Why Do Investors Keep Overpaying On Properties?

52 Replies

Overbidding is the opposite of being a conservative investor. It happens when you buy above the market rate, compared to similar properties in the same general area. Another telltale sign of overbidding is when you purchase a property at a higher cap rate than market cap rates.

Capitalization rates (which are calculated as net operating income divided by purchase price) show what your return would be if you paid cash for the property. The lower the cap rate, the higher the price you’ll pay for the property. Higher cap rates usually lead to higher returns, but a cap rate that is too high can be an indicator of risk in the investment. The national cap rate for multifamily is 5%.

Here's something to think about: You may be overbidding on a property if you ignore signs that you should be more cautious in your investment approach. This can happen when an investor is new and inexperienced, and only sees the upside to a real estate deal while ignoring inherent risks.

A Closer Look At The Current Cycle

Has the multifamily cycle peaked? Some experts think it has. But there is still a strong demand for multifamily properties, along with a shortage of quality properties available for purchase. The factors that pushed multifamily property prices higher and caused investors to start overbidding are still in place. These factors include more retiring baby boomers electing to rent rather than purchase new homes, and millennials who are also choosing to rent rather than buy single-family homes.

So Why Do We Still Witness Overbidding?

Throughout my career in real estate, I’ve witnessed several key reasons why investors still overbid at this late stage of the cycle. Foreign investors are still bidding on U.S. properties, which is helping to drive up the price on multifamily properties, as well as contribute to overbidding. For foreign investors, making 3% cash-on-cash is better than 0.5% in their home countries. Institutional investors are also driving up prices by purchasing properties at higher prices, not only in the primary markets that they’re used to, like New York, Los Angeles and Chicago, but in secondary markets as well. They mainly make money on fees, and they have the power to lower their investors' expectations when it comes to returns. Hence, they are able to overbid.

Interest rates are at historic lows, which makes financing more attractive, and that fact allows investors to offer higher prices. In addition, novice investors are overbidding simply because they want to own real estate, and they are willing to do whatever it takes to acquire properties.

Another factor driving prices is the 1031 exchange. This tax-deferred exchange permits a seller to trade their asset for a similar one and defer their capital gains tax until the sale of the next asset — or even further down the line. So sellers are under pressure to acquire new properties and will do whatever is necessary to buy one, including overbidding, so they won't have to pay high tax on capital gains.

Lastly, many investors are overly optimistic, thinking that higher rent premiums will help to justify the price they’re willing to pay for the property. That’s simply not the case. Many investors and apartment owners will attest to the fact that when rents are raised beyond the market average, tenants will elect to move.

I tbought this was going to be self-promotion, instead, it's a well-written and easy-to-understand analysis of three basic factors driving overbidding in residential real estate. Very good information.

Nice breakdown and I agree. I see properties go for way over asking all the time and I scratch my head as to what investment strategy muse they are under. Be conservative and if you cant find a property for your numbers, don't buy. But Im a conservative investor... what do I know?

Originally posted by @Jim K. :

I tbought this was going to be self-promotion, instead, it's a well-written and easy-to-understand analysis of three basic factors driving overbidding in residential real estate. Very good information.

Yup for those in the business common knowlege.. but in reality its the herd mentality at work.. and safe haven.. Along with lack of inventory .. and then of course risk reward.

 

@Ellie Perlman You make some great points. I think what is clear though is that what one investor considers overpaying is not how every investor sees it. Saying that someone or some entity has overpaid for an asset is a subjective determination based on one (or even many) persons particular criteria, circumstances and view of the future. Every investor has different costs of capital, return requirements, risk tolerances, holding periods, tax implications, vision, information etc. Again, you touched on this with respect to foreign investment and 1031 exchanges and @Jay Hinrichs mentioned safe havens. Some people just want a safe place to preserve cash and don't care about cash on cash, IRRs or cash flow. They will be happy to break even and maybe get some asset appreciation.

I like what you put together, particularly the clear explanation of cap rates because most novice investors and even many experienced investors struggle with that concept. I just wanted to point out that the label of overpaying is a subjective one. Only in hindsight, after an investor has exited the investment could you really analyze their entire holding period and determine whether their original purchase was too high, and in some instances this could be decades or longer. 

