How to underwrite core deals in this environment

[Dan Bowe]

Seeing the market in reading the big brokerages reports on the main metros I invest in, everyone estimate rent growth at 0% for at least a year or two. Expenses naturally rise with inflation - insurance, property tax, utilities...

Those two factors, by definition, result in lower NOI down the road than in-place/year 1 NOI. Meaning that even with cap rate expansion set to 0%, the sale price is lower than the going in purchase price. resulting in negative/low yields.

Am I missing something here? Do core deals not pencil in this environment at all?

[Chris Seveney]

Quote from @Dan Bowe:

Seeing the market in reading the big brokerages reports on the main metros I invest in, everyone estimate rent growth at 0% for at least a year or two. Expenses naturally rise with inflation - insurance, property tax, utilities...

Those two factors, by definition, result in lower NOI down the road than in-place/year 1 NOI. Meaning that even with cap rate expansion set to 0%, the sale price is lower than the going in purchase price. resulting in negative/low yields.

Am I missing something here? Do core deals not pencil in this environment at all?

 They do not pencil out short term but real estate has always been meant to be a long term play (see why many MF syndicators are getting crushed). So while you may not see a gain in value over the next two years, over a 10-20 year span you would typically see excellent growth.

Also unlike the last five years where operationally the operator could be awful but saved by appreciation, today it is all about the asset management.How can you reduce costs, are there ways to add amenities to increase rents. Can you reduce vacancy. 

The next five years you will see who are the great operators and not so great based on how they manage their assets. 

[Kevin Sobilo]

@Dan Bowe, you are looking to broadly and thinking too narrowly IMO.

Rent growth: So, estimated rent growth in a given market is 0% for the next couple years.

1. First off that is "estimated" not what will actually happen.

2. Rent's can remain flat and you can still bring in more money! For example, you might reduce rent by 2% and cause your vacancy to dip to almost 0% causing your rent received to actually RISE!

3. Even for a buy & hold investor there are opportunities to make more money when rents are flat by attacking expenses. Activities such as appealing assessed values, shopping for cheaper utility providers, shopping for cheaper insurance, or even energy efficiency upgrades are all on the table.

Expenses naturally rise with inflation: True and also COMPLETELY FALSE!

1. Yes when you look at inflation prices are rising SOMEWHERE, but NOT equally everywhere! So, while ON AVERAGE prices are rising that does not mean YOUR expenses will or will at the same rate.

2. Inflation might cause prices to spike but some taxing bodies might not need to raise taxes for MANY reasons. For example, maybe the tax basis is growing because of industrial development or expiring tax breaks.

3. Insurance may go up, but if you haven't shopped it recently you might actually be able to reduce your expense at the same time prices are going up!

Other factors:

1. You have other factors in your rental business such as the cost of money. Rates are higher right now then they have been in recent history. A property purchased today might be able to be refinanced in a couple years for a rate reduction and corresponding reduction in expenses.

2. Deals are more about what YOU make of them then what the broad statistics say they are. The factors within your control/influence are much greater than some modest market environment headwinds.

[Robert Rixer]

Rent growth also outpaced expense growth in many markets the previous few years so you could see it as a re-balancing. These are all broad trends however, there is nothing to say you can find a one-off deal in any market environment that pencils out.

[Evan Polaski]

@Dan Bowe, I think all your answers are below, but I will note that to buy basically any type of deal today still feels pretty risky.  Sellers still want fairly top dollar.  Buyers want to price in all the risk and then some.  Cap rates are generally still lower than interest rates.  Institutional buyers are effectively out of the market.  Private buyers, and especially those that are raising capital from investors, are having trouble bringing together equity.  

And while I think there will be continued distress in various pockets and at various times, I don't expect it to hit all at once, creating an acute effect on prices.  But, as you note, there is a lot of uncertainty in the market, making it hard for deals to pencil.  And unfortunately, when there is more certainty, there is tons of demand that will drive prices back up, making them hard to pencil at that point, too.  

What I equate all this to is: the secret is out on real estate.  There is, and will continue to be significant demand for real estate.  Yields will be lower going forward across all types of residential real estate.  

[Jacob Sherman]

there are really good calculators out there based in excel spreadsheets