So, you probably read my recent post where I urged investors to “STOP IT!” and not overpay for multifamily assets anymore. What were you thinking when you read it? Perhaps…
- Why’s he yelling at me? I would never do a dumb thing like that. I’m a totally rational investor.
- He’s wrong. We’ve entered the era of “the new normal,” and apartment profits and pricing will continue to increase indefinitely. This time it’s different.
- This guy’s drunk on semi-boneless ham. After all, he’s the one who wrote the apartment book calling multifamily “the perfect investment.” (And why does he seem to be obsessed with semi-boneless ham anyway?)
- He said that people are overpaying for multifamily right now, but he didn’t really explain that. Why on earth would anyone overpay for any real estate investment?
Well friends, if you were musing about any of the first three points, I would encourage you to “STOP IT!” and ignore the rest of this article. I can’t help you. (Especially with point #3.)
But if you’re asking yourself the last question, you’re in the right place—because I’ve been asking myself that for some time.
And I think I may have some answers.
As I’ve been saying, I really do think multifamily is the perfect investment. The demographic trends, a series of government faux pas, a shift in the definition of the American dream, and the pain from the Great Recession have all contributed to a historic opportunity for multifamily investors.
The problem is that the secret’s out. Too many people realize this, and multifamily has become largely overheated. Many syndicators and investors are paying too much for multifamily of all sizes, and it’s likely to come back to bite them.
My company has not done a good job at sniffing out those great deals that are still out there (even if they are needles in a haystack). But we have succeeded at not getting sucked into the mania that seems to have swept much of multifamily investing world. (And hence our shift in focus that I’ve discussed widely.)
So, Why Would Anyone Overpay?
Why would anyone overpay for a multifamily deal? Why are some syndicator/investors still buying assets while others are running to the hills?
We don’t know most buyers, but I will suggest seven possible reasons here…
1. 1031 Tax-Deferred Exchanges: Pay Me Now or Pay Me Later (or How About Never?)
I can’t prove that there are a record number of 1031 like-kind exchanges happening right now. But there sure are a lot. Multifamily syndicator/investors have made massive profits since the recession, and that could mean record taxation as well. Ouch.
The 1031 like-kind exchange allows sellers to effectively trade their asset for another similar one and defer the capital gains tax until at least the sale of the next asset (or beyond, which could turn into forever if there is a step-up-in-basis someday).
Related: Why I Don’t See Anything Slowing the Multifamily Freight Train Any Time Soon
But using this strategy means the seller has to buy a new asset. And there may be time pressure. And the market is overheated.
So the seller may have to make a choice between paying Uncle Sam and overpaying for his next apartment complex. And it is easy to understand how he may choose the latter.
2. International Investors: Can You Say Overpay in Chinese?
I have a friend who works with a group of high net worth investors in China. He said they would sometimes be willing to invest at zero return if they can just get their funds out of Chinese currency and into the seemingly more stable U.S. dollar.
The value of the Chinese Renminbi currency has dropped versus the U.S. Dollar in the past several years. Here’s a chart from the beginning of 2014 to today. If a Chinese investor did nothing, holding onto cash in his currency, she sees the possibility that the value of her cash would drop. Some were predicting by 30 to 40% a few years back.
But if she could just get her cash swapped into U.S. dollars and still did nothing, she would have a relative gain (again, perhaps a sizable gain).
So with the hot US multifamily market, where investors have been enjoying returns as high as 20% or more in total annually (I’m counting cash flow, appreciation, and principal pay down), you can see why some Chinese investors would invest in U.S. assets and be willing to overpay.
(I realize the Chinese government is cracking down on foreign investments, but laws were made for commoners, not mega-investors.)
And there are many other countries who view the world the same way. I’ve spoken to investors in many countries that tell me cap rates of 2 to 4% have long been the norm in their country, which fuels my argument further.
But where does this leave us?
Well ask yourself this: If you are trying to get a 5% to 10% cash-on-cash return from a multifamily asset you’re buying, and you’re competing with someone who is willing to accept as low as zero return (or even 4% for the sake of argument), how will you win? Only by seriously overpaying. Woops.
3. The Institutionals Are Coming Your Way
Many institutional buyers—like REITs and life insurance companies—are looking for stable, predictable, boring commercial real estate assets. And they may be willing to live with (say) a 4% annual return in exchange for that stability.
Part of their equation, in some cases, has been to invest in large assets, in large markets, and often in primary/gateway cities which are often on the coasts. Places like New York, Boston, LA, San Francisco, or Chicago (North coast, right?).
These investors have to have a return. They can’t make their numbers work by sitting on the sidelines in cash. And returns in these large, stabilized assets in large primary cities are getting harder and harder to come by.
So they’ve not only driven these prices to all-time highs, but they’ve crept into smaller assets. And less stabilized assets. In secondary, tertiary, and even smaller markets. All to chase yield.
