The investing landscape has changed drastically over the past few years. As we have progressed deeper into this current real estate cycle, the phrases that I hear often are: “The low hanging fruit is gone” and “Cap rates are compressing.” We actually have to put in effort and time to look for attractive deals.
Gone are the days of looking at the MLS or Loopnet and picking out deals. The 100-10-1 rule is back with a vengeance (research 100 deals, 10 are actual deals, and you close on one). Jake and I favor this type of market because most investors give up looking since it is laborious and time-consuming. But I promise you, if you stay persistent, you will land your next deal.
Are We Headed for a Market Correction?
Now, is the current market heading towards a major correction? The only way to tell is to analyze current data. Let’s begin with cap rates and the risk premium. The national average cap rate is currently 5.6%, not lofty by any stretch of the imagination. The secondary markets have a cap rate that is a bit higher, but not by much. Risk premium is simply the difference between investing in real estate and an investment that is considered “risk-free.” I use the Ten Year Treasury Note as a barometer for a risk-free investment, which stands at roughly 1.5%. Therefore, take the cap rate of 5.6 and subtract the T bond of 1.5, and the risk premium is 4.
Obviously, there are other benefits to investing in real estate. But there is also a ton of work and risk involved. Each investor has to decide for himself if a risk premium of 4 is justifiable for all of the effort to invest in real estate. The old timers will hearken back to 2006-07 when cap rates were hovering in the 5 % range. We all know what happened next. The smart money left the building, and most of us were left holding the bag (me included).
Positives and Negatives of the Current Market
There are two positives to this narrative. Interest rates are ridiculously low and appear to be stuck there. Rates were not increased in June, and the Fed chairman used the economic uncertainty and Brexit as two excuses for postponing a rate hike. It appears rates will maintain this level for some time. Once rates begin to rise, all bets are off.
The next set of figures that I would like to discuss is the number of new units being delivered to the market. There is a prediction that 240,000 new units will come on-line this year, mostly A-class assets. The market is definitely flowing between the expansion and hyper-supply stage. (Click here to read about the four stages of a market cycle.)
This can be seen as a positive and a negative. There is demand for new apartment housing, but at what point will supply overtake demand? It is your job to understand the market you invest in. For instance, the city of Nashville is booming and expects to add over 2,000 units in the second quarter. There will be a point when owners will have to begin offering concessions or dropping rates to entice renters. We invest in the east part of the state, and although there is new inventory coming onboard, it is nowhere near the levels of Nashville. We are not too concerned with new inventory because we cater to B to C tenants who can’t afford the lofty rental prices of the newer A assets.
A Nation of Renters
With all this new supply, how will the market react? I have written that the United States is quickly becoming a renter nation due to the demographics and the cost of housing. Young people can’t afford to buy, older people are downsizing, and the allure of homeownership has been waning the past few years. It will be very interesting to see how the market reacts to the new inventory being built, but my guess is that the older properties will suffer less than the newer assets.
This leads me to my next two metrics: occupancy rate and rental rate growth. Occupancy rates currently stand at 96.5%, very close to an all-time high. Rental growth has been on a tear the past few years, although it has slowed down the last 12 months. Rent growth was 4.7% for 2015, and several markets saw double-digit growth. Just ask Portland, Oregon or Seattle, Washington tenants what they are paying for rent. How long can this last? As long as demand outstrips supply. Once again, real estate is market specific, and understanding the dynamics and the overall picture of your market will tell you whether your market is about to enter a correction phase.
Let’s look at another measurement: foreign investors. A large part of the expansion in multifamily has been fueled by foreign investors, namely the Chinese, the Europeans, and Latin America. For 2015, foreign investors purchased $7.3 billion in multifamily assets, compared to $5.6 billion thus far in 2016. When the rest of the world is in turmoil, the United States becomes the safe haven for investment. Will that trend continue? I think it will.
Finally, a look at sales volume in multifamily real estate shows a 5% year-to-year increase from 2015. Most experts were expecting a much bigger slow down in sales. My opinion is that investors are looking for a return on their capital, and multifamily real estate is the new flavor. Commodities such as gold and oil had their massive run up. Next, it was the stock market. Now, the money appears to have been rotating to the real estate market these past few years.
What does this all mean for you? I still think there are deals out there that make sense. We just purchased a B asset in our market at an actual 8 cap and are negotiating another purchase in the same neighborhood. But it is taking longer to locate these deals. My advice is to stick to your buying criteria and be willing to walk away if the numbers don’t work. As my partner Jake likes to say, “Patience, persistence — but willing to walk away!”
Educate yourself on your market by asking brokers these important questions. Develop a strict “buy” set of benchmarks (cash on cash, cap rate, etc.) that you will adhere to. Assess the level of risk you are willing to assume, and begin to analyze deals. Do not listen to the naysayers that there are no deals left. Finally, be patient and persistent, but willing to walk away.
Investors: What are you seeing in YOUR market? Do you agree with this assessment?
Let me know your thoughts with a comment!