Are people over bidding, or are you misjudging values?

By definition, the price a property sells for is the market price. So however high or low a property closes, that is the market price. 

California in particular has a very serious problem with foreign syndication investors. We are not only competing with American investors but people around the world. This has dramatically increased over the last 10 years. I'm starting to slowly see it now in the DC/MD/VA area. These investors typically will go 10 to 15% above asking price because they know they can buy the house and in 30 years when they are ready to retire it's still a great investment. Now if you go outside of major metropolitan cities - I highly doubt you will see foreign syndication investors in Milwaukee, Wisconsin.

Originally posted by @Jonathan Taylor :

Nice breakdown and I agree. I see properties go for way over asking all the time and I scratch my head as to what investment strategy muse they are under. Be conservative and if you cant find a property for your numbers, don't buy. But Im a conservative investor... what do I know?

That's probably because people are using the bank's money, not their own money, and do not assess risk properly. This will make things even worse when there is an economic downturn.

"Why Do Investors Keep Overpaying On Properties?"

I dunno - I had lots of guys that got outbid saying the same thing - In 2011.

They lost out big.

You need to look at an opportunity for return today and make reasonable assumptions about future income and value growth and then make a decision.

I'm an apt broker, some deals in PDX I wouldn't touch and some others in the same area I'd reach for since I think they have lot better growth potential.

I don't disagree with the concepts here, but I don't believe in the idea of "overbidding." Every property sells for exactly what it is worth. The worth to one investor might be different than what it's worth to you, but it sells for what it's worth. 

Rookie investors need to understand that not every investor is using the same metrics to analyze a deal that you are. Most new investors are looking at one metric, usually focused on the monthly or annual return on their cash (1% rule, 2% rule, CoC, etc) while more experienced investors are typically looking at the equity and leverage an investment will provide them over the long term. The experience investors don't give a second though to the newbies, but the newbies think the experienced investors are "crazy" for "overpaying."

You might keep an eye on what the experienced investors are doing- if they are paying cash for a property and have a large, performing portfolio, maybe they are on to something?

Originally posted by @Trevor Imlay :

California in particular has a very serious problem with foreign syndication investors. We are not only competing with American investors but people around the world. This has dramatically increased over the last 10 years. I'm starting to slowly see it now in the DC/MD/VA area. These investors typically will go 10 to 15% above asking price because they know they can buy the house and in 30 years when they are ready to retire it's still a great investment. Now if you go outside of major metropolitan cities - I highly doubt you will see foreign syndication investors in Milwaukee, Wisconsin.

 What makes you so sure about that Trevor?

Originally posted by @Jim K. :

I tbought this was going to be self-promotion, instead, it's a well-written and easy-to-understand analysis of three basic factors driving overbidding in residential real estate. Very good information.

 Knowing you, I assume you're being facetious, and I agree :)  Asking a question and then answering it yourself, using mostly anecdotal statements that don't really have any weight of statistical evidence behind them, would make me suspicious as well. Why ask a question if you already know the answer? 

But since we're all in there playing in the overpriced sandbox, let's talk about it. I agree with @Russell Brazil and a couple of the others above. When you are buying a commodity without a fixed value - which is almost everything, but I digress - there's no definition of "overpaying" without context, and there's really no such thing in a free market since demand+supply will largely set the price. By very definition someone can't be overpaying for something, because there's a fair exchange of goods based on perceived value to each party. Just because someone else is willing to pay $120k for a house I am only willing to pay $100k for, who am I to say S/he is overpaying? Maybe they're a better judge of future value than me. Maybe they see some current or future better use of the property than I see. Maybe the property is part of an overall bigger plan, like buying 10 $50k houses and then combining them into one property for $1 million.

Bottom line for me is when you start talking about "overpaying" for houses, you're having a discussion about nothing because it means nothing without context. There's houses I passed on because I thought I would be overpaying that I wish I had now, that's for sure. Funny thing is you rarely hear this conversation in other, more mundane topics. No one posts "Why do shoppers keep overpaying for milk?" and then goes on to pontificate about the virtues of Walmart and how Whole Food shoppers are misinformed.

