guide to Investing in Passive Real Estate Syndications, and is a frequent public speaker at real estate conferences and events nationwide.
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