7 Reasons So Many People Are Overpaying for Multifamilies Right Now

by | BiggerPockets.com

So, you probably read my recent post where I urged investors to “STOP IT!” and not overpay for multifamily assets anymore. What were you thinking when you read it? Perhaps…

  • Why’s he yelling at me? I would never do a dumb thing like that. I’m a totally rational investor.
  • He’s wrong. We’ve entered the era of “the new normal,” and apartment profits and pricing will continue to increase indefinitely. This time it’s different.
  • This guy’s drunk on semi-boneless ham. After all, he’s the one who wrote the apartment book calling multifamily “the perfect investment.” (And why does he seem to be obsessed with semi-boneless ham anyway?)
  • He said that people are overpaying for multifamily right now, but he didn’t really explain that. Why on earth would anyone overpay for any real estate investment?

Well friends, if you were musing about any of the first three points, I would encourage you to “STOP IT!” and ignore the rest of this article. I can’t help you. (Especially with point #3.)

But if you’re asking yourself the last question, you’re in the right place—because I’ve been asking myself that for some time.

And I think I may have some answers.

Context

As I’ve been saying, I really do think multifamily is the perfect investment. The demographic trends, a series of government faux pas, a shift in the definition of the American dream, and the pain from the Great Recession have all contributed to a historic opportunity for multifamily investors.

The problem is that the secret’s out. Too many people realize this, and multifamily has become largely overheated. Many syndicators and investors are paying too much for multifamily of all sizes, and it’s likely to come back to bite them.

My company has not done a good job at sniffing out those great deals that are still out there (even if they are needles in a haystack). But we have succeeded at not getting sucked into the mania that seems to have swept much of multifamily investing world. (And hence our shift in focus that I’ve discussed widely.)

how-to-value-multifamily-property

So, Why Would Anyone Overpay?

Why would anyone overpay for a multifamily deal? Why are some syndicator/investors still buying assets while others are running to the hills?

We don’t know most buyers, but I will suggest seven possible reasons here…

1. 1031 Tax-Deferred Exchanges: Pay Me Now or Pay Me Later (or How About Never?)

I can’t prove that there are a record number of 1031 like-kind exchanges happening right now. But there sure are a lot. Multifamily syndicator/investors have made massive profits since the recession, and that could mean record taxation as well. Ouch.

The 1031 like-kind exchange allows sellers to effectively trade their asset for another similar one and defer the capital gains tax until at least the sale of the next asset (or beyond, which could turn into forever if there is a step-up-in-basis someday).

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

But using this strategy means the seller has to buy a new asset. And there may be time pressure. And the market is overheated.

So the seller may have to make a choice between paying Uncle Sam and overpaying for his next apartment complex. And it is easy to understand how he may choose the latter.

2. International Investors: Can You Say Overpay in Chinese?

I have a friend who works with a group of high net worth investors in China. He said they would sometimes be willing to invest at zero return if they can just get their funds out of Chinese currency and into the seemingly more stable U.S. dollar.

Here’s why.

The value of the Chinese Renminbi currency has dropped versus the U.S. Dollar in the past several years. Here’s a chart from the beginning of 2014 to today. If a Chinese investor did nothing, holding onto cash in his currency, she sees the possibility that the value of her cash would drop. Some were predicting by 30 to 40% a few years back.

But if she could just get her cash swapped into U.S. dollars and still did nothing, she would have a relative gain (again, perhaps a sizable gain).

So with the hot US multifamily market, where investors have been enjoying returns as high as 20% or more in total annually (I’m counting cash flow, appreciation, and principal pay down), you can see why some Chinese investors would invest in U.S. assets and be willing to overpay.

(I realize the Chinese government is cracking down on foreign investments, but laws were made for commoners, not mega-investors.)

And there are many other countries who view the world the same way. I’ve spoken to investors in many countries that tell me cap rates of 2 to 4% have long been the norm in their country, which fuels my argument further.

