How Much Debt Is Too Much?

I believe there are a few immutable laws to investing in real estate, particularly multifamily. If followed, they lead to a path of sustained success, lower beta or volatility, returns that far outpace industry benchmarks and, most importantly, less catastrophic risk. They include:

➤ Don’t price to perfection; allow for a margin of safety

➤ Be patient and disciplined

➤ Be a pig, not a cow

➤ Develop core competencies that give you a competitive advantage

➤ Be more of an operator than an investor

➤ People are more important than assets

➤ Debt can be a drug; be careful

It is the last point that is topical in this instance. Additionally, it happens to be the overwhelming focus of this writer for the past nine months. How much debt is too much, especially for a nation—and a government—that seems to be addicted to the drug?

We all know that higher levels of debt lead to higher levels of risk. It’s why pension funds and insurance carriers leverage at much lower levels, and it’s not surprising that they have the lowest rate of default among real estate equity investors. Another example is how debt perceives debt. If you get a 10-year fixed multifamily loan today, on an A asset in a core market at 80 percent leverage, it will price at approximately 5.15 percent vs. a 50 percent leverage loan at 4.4 percent. The implications of debt are very clear, and from one cycle to the next, we have been taught to be rational with debt. But what happens when external issues create the risk that may lead to our demise?

We, as a nation, have accumulated a level of debt that has now surpassed the levels of every recession for the past 100 years, as well as the Great Depression. Our debt-to-GDP ratios, which is one of the most important metrics to gauge the health of a sovereign nation, is at the highest level in our history, and most other nations who are at these levels are under severe stress or are already bankrupt.

When you look at where we are, with historical levels of debt—and the only nation growing its debt—we must try and understand the implications of this on our business and the risks it creates. Through scenario analysis and modeling, let us attempt to evaluate the risks of our nation’s debt on the multifamily business.

Scenario 1: We implement broad and deep cuts soon, over one to three years

One day we will be forced to make broad and deep cuts to bring the budget into balance and shrink the outstanding debt. This will either be forced upon us by the bond or currency markets or we will, hopefully, enact them ourselves. Either way there will be pain, with the latter option bringing much less pain. A few, and certainly not all, of the possible implications on multifamily are likely to be higher unemployment, creating higher vacancy and lower rent; a wave of defaults from over-leveraged owners and the availability of debt contracts; prices falling between 15 percent and 30 percent and creating a buying opportunity for liquid and disciplined investors. The cycle takes three to five years for us to recover and stabilize.

Scenario 2: We debate, increase the debt ceiling again and make modest cuts

This will cause the debt to continue rising; we begin to lose the confidence in foreign and domestic investors in our bonds, as well as our ability to manage our balance sheet. We have a debt crisis, interest rates rise dramatically, severely stressing the balance sheets of our families, businesses and GDP contracts, and we could have a very deep recession or depression. A few of the possible implications on multifamily are likely to be: severe unemployment (15 percent to 30 percent);  creating ghost buildings and devastating property fundamentals across all classes and markets; default rates hitting 15 percent to 35 percent and debt completely evaporating; prices falling between 40 percent and 70 percent and creating a centennial buying opportunity for hyper-liquid investors. The cycle takes seven to 15 years for us to recover and stabilize.

As proven by the work of economists Reinhart & Rogoff (“This Time is Different,” 2009), when debt levels reach 90 percent of debt to GDP, there is a significant drain on the economy and GDP retracts. Our debt levels may be having an impact and drag on our ability to recover.

I can continue with more scenarios, but the reality is we all know debt can be very dangerous to our business, and this has the same implication for any nation. Let’s just take Greece, Japan, Ireland, Spain, Iceland and Portugal as a few examples. Greek interest rates are above 20 percent, Spain unemployment is at 21 percent, and Japan real estate values have declined by 80 percent, having not recovered in 10 years. All these nations are either in need of bailouts, on the brink of default or have lost decades of prosperity.

How about solutions, you may ask? It’s a very complicated issue, and because the problem is now so severe, and we have delayed cutting for so long, there are no easy solutions. All the solutions require sacrifice, pain and austerity. But the best solution I’ve seen is the Heritage Foundation’s “Saving the American Dream: The Heritage Plan to Fix the Debt, Cut Spending and Restore Prosperity.”

The implications of our national debt to real estate, our families and our future cannot be ignored. It’s a drug we can no longer afford. It’s time for rehab!

Paul Daneshrad is the president/CEO of StarPoint Properties LLC, a real estate company based in Beverly Hills, Calif. that specializes in the acquisition, re-development and re-positioning of multifamily and commercial properties. The views expressed in this Perspective are the opinion of the contributor.