Value is always in the eye of the beholder. You just have to be smart about what you value if you ever want to part ways with it in the future. If you don't, you can do whatever you want/can afford.

Originally posted by @Corby Goade :

Every property sells for exactly what it is worth.

Slight disagreement.  I'd say properties sell at value since it only takes one buyer to set his value.

Worth comes from the market.  I see a lot of guys from LAX in 1031s pay too much beyond what it's actual worth is to the rest of the market at the time of close.

 

Originally posted by @Marcus Auerbach :
Originally posted by @Trevor Imlay:

California in particular has a very serious problem with foreign syndication investors. We are not only competing with American investors but people around the world. This has dramatically increased over the last 10 years. I'm starting to slowly see it now in the DC/MD/VA area. These investors typically will go 10 to 15% above asking price because they know they can buy the house and in 30 years when they are ready to retire it's still a great investment. Now if you go outside of major metropolitan cities - I highly doubt you will see foreign syndication investors in Milwaukee, Wisconsin.

 What makes you so sure about that Trevor?

Are you asking about less foreign investors in Milwaukee? Probably wasn't a great example because foreign investors like any good investor will go wherever a return is profitable. I know small farm towns outside of Columbus, OH that have been dismantled by foreign investors. Most of these investments are extremely long term plays hoping that land values will dramatically increase. All you have to do is look up your county tax records research the names on the title or deed and typically find that one foreign entity has been buying up properties through an American owned business. I'll provide some examples when I get home from work.

 

What I want to know is who are all these cash buyers buying beat up houses that need a complete rehab from wholesalers for only 50k under market value (on a 200k place) and how are they possibly making money?!

Originally posted by @Corby Goade :

I don't disagree with the concepts here, but I don't believe in the idea of "overbidding." Every property sells for exactly what it is worth. The worth to one investor might be different than what it's worth to you, but it sells for what it's worth. 

Rookie investors need to understand that not every investor is using the same metrics to analyze a deal that you are. Most new investors are looking at one metric, usually focused on the monthly or annual return on their cash (1% rule, 2% rule, CoC, etc) while more experienced investors are typically looking at the equity and leverage an investment will provide them over the long term. The experience investors don't give a second though to the newbies, but the newbies think the experienced investors are "crazy" for "overpaying."

You might keep an eye on what the experienced investors are doing- if they are paying cash for a property and have a large, performing portfolio, maybe they are on to something?

 If a property always sold "for what it is worth" there would not be real estate crisis where prices drop dramatically like 2008 - 2011 (and in most of the world, 2008 - 2014 / 2016, depending on the country). There would not be people that let the banks foreclose on their properties either. Sometimes people can pay their mortgages but it does not make sense for them any more, because they know they paid a lot more than a property was worth.

@Juan Pardo , if someone can't pay the mortgage that the bank and their backers approved, that's because the person either didn't manage their money well or they had a personal crisis. That happens all of the time to first time homebuyers picking up entry level houses. Has nothing to do with what a house is "worth." People default on credit cards, cars, boats, houses, etc all of the time, there's no correlation between default and what the securities are worth.

I do believe a price correction is on the horizon. 

Originally posted by @Ellie Perlman :

Overbidding is the opposite of being a conservative investor. It happens when you buy above the market rate, compared to similar properties in the same general area. Another telltale sign of overbidding is when you purchase a property at a higher cap rate than market cap rates.

Capitalization rates (which are calculated as net operating income divided by purchase price) show what your return would be if you paid cash for the property. The lower the cap rate, the higher the price you’ll pay for the property. Higher cap rates usually lead to higher returns, but a cap rate that is too high can be an indicator of risk in the investment. The national cap rate for multifamily is 5%.

Here’s something to think about: You may be overbidding on a property if you ignore signs that you should be more cautious in your investment approach. This can happen when an investor is new and inexperienced, and only sees the upside to a real estate deal while ignoring inherent risks.