But where does this leave us?

Well ask yourself this: If you are trying to get a 5% to 10% cash-on-cash return from a multifamily asset you’re buying, and you’re competing with someone who is willing to accept as low as zero return (or even 4% for the sake of argument), how will you win? Only by seriously overpaying. Woops.

3. The Institutionals Are Coming Your Way

Many institutional buyers—like REITs and life insurance companies—are looking for stable, predictable, boring commercial real estate assets. And they may be willing to live with (say) a 4% annual return in exchange for that stability.

Part of their equation, in some cases, has been to invest in large assets, in large markets, and often in primary/gateway cities which are often on the coasts. Places like New York, Boston, LA, San Francisco, or Chicago (North coast, right?).

These investors have to have a return. They can’t make their numbers work by sitting on the sidelines in cash. And returns in these large, stabilized assets in large primary cities are getting harder and harder to come by.

So they’ve not only driven these prices to all-time highs, but they’ve crept into smaller assets. And less stabilized assets. In secondary, tertiary, and even smaller markets. All to chase yield.

So you may be surprised to be bidding against these big guys in Kansas City. Or Lexington, Kentucky. Or Roanoke, Virginia.

And you may have thought you’d never see a buyer like this for an asset under 500 units, or older than 1999.

But you may be seeing otherwise these days.

You and I are obviously a lot smarter than these guys with teams of researchers, decades of experience, and millions to burn. So what do we do? Overpay.

Great idea. Not.

4. What We Can’t Get in Cash Flow, We’ll Make Up for in Appreciation

Do you remember this line? You should if you were around before the Great Recession. All types of real estate was climbing so fast and high that buyers could live with breakeven cash flow at 90% LTVs on inflated appraisals as long as they could pass the hot potato fast enough.

But it didn’t work that way, and a lot of investors lost everything. Many of them, like Rod Khleif, said he would have survived if he would have focused on healthy, cash-flowing multifamily assets.

Like I said last time, if you’re counting on appreciation, and worse banking on high-LTV variable rate financing to see you through the next several years… my prayers are with you. You may be fine. But do you really want to live with that level of risk?

Related: 5 Reasons I’m Not Worried About the New Real Estate Market Correction

Last week, I heard the story of a multifamily syndicator who was buying a very large apartment complex at a 4% cap rate, and the projected cash-on-cash return from operations is under 1% annually. What happens to this deal and these investors if rents or occupancy drop a hair? Or if there is an unexpected maintenance expense? There are lots of ways this could go south. And who wants that type of return anyway?

I was about to delete this paragraph from the post, because I found this story hard to believe. But then I ran into this same guy at a conference this week. I actually heard him say these words with my own ears two days ago: “Don’t worry about overpaying!  Just get a great apartment complex in a great location!”

single-multi-apartment

5. Less Experienced Operators Are Mistakenly Overpaying

The massive surge in commercial real estate values has led to a big uptick in the exchange of information on places like BiggerPockets (for which I’m truly grateful). And our increasingly entrepreneurial society has become less enamored with the prospect of 40 years behind the same desk. And the explosion of coaching and mentoring programs has resulted in a significant increase in new entrants into the market. Many of these entrants weren’t investing in real estate before the crash.

Combined with a record influx of investor cash, we have a situation where some syndicator/investors may be mistakenly overpaying. We entrepreneurs are an optimistic bunch by nature, and it is far more likely that any of us could overpay than underpay.

It can be caused by one or two optimistic assumptions—or even one small error on a spreadsheet. Seriously.

What’s the remedy? I’d guess there are many. But please don’t be overly optimistic, double check all your numbers, and make sure you have an experienced pro looking over your shoulder.

And please don’t allow any broker or banker tell you what the value of a multifamily asset is worth. Some of them stand to gain regardless of how the deal turns out, and you (and worse, your investors) could be the big losers in that game.

