Why I Don't See Anything Slowing the Multifamily Freight Train Any Time Soon

Do you remember Elvis? Do you remember all of the excitement and craziness that surrounded this cultural icon at his sold out concerts all over the country? I do. Well, sort of. I have a vague memory of watching lots of old Elvis movies at my grandmother’s house as a kid.

Have you ever heard the phrase “ladies and gentlemen, Elvis has left the building”?

This phrase became popular at the beginning of Elvis’s career when he was the hottest thing since sliced bread. The crowds following him were completely unmanageable. Women were throwing themselves at him, people fainted, and crowds rushed the gates—some pretty crazy stuff!

Promoter Horace Logan coined the phrase at the Shreveport Municipal Memorial Auditorium in Shreveport, Louisiana on December 15, 1956. Elvis had just appeared in the middle of the night’s lineup. Logan needed to quiet the audience so that the remaining performers could play. In an attempt to restore order, he told the audience that Elvis had indeed left the building, and for some reason it stuck. The saying has been a fixture in pop culture ever since—used in songs, movies, sporting events, and even video games.

At this point, you may be asking yourself what this has to do with real estate investing. Let me explain. As a multifamily syndicator, I am confronted daily with the fact that the multifamily asset class is crazy overheated—or, as insiders like to say, it’s “frothy.”

The frenzied behavior behind the fierce competition for multifamily assets reminds me of what it must have been like to be at an Elvis concert—relatively sane people swept up in the emotion of the moment, doing crazy things that they would later regret.

The Problem

The multifamily space has been a great place to invest for decades. However, up until 15-20 years ago, few investors in the United States were paying much attention. Times sure have changed! Institutional money, insurance companies, family offices, international investors, and sponsors/syndicators are all chasing the same limited number of deals.

Over the past 24 months, the value of commercial multifamily assets has skyrocketed. An ever-widening pool of investors chasing yield has driven prices to all-time highs. Foreign investors with reduced return expectations are venturing into secondary and even tertiary markets snapping up assets. Desperate bidders are pitching in huge amounts of hard money (sometimes sight-unseen), raising the ante even further. And don’t forget the occasional unscrupulous sponsor who is willing to overpay on a deal just to collect his fees.

In my book, I discuss the power of 1031 exchanges. Overpriced multifamily assets render the 1031 exchange ineffective. Many sellers of multifamily assets are finding no options to exchange into when they sell their property. The only properties available for purchase are so overpriced, the tax savings from the exchange are completely offset.

Something has to give when the price point on the majority of deals no longer makes any financial sense. Our company was the bridesmaid on a number of deals last year. As a result, we have all but given up on chasing publicly marketed deals. We simply refuse to participate in the madness and to overpay!

“Ladies and Gentlemen, Elvis Has Left the Building”

All of that being said, have we hit the top? Has the market peaked? Can prices go any higher? Are we now sitting on the precipice heading for a huge correction in the multifamily space, or are we in for more craziness?

That same question was on the minds of just about everyone who attended the January National Multifamily Housing Conference in Orlando, Florida. Brokers, lenders, owners, and exhibitors were all asking the same question: “How much longer can this run go on?”

Industry pundits have been predicting a pullback for one, two, and some even three years now. In the last six months of 2017 and the first six months of 2018, there were stronger signs of market softening. Rent growth began to slow in some of the top tier markets, and absorption rates began creeping up. Economic concession rates also grew, although primarily in the class-A rental markets.

Related: Here’s Why I’ll Never Sell My Multifamily Investment Properties

Even with a few indicators beginning to turn, I personally believe the market is just catching its breath, mostly due to excessive delivery of new product in a number of markets. I think that the current run has quite a bit of steam left in it. There may be a slowdown in the pace at which rents grow and multifamily asset prices rise; however, I don’t see any major setbacks in this asset class. If there is a small pullback, I feel it will primarily hit class-A product.

The fundamentals of a strong multifamily market have not changed. Millennials are still waiting longer to form households and continue to place a higher importance on mobility than previous generation. Baby Boomers are downsizing at an ever-accelerating pace, and the growing migrant population continues to chose renting out of necessity.

Freddie Mac’s January 24th 2018 Multifamily Outlook pointed to the same conclusion. They noted that in 2017, rent growth and prices moderated while occupancy grew only slightly due to new product completions outpacing demand. They were expecting a small expansion of cap rates and slowing growth in property prices in 2018. Remember, even though the rate of growth has slowed some, it remains well above historic averages.

More of the Same?

In the fall of 2017, a seismic economic event occurred that affects every American’s wallet and has the potential to change the economic course of multifamily investing for the next decade and possibly longer—tax reform.

I am not an accountant and don’t play one on TV, so take this info for what it’s worth.

I believe four main points in the new tax law have the most potential to affect the real estate industry. These should fuel additional investor demand and sustain the overheated multifamily market for a number of years. The National Real Estate Investor has a good article summarizing the new law as well.

Here is a basic overview of each relevant point:

Congress allowed the 1031 exchange law to remain mostly intact for real estate. The 1031 exchange was axed for some personal property investments, such as art work, auto fleets, and heavy equipment but remained in place for real estate related businesses.
Tax rates were lowered for LLCs and S Corps from 35% to 21%. In addition to the lower tax rates, a 20% up-front deduction for business income is allowed.
Carried interest on any property held for at least three years is now treated the same as capital gains and taxed at a lower rate, whereas before it was treated as ordinary income.
Because the standard deduction was doubled, the value of mortgage interest and property tax deductions has been devalued. Congressional estimates suggest only 5-8% of individuals will now be able to take advantage of these deductions. The tax advantages of owning a home versus renting just vanished for majority of the population. This will lead to more people considering longer rental horizons.

These new changes will do nothing but attract more investor dollars to an already-overheated multifamily market. I expect nothing but continued craziness and overblown prices. Short of a complete economic meltdown, there is not much on the horizon that will slow the multifamily freight train.

Probably the most significant roadblock is rising interest rates. The Fed has indicated it will increase interest rates several more times over the coming months. This move will undoubtedly expand cap rates, creating a drag on multifamily price points. However, the momentum of commercial multifamily real estate is so great that even this will have a muted effect.

I expect the multifamily run will continue, although at a more tepid pace for the next several years. Due to a lack of reasonably priced multifamily assets, our multifamily investment firm has begun to look to other asset classes such as self storage to generate ample returns for our investors. How about you?

What are you experiencing in the multifamily market? Do you agree with this assessment?

Leave your comments below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.