How are multi family affected by the 18 year property cycle?
Belfast, Northern Ireland · Member since 2018 · 128 posts · 56 votes
@Noah Mccurley welcome to BP! First, I'd disagree that there is such a thing as as "the 18-year property cycle". If markets were actually that predictable everyone would sell at 17.75 years and buy back at year 19 and the whole concept would be a self-fulfilling prophecy. Markets trade in different cycles, and different asset classes of real estate trade out of phase with one another. For example, apartments might be doing great while retail is suffering, or single-family homes might be taking off while office is stagnant, etc. Or multifamily is Phoenix is strong while multifamily in Omaha is weak. That type of thing. Sorry, I'm not picking on Omaha! :)
It is true that multifamily is valued by the income stream that it generates. However that is only one side of the mathematical equation. Value is expressed by dividing the income stream by a cap rate. So if the property generates $100,000 per year and the prevailing cap rate for that type of property in that area is 10%, the property is worth $1 million. $100,000/0.1=1,000,000.
So if the income goes up the value goes up, right? Not necessarily. The denominator in the equation above is the cap rate. Many people think (incorrectly) that the cap rate is something they want. In other words, "I want a 10% cap rate and the property generates $100,000 of income so the property is worth $1MM." Well, perhaps that's what it's worth to them, but the cap rate is set by the market at large, not by one individual investor.
And the cap rate does move. If real estate is highly in favor, cap rates drop (which forces up prices). And if real estate is considered toxic the cap rate inflates (which forces prices down for the same income stream). Think 2008. People hated real estate in 2008 and 2009 and cap rates went up. Then by 2012 people saw that real estate was safe and that forced cap rates down. Other factors such as interest rates, availability of debt financing, and many other things enter the fray when it comes to prevailing cap rates.
And some might argue that in a recession rents don't drop and thus neither do prices. Setting aside the cap rate variable for a moment that still isn't true. While landlords hate to drop rents, and resist it like the plague, make no mistake that during a downturn your income will fall even if you don't drop rents.
Vacancies will increase, credit loss from non-paying tenants will increase, eviction costs will increase, you'll have to offer concessions like free rent or temporary discounts to attract tenants and keep the property full. And yes, you might even have to drop rents to stay competitive. Ask me how I know this.
So I can't tell you exactly what a cycle will look like, but I can tell you they are painful and some element of the above factors will be at play. You can prepare for it, though. Buy the right properties in the right areas (not "area" like Main and Main, I mean areas like U.S. cities where there is a lot of job growth and a likelihood that it will continue). Don't over-leverage. Stress-test your income. Have multiple exit strategies. And most importantly, don't over-leverage. By the way, did I mention not to over-leverage?
You are correct. The city I lived in during the Great Recession actually saw almost no dip in prices for multi-family properties, because the rental market became really strong during those years and rents actually went up in that city. The property's monthly income is the main determining factor in the price someone will pay for it, so things that affect its income are what will predict the cycle (for example, if a certain area's economy slumps and the rental market sags, your value is going to drop as well. Or higher interest rates which result in less income would also decrease demand for the property.)
One other note is that while buyers will value 2-4 unit properties based on their income potential, from the bank's perspective 2-4 unit properties still have to be appraised using the sold comparables, while 5+ unit properties are valued using their income.
@Noah Mccurley Don't know where you got the 18 year cycle part but if you can figure out exactly where we are in the cycle, we should talk. Each cycle is different and it's hard to go forward looking in the rear view mirror.
Each cycle is local and driven by Econ 101 factor like demand and supply. Even in 2008, there were some areas that got badly affected and in some areas nothing happened.
It's all about supply and demand. What is being built and what new jobs/population is coming in. If there are more units being built that people moving into them, then you have supply issues, which will cause a downturn. You also have other factors, such as lending terms. emotions, deflation, inflation and market trends. Hard to say exactly what will happen, but if you focus on cash flowing assets in growing markets with affordable rents, you should be able to make it through a downturn and thrive.
@Noah Mccurley welcome to BP! First, I'd disagree that there is such a thing as as "the 18-year property cycle". If markets were actually that predictable everyone would sell at 17.75 years and buy back at year 19 and the whole concept would be a self-fulfilling prophecy. Markets trade in different cycles, and different asset classes of real estate trade out of phase with one another. For example, apartments might be doing great while retail is suffering, or single-family homes might be taking off while office is stagnant, etc. Or multifamily is Phoenix is strong while multifamily in Omaha is weak. That type of thing. Sorry, I'm not picking on Omaha! :)
It is true that multifamily is valued by the income stream that it generates. However that is only one side of the mathematical equation. Value is expressed by dividing the income stream by a cap rate. So if the property generates $100,000 per year and the prevailing cap rate for that type of property in that area is 10%, the property is worth $1 million. $100,000/0.1=1,000,000.
So if the income goes up the value goes up, right? Not necessarily. The denominator in the equation above is the cap rate. Many people think (incorrectly) that the cap rate is something they want. In other words, "I want a 10% cap rate and the property generates $100,000 of income so the property is worth $1MM." Well, perhaps that's what it's worth to them, but the cap rate is set by the market at large, not by one individual investor.
And the cap rate does move. If real estate is highly in favor, cap rates drop (which forces up prices). And if real estate is considered toxic the cap rate inflates (which forces prices down for the same income stream). Think 2008. People hated real estate in 2008 and 2009 and cap rates went up. Then by 2012 people saw that real estate was safe and that forced cap rates down. Other factors such as interest rates, availability of debt financing, and many other things enter the fray when it comes to prevailing cap rates.
And some might argue that in a recession rents don't drop and thus neither do prices. Setting aside the cap rate variable for a moment that still isn't true. While landlords hate to drop rents, and resist it like the plague, make no mistake that during a downturn your income will fall even if you don't drop rents.
Vacancies will increase, credit loss from non-paying tenants will increase, eviction costs will increase, you'll have to offer concessions like free rent or temporary discounts to attract tenants and keep the property full. And yes, you might even have to drop rents to stay competitive. Ask me how I know this.
So I can't tell you exactly what a cycle will look like, but I can tell you they are painful and some element of the above factors will be at play. You can prepare for it, though. Buy the right properties in the right areas (not "area" like Main and Main, I mean areas like U.S. cities where there is a lot of job growth and a likelihood that it will continue). Don't over-leverage. Stress-test your income. Have multiple exit strategies. And most importantly, don't over-leverage. By the way, did I mention not to over-leverage?