6. Less-Than-Scrupulous Operators are Over-Promising to Make a Buck

This one is similar to my last reason, but these operators may stretch their optimistic assumptions into the realm of fantasy to get a deal done.

Perhaps some have their own cash and investors lined up waiting to get into this hot market. Maybe they will make more in acquisition fees, broker commissions, and asset management fees than they would lose if the deal goes south.

Please don’t perpetrate this offense against your families and your investors. And if you’re looking to invest, make sure the sponsor’s interests are closely aligned with yours. Ask hard questions, and don’t be satisfied with anything that doesn’t pass your head and heart checks. There are too many other good opportunities out there (or there will be if you keep looking), and sometimes the best investment you can make is none at all.

7. The Tax Reform Act Has Injected New Life into a Market That Was About to Soften

About this time last year, I wrote a post trumpeting the top of the overheated multifamily market.

I was wrong.

I penned that in early December 2017, then the tax reform bill was passed in late December. A few months later, I checked some investor sentiment polls comparing sentiment in November versus January 2018. What a change.

This short post from National Real Estate Investor gauged investor sentiment in November 2017 and again in January 2018, right after the new tax law passed. It showed a 50%+ increase in investors who believed real estate was in an expansion mode—from 26% in November up to 41% in January.

The impact of tax reform cannot be ignored. And it continues now, almost a year later.

In Summary

Have you been beating your head against a wall trying to buy overpriced apartments these past few years? Have you felt alone while you see others closing deal after deal?

You’re not alone. And you may be the smartest guy or gal in the room.

While it’s possible that this is the new normal, and compressed cap rates are here to stay, that’s probably not the case. While I don’t have a crystal ball, I can look back at decades of history and see that this bull run probably won’t last forever.

While history doesn’t really repeat itself, it truly does rhyme. And if the next several years play out as many expect, your patience will reward you. And then you, patient investor, will have many opportunities to buy while others run for the hills or sell in a panic. You’ll have your day in the sun! 

Why do you think people are overpaying for apartments? Or do you think this is just the new normal?

Weigh in with a comment!

About Author

Paul Moore

Paul is author of The Perfect Investment - Create Enduring Wealth from the Historic Shift to Multifamily Housing, which you should probably get if you want to learn to invest in multifamily. He is a Managing Partner at Wellings Capital, a multifamily and self-storage investment firm, and hosts the How to Lose Money podcast. Paul was 2-time Finalist for MI Entrepreneur of the Year, has flipped 60 homes and 30 waterfront lots, developed a subdivision, and appeared on HGTV. Paul's firm invests heavily to fight human trafficking and rescue its victims.

35 Comments

  1. Michael P. Lindekugel

    1. 1031 Tax-Deferred Exchanges: Pay Me Now or Pay Me Later (or How About Never?)

    most deals i analyze after close it appears the real estate broker churned the client. the only person that made money was the broker at the expense of the seller/exchanger. the premium paid for the acquisition of the asset on the second leg of the exchange was more than the capital gains tax rate completely negating the point. it is disservice (malpractice in my opinion) for a real estate broker to fail to perform adequate financial analysis to determine the component IRR and overall IRR for a disposition/exchange/acquisition versus a disposition and acquisition. the effective IRR for each outcome needs to be calculated for decision analysis.

    the best scenario for a 1031 tax deferred exchange is during a normal market after a lengthy hold time to avoid paying a premium to conduct the exchange.

    • Paul Moore

      Great points, Michael.

      In residential real estate, the buyer has someone advocating for them. Not so in commercial real estate. The broker is about making a deal, and typically represents the seller. So no one but the eager buyer is advocating for him/her. Hopefully they have a clear head.

  2. Christopher Smith

    My last bay area real estate purchase was 2013, and my last purchase of real estate anywhere was 2016. The bay area is afflicted by many of the factors above (e.g., mainland Chinese money more than satisfied with a zero percent return). My only avenue recently has been REITs (e.g., MPW, CIM, etc.), but even those have gotten pricey.