A Closer Look At The Current Cycle

Has the multifamily cycle peaked? Some experts think it has. But there is still a strong demand for multifamily properties, along with a shortage of quality properties available for purchase. The factors that pushed multifamily property prices higher and caused investors to start overbidding are still in place. These factors include more retiring baby boomers electing to rent rather than purchase new homes, and millennials who are also choosing to rent rather than buy single-family homes.

So Why Do We Still Witness Overbidding?

Throughout my career in real estate, I’ve witnessed several key reasons why investors still overbid at this late stage of the cycle. Foreign investors are still bidding on U.S. properties, which is helping to drive up the price on multifamily properties, as well as contribute to overbidding. For foreign investors, making 3% cash-on-cash is better than 0.5% in their home countries. Institutional investors are also driving up prices by purchasing properties at higher prices, not only in the primary markets that they’re used to, like New York, Los Angeles and Chicago, but in secondary markets as well. They mainly make money on fees, and they have the power to lower their investors' expectations when it comes to returns. Hence, they are able to overbid.

Interest rates are at historic lows, which makes financing more attractive, and that fact allows investors to offer higher prices. In addition, novice investors are overbidding simply because they want to own real estate, and they are willing to do whatever it takes to acquire properties.

Another factor driving prices is the 1031 exchange. This tax-deferred exchange permits a seller to trade their asset for a similar one and defer their capital gains tax until the sale of the next asset — or even further down the line. So sellers are under pressure to acquire new properties and will do whatever is necessary to buy one, including overbidding, so they won't have to pay high tax on capital gains.

Lastly, many investors are overly optimistic, thinking that higher rent premiums will help to justify the price they’re willing to pay for the property. That’s simply not the case. Many investors and apartment owners will attest to the fact that when rents are raised beyond the market average, tenants will elect to move.

 

The statement about cap rates is a bit confusing. If I’m buying a property with a higher cap rate than the market, I’m accounting for the additional risk and being compensated  for it. However, if I’m buying a property at a below market cap rate, assuming all else is equal similar rent levels, expenses, location, risk, etc, then I would be over paying and not be compensated for the additional risk. 

In regards to the NYC market and investors buying at very low cap rates, was more due to the low risk/ high reward assumptions of the rent stabilization component in conjunction with high demand and low vacancy rates. Therefore, many investors were basing purchases off of overall rates of returns (IRRs) vs. going-in cap rates. Some rent stabilized tenants were paying 50% of market rent (low risk) and when owners would buy them out or they would leave the apartment and it would be renovated and released at market rates notably increasing the income (high reward).  

I 100% agree that looking over most deals it appears people are over paying. However, when building up a desired rate of return, you must consider other investment vehicles, stocks, bonds, savings accounts, etc. The compression in other asset yields, particularly lending investments (bonds, t-bills) vs. ownership investments (stocks, real estate) in conjunction with compressed mortgage rates has pushed a lot of investors into riskier asset classes like real estate and stocks in order to squeeze out some sort if return. Hence the large amount of "dry powder" everyone keeps referring too. Also there is a great deal of FOMO (fear of missing out) going on. No one wants to hear how their brother-in-law, who has the investing knowledge of a ham sandwich, is making double-digit returns on some apartment building he bought at every family BBQ.

As others have mentioned, if cap rates start rising, due to a decrease in demand, higher interest rates, etc. This could spell trouble for the market and truly prove who over payed. In fact since the rent laws have changed in NYC (spoiler alert: not in the landlord favor) this exact scenario is paying out. Many who purchased at 4.00% cap rates with the expectation of increasing rental rates on stabilized units are now stuck with stagnant rental rates and rising expenses and eviction moratoriums to boot.

  

Originally posted by @Corby Goade :

I don't disagree with the concepts here, but I don't believe in the idea of "overbidding." Every property sells for exactly what it is worth.

Worth to a seller at that point in their life maybe, but can definitely pay less than its worth to someone else.. if someone else knew it was for sale.

