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

by | BiggerPockets.com

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.

multifamily-benefits

Related: These Are My Favorite Ways to Finance Multifamily Investments

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!

About Author

Brian Robbins

Dr. Brian is a practicing Chiropractic Physician and a co-founder of Wellings Capital, a commercial real estate syndication company. He just finished his first book titled DONE! The Professional’s Guide to Double-Digit Returns, Multi-Generational Wealth, and a Worry-Free Retirement. His real estate experience includes single and small multi-family properties, as well as syndicating larger multifamily property and self storage assets. He currently owns a 32,000 sq ft commercial lease strip center which he is in the process of converting to a climate controlled self-storage facility.

21 Comments

  1. Jerome Kaidor

    I suspect you’re right. I have all but given up looking for multifamily deals. I see a deal on Loopnet or whatever, run my numbers, it doesn’t make sense, I pass, and a week later, it’s in contract. I keep wondering – where is all the money coming from?

    So I have decided instead to hunker down and invest in what I already have. I refinanced one of my complexes and am throwing all the money back into the buildings.

  2. Sam Grooms

    Great article. I agree that there’s a lot of signs that multifamily isn’t slowing down. I just want to clarify your point on carried interest.
    “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.”
    Actually, the carried interest rule was in place before. It went from a one year hold requirement to three years, making it worse. In light of that, your four points may need to come down to three.

  3. Paul B.

    I think the ability to take bonus depreciation will encourage some to buy strictly for the tax savings, which will drive down cap rates even further. A property that wasn’t a great deal in terms of cash flow might still sell at an inflated price, if the buyer is a real estate professional and fully deduct the depreciation against other income, say if the spouse is a high W2 earner.

    • Brian Robbins

      Paul B,
      I agree completely. The tax rules cause actions in the market place which do not always have the intended results. There are a number of reasons that investors are paying too much for MF assets at this point in history….thus the reason we have begun to focus on other asset classes until the market comes back to earth.

      Brian

      • Paul B.

        I wasn’t paying attention in 1986, but I hear that the tax reform that year eliminated a major tax benefit to owning commercial real estate (the ability to deduct passive losses). The impact was devastating to the entire commercial market. Perhaps it was even responsible for savings & loans going belly up?

  4. Joel Brown

    Good article with a number of points to ponder. Perfectly explains why I want to hold mostly single family. I’ll let those wanting to brag about their number of doors do the overpriced multi family thing. Sure I’ll keep watching for multifamily deals but I refused to buy a Yugo at a Mercedes price. Further comfirmation of my good decicion to close today on a single family home in Memphis. Ironically it is about 8 miles East of Hraceland. Elvis has indeed left the building. I invite my fellow investors to look at the big picture. If you want to over spend in multi by all means leave me less competition in single family.

  5. Tyler Sharrett

    Good article thank you Brian.
    I am usually a day late and a dollar short, but I’m jumping on the train! I think there are still small town deals out there especially in C class. I’m looking to turn C’s into Bs and catch some of the millennial and downsizing baby-boomer population.
    What’s your thoughts on assisted living? There is certainly a higher management cost but can the prices of income gained through quality care and facilities overcome the costs that are being asked for buildings that meet size and care requirements?
    Thanks again

    • Brian Robbins

      Tyler,
      I agree there are still deals in the tertiary and smaller markets but make sure you are not paying compressed CAP rates in those markets. Smaller markets are great if you are a buy and hold investor but if you have short hold periods in mind remember the buyer pool in small markets is also much smaller. Also if you plan to have a property management company manage your assets you will have a very small pool to choose from.
      Brian

  6. Mike Hajjar

    Does this mean I should be cashing in on a few bloated buildings ? I am torn, keep or sell. How much return makes it worth it ?!

    At the same time I am buying Cash flow, Turn key, Tax havens for someone to relieve me of next year.

    • Brian Robbins

      Mike,
      The answer may depend on how long you have owned the buildings? If you have used an accelerated depreciation schedule and have used up most or all of your tax benefits then it may be time to sell given the historic high prices. If so work hard to use a 1031 exchange.

      Good Luck,

      Brian

  7. Kevin O'Brien on

    Brian, this was a really interesting article. Question though – I’ve been seeing all over that the multifamily space is overheated….are they all just talking about commercial properties? What about smaller multi’s?

    I’m under contract on a triplex (my first property) and the numbers work but all of these articles have me a little spooked. I’ve watched the market for a couple years now and price appreciation for duplex/triplex properties seem to be in line with the overall SFH market. What are your thoughts?

    • Brian Robbins

      Kevin,
      I think that there are definitely opportunities to be had still. Make sure the numbers work and run them more than once 🙂 Smaller properties have pluses and minuses. If you have a super small number of doors the finances will not support a professional property manager. I believe your PM is close to 50% of your success in MF deals. If you are willing to get in the trenches and work the property yourself then you will be fine. PM’s usually get 3-4% for managing 100+ doors and you will likely pay 8-10% for a local PM. I am not a big fan of hiring the local real estate office that just happens to also manage properties as well. Also don’t underwrite depending on appreciation to make your deals work. At this point in the cycle I would buy for cash flow. I heard it once said that while “appreciation is your schizophrenic friend, cash flow is your constant companion!” I love that saying and wish I could remember who to attribute it to. Feel free to contact me offline if you have additional questions.
      Brian

  8. Kevin O'Brien on

    Brian,
    I really appreciate the thoughtful response. This deal is a house hack that luckily cashflows even while I live in one unit…plus I get some PM experience! The property will steadily cashflow more once I move out in 1-2 years and any appreciation would be icing on the cake!

    Thanks

  9. Colin Bumby

    Brian, great article. I strongly agree with your assessment. I started investing about 10 years ago as a buy and hold multifamily investor. The cash flow and returns on my initial purchases were great — I wish I had a time machine to go back and tell myself to buy more. However, like you, I’ve been finding alternatives for my money as the cap rates have dropped and the competition for multifamilies has increased. For the last three years I’ve invested as a hard money lender — with the right terms and conditions, I’ve found that I can get a nice return relative to the risk. I am also starting to expand my existing buildings to add additional units — so far, this strategy has worked well for me in my “home” market because with the right building, the cost per unit of expanding the building is roughly 1/3 to 1/2 of the cost per unit of acquiring a new building. I would be very interested to learn what you end up investing in.

  10. Brian Robbins

    @CBumby I would love to hear more about how you are adding units to your existing buildings given the parking spaces requirements and tight zoning on utility usage in most cities. I can tell you that we have shifted much of our focus to Self Storage right now. It has a excellent track record regarding risk and return on investment. The Sharpe ration of Self Storage is at the top of the asset classes and most importantly since there are still lots of mom and pop owners…there are still deals to be found!

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