After the 2008 crash, the world of multifamily real estate has exploded mainly due to the low cost of capital by lenders and by individuals flush with cash. Sellers of multifamily understand that all this cash is looking to be put to work and this is driving prices to new heights across the U.S. Reports published by Black Creek Group show that almost ALL the 54 Metropolitan Statistical Areas they monitor are either currently in or about to be in hyperinflation.
This explosion is not just limited to appreciation markets like New York or Los Angeles, but tertiary cashflow markets alike. My partners and I are shocked at the prices that the asking and sale prices for some of these apartments deals.
Some of this heated market is commercial brokers inflating prices to get an institutional or foreign investor to overpay for deals. What’s more, many of these people are coming to the table with up-front non-refundable deposits before due diligence plus a 15% premium. Bear in mind that this was for a C-Class portfolio in a market that usually sits at about a 10% cap rate. They paid a 5.5% cap. Unless they are only worried about parking money, it will be hard to get a decent return on that investment.
To me, it seems that these investors are going ahead and overpaying for deals and ignoring the fundamentals of this business such as cash-on-cash return, cash flow, and ROI. But why are they doing it? Here are some possible reasons:
1) Individual investors have 1031 exchange funds that need to be put into real estate to avoid being taxed by the IRS. Because there is a tight time constraint of getting those funds into another real estate deal, they are willing to take a slightly lesser return than have it taken by the IRS.
2) Institutional investors are lowering their bar and going after smaller deals. They used to just look at deals exceeding 250 units – usually 500+ units. There are so few deals out there that they are now going after smaller deals. They are willing to take the smaller returns to put their cash to work.
3) Out of state investors are not seeing the returns in their local markets because their respective markets are way too expensive. They look to the midwest and are attracted to a “cheap” cost per door. International investors want to put their cash into a stable and strong U.S. dollar and see the same cost per door as an easy way into the market. In both cases, they are still paying a premium as the buyers in the local market won’t even touch that deal.
4) Buyers and Syndicators believe that ALL markets are appreciation markets and will sacrifice a lower return for that they believe will be a huge boost in the sale price down the road. This is not the case in many markets. There is nothing wrong with buying for appreciation, but people need to understand what they are buying.
5) Buyers and Syndicators are bending their conservative rules and taking reduced cash flow and returns to get into a deal. They assume the market will continue its climb for the next 20 years with no economic disruption while tacking on rent increases of 4% to 6% a year in their financial models.
6) When these same Buyers and Syndicators perform their underwriting, they assume that bank interest rates will be as low as they currently in 5 years from now. If you look at the trend of the Federal Funds Rate Historical Chart, it’s on the way up. I’m willing to bet it will continue to climb.
7) That broker on Loopnet ACTUALLY returns a buyers’ call and tells them about a sweetheart, off-market deal that they just can’t pass up. However, they need to pay top dollar to win it. So they accept the broker’s proforma as truth and buy the property. The broker then takes that comp and puts it on the next deal they are peddling.
I’m not saying that anyone making deals today doesn’t know what they are doing or that any deal trading today is overpriced. The buyer may have access to an off-market deal or there is a true value-add play where the rents are 30% below market and occupancy is at 78%. In this case, you and your team are adding value by stabilizing the property. Regardless, the investors in these deals make sure it meets their minimum investment criteria and do not deviate. They also adjust the model to the work involved to stabilize it to the level of risk.
I am a believer in buying for cash flow. My partners and I stick to the numbers and leave the broker’s opinion and pro-forma out of our decision-making process. Unless you are getting into a big turnaround situation as I described before, your best bet is to apply conservative underwriting to your deal based on actual performance. If the deal performs well and you can still build in reserves while still satisfying your investment criteria, then you take that deal down. This means you will be analyzing a boatload of deals, but it’s the only way you won’t crash and burn on a deal.
Anyway, is there any situation where it’s OK to overpay for a deal? When would you do it? Let me know in the comments.