    I’m seeing a lot of very highly levered novices paying unreal prices for stuff. It really makes you wonder what will happen if/when they hit a bump in the road having invested in projects that are at their very best profitable only on the absolute fringes of the margin.

    I have no idea of whether there will be a day of reckoning for that kind of flying by the seat of your pants, but I can’t ever envision myself assuming that kind of risk. Seems a tad bit reckless and lacking a reasoned business analysis.

    • Paul Moore

      ?James,

      You wrote a great article, and you are right, I had not thought about the IO issue in my analysis. I will add that to the list…

      People are overpaying because easy access to interest-only loans gives them an inflated view of the true profitability of an asset.

      Nice. Thank you.

  3. Cory Binsfield

    Everyone is a syndicator today. It will be interesting to see how this plays out. My best guess is the passives will be wondering what happened to their equity. The Sponsors will be fine due to all the fees they charge. They have no skin in the game-except for the good ones.

  4. Brian Serina

    Good post, Paul. As both a passive investor and c broker, I see a lot of proposals cross my desk each week. A troubling trend I have been seeing is little if any sponsor ‘skin-in-the-game’ and a ton of sponsor fees, none ever seem to be tied to any kind of performance.

  5. Rob Cook

    Betting and counting on natural value appreciation is always speculation, not investing. And investing without a cash-flow, can be okay even absent any appreciation, IF and ONLY if, the investor a) gets lucky, or b) has deep pockets to cover unexpected downsides or expenses. Staying power.

    Even though, in my opinion, EVERY deal should stand on its own, the reality is, that more wealthy investors can take bigger risks on any individual property, as they are “hedged” by other cash-flows and reserves, to weather storms. This is why the “big boys” usually can outbid the typical individual investor, and still not be acting stupidly.

    One thing that is often overlooked in many of these analysis/discussions (not this one Paul), is that all INVESTORS are not equal, and that fact also becomes a factor and metric in the deal analysis. What is too risky for some, is not risky at all to another, etc.

    • Paul Moore

      Rob,

      This is a brilliant analysis. I had not thought of this exactly this way, and it makes a lot of sense. Large, diversified, long term holders can afford to buy at a higher price and hold through downturns. A large player who sees the positive demographics that will cause apartments to soar for decades to come can play the long game and they would rather be in at a higher price than sit on the sidelines.

      Thanks Rob.

  6. Paul Moore

    Rob,

    This is a brilliant analysis. I had not thought of this exactly this way, and it makes a lot of sense. Large, diversified, long term holders can afford to buy at a higher price and hold through downturns. A large player who sees the positive demographics that will cause apartments to soar for decades to come can play the long game and they would rather be in at a higher price than sit on the sidelines.

    Thanks Rob.

  7. Mike Dymski

    “The purchase cap is not relevant…what is relevant is how you operate the property…” is becoming common language to explain high acquisition prices. There is truth in this position but it’s nuanced and when the purchase cap and interest rate on the loan are nearly the same, rents HAVE to go up (and market conditions can prevent that from happening). In the right locations, good operators are likely able to execute their business plan even if market conditions turn but it is a risk none-the-less.

    • Paul Moore

      I like the way you put that, Mike. There is a certain degree of speculation in knowing what you will really operate it at. There are great plans… then you get punched in the face, right?

      I know that some great operators are making this work at these prices. I think it is more of an exception in the coming years, though.

      I look forward to your “Thought of the Day” every morning. I’ve read each one and shared them often. Thanks Mike!