I agree with the OP as to listed property. I'm seeing 4 caps being drooled over in a 5 cap asset class and area. GRMs of 15+ to an old 10 investor.  Time to reduce headache properties and resume my nap schedule.  

Until an older landlord wants to retire to a new state and just wants enough from his 11 units to buy his new house  Deals are still out there if you're working quietly with off market sellers. 

@Ellie Perlman

Very interesting point. I actually liked it. However overall I’m not sure if I would agree for two main reasons:

1. we only know if someone overpaid for something when we look back in time. It happened to me several times when I felt that I was overpaying at the time of purchase, but several years later it turned out to be a great decision.

2. Many multifamily (and other) investors feel that the prices are high and some adjustments will happen soon. Many investors are sitting on huge chunk of cash ready to invest when that happens.

In my opinion super conservative investing today is more important than ever. It appears to me that we’re on a top of the current cycle. But to be fair, I have been saying that for 2-3 years and I have been buying and refinancing, with caution.

Nobody really knows, we’ll see. :)

Originally posted by @Kevin K. :

The statement about cap rates is a bit confusing. If I’m buying a property with a higher cap rate than the market, I’m accounting for the additional risk and being compensated  for it. However, if I’m buying a property at a below market cap rate, assuming all else is equal similar rent levels, expenses, location, risk, etc, then I would be over paying and not be compensated for the additional risk. 

Kevin,

It's not confusing, your understanding is correct. Looks like the OP got it backwards. Maybe it's a typo.

The OP's statement:

"Another telltale sign of overbidding is when you purchase a property at a higher cap rate than market cap rates."

is backwards. If you purchase a property at a higher cap rate than market cap rates, then you have NOT overbid... you just got yourself a good deal. If you pay at a lower cap rate than market then you might have overpaid OR you might just be setting a new trend. Again it may just be a typo on the OP's part.

Cheers... Immanuel

I always laugh when people talk down about "newbies" and act like "experienced investors" are somehow smarter.  This business is no more nuanced than anything else, and is in a lot of ways, MUCH LESS nuanced.  Experienced investors aren't better at math than anyone else, and they don't have a crystal ball.  I'm relatively new in real estate and I haven't entered into a bad deal yet even in an uncertain market.  I'm also branching over from an industry much more complicated than real estate.  

If some of the people that are "realtors" can make a living in this business pressuring their friends into giving them commissions then anyone can do it.  That's part of the beauty of it.  If you're willing to get in the arena, the arena is willing to reward you.  You only show your misunderstanding of markets when you say someone has overpayed.  

@Russell Brazil

Could not disagree with you more. The market is so inefficient that to say that something sells for market price is short sighted. It sells for what someone is willing to pay. Assets that are "thinly" traded like real estate have tons of factors that weigh the buy/sell price. Those include marketing, emotion, perception, status, and then some quantitative measurements as well (lol). Look at what is required to be a "well marketed" property on the MLS, professional photos, 3-D tours, staging with mini furniture, a write up done with some jazz hands or something that will make you want to smell roses. If you can tell me which one of those 4 add value to a property, like actual value to the buyer, I would be all ears.

There once was a time when a 3.5 megapixel camera was all you needed to “show off” a house.

I agree with those stating that real estate is inefficient. In a highly liquid and uniform market like the stock market, which has thousands of buyers and sellers, then whatever the item last sold for is the market value.

Real estate is not uniform and not liquid. It’s not uniform because every property is unique. Maybe it has the same builder as the house next door but it’s gonna be in a different condition with different characteristics. It’s not liquid because in a given market or sub market you have a limited amount of sellers and buyers.

The closest the market gets to being efficient is when a property is well marketed on the MLS. Then it's being presented to a large number of buyers. I think in many cases the winning buyer overpays. They overpay because if they wanted to resell that property right away, they'd need to sell at a loss. Everybody else wanted to pay LESS than they did!

Off market, direct to seller is a different story. Those deals can still be overbid (I compete against these offers all the time) but off market is your best chance to truly get a good deal. Best case is you get a great deal because the place needs a lot of work, and you value the rehab cost correctly while the seller might overvalue the rehab cost because it just seems too overwhelming to them.

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