So you may be surprised to be bidding against these big guys in Kansas City. Or Lexington, Kentucky. Or Roanoke, Virginia.
And you may have thought you’d never see a buyer like this for an asset under 500 units, or older than 1999.
But you may be seeing otherwise these days.
You and I are obviously a lot smarter than these guys with teams of researchers, decades of experience, and millions to burn. So what do we do? Overpay.
Great idea. Not.
4. What We Can’t Get in Cash Flow, We’ll Make Up for in Appreciation
Do you remember this line? You should if you were around before the Great Recession. All types of real estate was climbing so fast and high that buyers could live with breakeven cash flow at 90% LTVs on inflated appraisals as long as they could pass the hot potato fast enough.
But it didn’t work that way, and a lot of investors lost everything. Many of them, like Rod Khleif, said he would have survived if he would have focused on healthy, cash-flowing multifamily assets.
Like I said last time, if you’re counting on appreciation, and worse banking on high-LTV variable rate financing to see you through the next several years… my prayers are with you. You may be fine. But do you really want to live with that level of risk?
Related: 5 Reasons I’m Not Worried About the New Real Estate Market Correction
Last week, I heard the story of a multifamily syndicator who was buying a very large apartment complex at a 4% cap rate, and the projected cash-on-cash return from operations is under 1% annually. What happens to this deal and these investors if rents or occupancy drop a hair? Or if there is an unexpected maintenance expense? There are lots of ways this could go south. And who wants that type of return anyway?
I was about to delete this paragraph from the post, because I found this story hard to believe. But then I ran into this same guy at a conference this week. I actually heard him say these words with my own ears two days ago: “Don’t worry about overpaying! Just get a great apartment complex in a great location!”
5. Less Experienced Operators Are Mistakenly Overpaying
The massive surge in commercial real estate values has led to a big uptick in the exchange of information on places like BiggerPockets (for which I’m truly grateful). And our increasingly entrepreneurial society has become less enamored with the prospect of 40 years behind the same desk. And the explosion of coaching and mentoring programs has resulted in a significant increase in new entrants into the market. Many of these entrants weren’t investing in real estate before the crash.
Combined with a record influx of investor cash, we have a situation where some syndicator/investors may be mistakenly overpaying. We entrepreneurs are an optimistic bunch by nature, and it is far more likely that any of us could overpay than underpay.
It can be caused by one or two optimistic assumptions—or even one small error on a spreadsheet. Seriously.
What’s the remedy? I’d guess there are many. But please don’t be overly optimistic, double check all your numbers, and make sure you have an experienced pro looking over your shoulder.
And please don’t allow any broker or banker tell you what the value of a multifamily asset is worth. Some of them stand to gain regardless of how the deal turns out, and you (and worse, your investors) could be the big losers in that game.
6. Less-Than-Scrupulous Operators are Over-Promising to Make a Buck
This one is similar to my last reason, but these operators may stretch their optimistic assumptions into the realm of fantasy to get a deal done.
Perhaps some have their own cash and investors lined up waiting to get into this hot market. Maybe they will make more in acquisition fees, broker commissions, and asset management fees than they would lose if the deal goes south.
Please don’t perpetrate this offense against your families and your investors. And if you’re looking to invest, make sure the sponsor’s interests are closely aligned with yours. Ask hard questions, and don’t be satisfied with anything that doesn’t pass your head and heart checks. There are too many other good opportunities out there (or there will be if you keep looking), and sometimes the best investment you can make is none at all.
7. The Tax Reform Act Has Injected New Life into a Market That Was About to Soften
About this time last year, I wrote a post trumpeting the top of the overheated multifamily market.
I was wrong.
I penned that in early December 2017, then the tax reform bill was passed in late December. A few months later, I checked some investor sentiment polls comparing sentiment in November versus January 2018. What a change.
This short post from National Real Estate Investor gauged investor sentiment in November 2017 and again in January 2018, right after the new tax law passed. It showed a 50%+ increase in investors who believed real estate was in an expansion mode—from 26% in November up to 41% in January.
The impact of tax reform cannot be ignored. And it continues now, almost a year later.
Have you been beating your head against a wall trying to buy overpriced apartments these past few years? Have you felt alone while you see others closing deal after deal?
You’re not alone. And you may be the smartest guy or gal in the room.
While it’s possible that this is the new normal, and compressed cap rates are here to stay, that’s probably not the case. While I don’t have a crystal ball, I can look back at decades of history and see that this bull run probably won’t last forever.
While history doesn’t really repeat itself, it truly does rhyme. And if the next several years play out as many expect, your patience will reward you. And then you, patient investor, will have many opportunities to buy while others run for the hills or sell in a panic. You’ll have your day in the sun!
Why do you think people are overpaying for apartments? Or do you think this is just the new normal?
Weigh in with a comment!