  8. Mark Spidell

    This is one of the best posts I have read in a while. Nice work @Paul Moore. The ease of borrowing on multifamily is a big reason. For deep-pocket investors, high-quality multifamily properties in good locations are really in a league of their own compared to other commercial real estate asset types. I have observed 1031 situations as you described. For investors with the ability to easily borrow, imaged this scenario. You sell a $2 million multifamily property and have a $1 million of net proceeds. Why not do a 1031 exchange into a $3 million property and borrow the rest? Even without very good cash flow, you may be in a better place than you were before selling the smaller property. Instead of having a $1 million loan with the bank, you now have a $2 million loan. Previously, your principal reduce was around $3,000 per month and now it is $6,000. The amount of cash flow might not be that much better with the new property, but you are actually gaining more wealth each month in the new scenario. Plus, there might be qualitative factors involved such as easier to manage, lower turnover, etc.

    • Paul Moore

      Mark,

      Thanks for your very kind words. I really appreciate it. I’m not sure about all the rules with debt ratios surrounding 1031s, but I like what you’re saying. It makes a lot of sense. And higher quality properties in better locations are certainly worth a premium.

      Thanks!

  9. Sam Roselli

    Thank you Paul. Very new to this, but am always looking.

    Point 6

    I saw a 2-4 multi in the LA area that had a posted proforma of 500 over what the occupants were paying now. Unscrupulous sellers agent- how is that even possible with rent control.

  10. Costin I.

    How much of this is a reflection of hidden inflation caused by years of quantitative easing (here and by other central banks)? Given there is more money than good deals, all trying to find a safe harbor, a more solid asset than paper? If that ever takes off and ends up in wide spread inflation or worse, hyperinflation, the opposite of a crash and overpaying might be the result. Just MHO, playing devil’s advocate a bit here, I think the article is excellent.

    • Paul Moore

      Costin.

      Great point. I’ve wondered about this often, and I agree that could be the case. The problem is that those who live by a crystal ball end up eating glass. I tried that in 1999/2000, and again in 2008/09, and never got it right. But that day will come. Thanks!

  11. Michelle Massa

    This is an excellent article – fact-based and also drawing on insights and experience by the author. I wish there was more content of this caliber on Bigger Pockets! Thank you, Paul. We are in the Dartmouth area of NH/VT and with low inventory and sky high prices on any MF, we are just learning as much as we can and lining up team members for when things settle out.

  12. Cole A. Boje

    Hi Paul,

    I have read your two most recent articles and I wanted to thank you. I am new to real estate investment, and although I have done lots of homework, networked, listened to the podcasts, etc., I haven’t been able to purchase my first investment property yet (targeting a duplex or triplex for an owner-occupy arrangement with an FHA loan to get things started). I have been looking diligently for 7-8 months now. The problem I am running into is exactly as you have described. Most of the multifamily properties in my market (the greater Pittsburgh area (PA)) are overpriced and rarely make sense mathematically. I’m talking about listings that don’t even come remotely close to meeting the 1% rule and people are still buying these things up. Also, the places that do seem to yield good cash flow (which is rare) turn out to be secret rehab projects post-inspection. I have a decent nest-egg, but I can’t take on a place that barely cash flows that immediately needs $20K-$30K in work to meet positive numbers. People are buying those too. It’s ruining the market in my opinion, and making it extremely difficult to break into the market. I have recently decided to take an alternative approach with an off-market direct mail marketing campaign in targeted neighborhoods. I’m hoping a creative approach and some extra work will yield a good deal. It has been frustrating, but reading your articles has let me know that I’m not crazy or unqualified, and that I need to continue to be patient and vigilant. Please wish me luck, and let me know if you have any tips or further words of wisdom based on where I’m at!

    Thank you,
    Cole

    • Christian Yepez

      Cole, don’t Rush to crash.. Save your money, and be ready when the market crash, you will need time and money to acquire deals. Many of the properties that are beind acquired now or deals that were acquired in the last 5 years or so by other investors will come back to the market as (short-sale or foreclosure sale). I will be patient!!

  13. Christian Yepez

    For Newbies be-careful out there!! I have been in real estate since 2005, syndicators were making big $$ at the time, same thing, no Skin in the game! and guess what happened? in 2008 real estate crash began, then, the passive investors got Zero, nada in distributions. Many of them just got paid for over 1 years and the rest of the years was an agony due to market crash or bad operators. Many syndicators lost properties, and investors lost their faith to get their money back.I know 2 big guys that only paid for 1 year or so to investors and they kept hoping to solve their problems (vacancy, evictions, banks not lending etc) And around 2010 many of them sold apartments via shortsale or lost their properties thru foreclosure. Remember, many experienced syndicators knew that around 2008 the crisis or subprime problem was coming and they took advantage of the mass of investors around 2005-2007. And the new Syndicators had higher expectations and never thought of the market will take a hit.
    In conclusion, we are in the same market cycle similar to 2005-2007. The crash will come soon and this will happen again, Real Estate History or Cycles repeats and repeats.

  14. James Free

    I’ve been citing the first two reasons in Colorado for over a year, and I’ve lost out on every offer I made in that span but one, which I now regret. This article gets it.

    I do wish Paul had expanded on the 1031 angle, though. It’s a big one. People who’ve seen large appreciation on a single-family sell, then try to 1031 into a duplex or fourplex. They struggle to find a deal, and as the window closes they’re facing a huge tax bill if they don’t get a contract in time. Let’s say the bill is going to be $80k. What do they do? Find a decent-looking listing where they know the vultures will overpay by $30k and offer to overpay by $50k.

    Why not? A $50k loss is better than an $80k loss!

    They get their contract, save their 1031, save themselves $30k, and the rest of us suffer from a market where you have to overpay by $50k to get a contract.

  15. Jim Costa

    Some great comments. @James Free nailed one of the reasons for overpriced properties and @Mark Spidell hit another big one. Not just large but small to medium sized investors are at a point where cashflow is no longer the focus but wealth building is the push. You can only spend so much money. Before the comments, once you reach the 200-300K mark (in cash flow), 1% rule $2-3 million an assets, you are now looking at ways to generate, generational wealth. One of the best ways to do that is with buy and hold properties. Investors have bought properties 15-25 years ago with substantial principal buy down, OK cash flow (still making a $300K mortgage payment on a $60K loan balance) and huge tax consequences if they sell. Thus enters the 1031. Like @Mark explained, the once purchased $300K 20 years ago is now worth $500K-1 million. The investor purchasing the new property is looking at principal depreciation, capital appreciation, and in last place is a minimal cashflow.

    The other big issue that hasn’t been talked about is the huge influx of millennials into the market place. This has 2 main impacts. The huge desire to rent rather than own is the largest impact. With this huge push of renting, look at the recent advertising campaigns from apartments.com, didn’t exist 5 years ago. Unlike past real estate markets, this has drastically changed the demand side for apartments and multi family. With this new demand, the market will still be around for a few more years and those buying in the good markets will continue to see what seems like an ok purchase with current rents be an incredible buy with the increased rents over the next few years, resulting in increased cash flow. Continue to sit by the sidelines and continue to miss out. I believe the next big push will be 3-7 years when the millennials will start to focus on families rather than carreer. They will no longer want to be in the apartment and will start seeking the single family home with the yard for pets and kids. This is starting to impact small multi family now for those that are starting to focus on family. Young couples are finding it difficult to qualify for the single family home of their dreams $300-400K so are opting for the 2-4 unit (same qualifying) $400-600K that brings the cost per unit more in line with their financing and brings the mortgage payment in line with what they would be paying for rent. Not ideal for them but the same amount they are paying for rent and now they own and have a write off for that double income. This is also driving up the price for small income properties.

    The big equalizer is coming down the path and glooming over the horizon … interest rate hikes! As interest rates continue to rise the buying power will go down. That $2000 rent/mortgage payment will see a $50-75K decrease in home value in what they can afford. This should have a double impact on multi family. It will keep values down on prices but should also keep rents up. Interesting times ahead! … buy right and know your numbers.

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