September 30, 2021

JF2585: Current State of the Multifamily Market | Passive Investing

In today’s episode of the Actively Passive Investing Show, Travis discusses a recent shocking U.S. statistic and what it means for the multifamily market moving forward. We’re diving into the five metrics you should pay attention to when looking at new deals, whether or not it’s a good time to invest, and the migration trends we’re starting to see since the pandemic.


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Travis Watts: Hey, everybody. Travis Watts with the Actively Passive Show. I’ve got another great episode for you guys today. It’s going to be a shorter episode, but definitely a worthwhile episode. We are checking in on the current state of the multifamily real estate market. Appreciate you guys being here and tuning in. As always, if you have any questions, feel free to reach out, I’m happy to address those, turn them into either 60-second questions or full episodes.

This is the overarching statistic that’s going to paint the picture for this episode today, and that is that the United States of America has been a country for roughly 250 years, I think it’s more like 243 or something like that, more or less… 40% of all the US dollars, okay, all the US currency was printed in the last 12 months. I’ll say that again, 40% of all our currency over almost 250 years was printed in the last 12 months. So what do you think that means for real estate?

I think you would agree that we’re all seeing inflation in real-time. It’s really happening, and it’s a bit brutal. We’re talking about inflation that we haven’t seen since the 70s or the 80s. You’re seeing food costs go up, we’re seeing wages go up. My wife and I, we used to live in Denver, Colorado, and we were driving around that city recently – everyone is hiring entry level jobs, $15 an hour plus. We even saw a fast-food burger joint, $16.50 an hour; grocery stores paying 18 an hour. Throughout this year, we’ve seen unprecedented things happen such as lumber cost spiking 300%, which thankfully, is now trickling back down, but that is an extreme price hike.

Currently, where we sit, inflation’s approximately 6%. That’s what we’re seeing, as far as what the data shows for 2021. Here we are, three-quarters of the way through the year, give or take. So there’s different metrics and different stats and different sources that you can look at. Obviously, if you’re going to look at just the black and white government statistics, you’re probably going to see a bit lower number, maybe 2% to 4.5%, something like that. If you look on resources like where they try to predict what the real inflation is, they’re going to say something like 12-14 percent. I’m going to go with 6% just to be conservative. Just google it and decide what makes sense to you.

The other thing is that cap rates have been compressing for years; we’ve covered that on the Actively Passive Show. Previously, Theo and I pulled up a chart of interest rates and cap rates and we can see the decline since about 2001. In fact, today there’s some Class A apartments, luxury, new build construction, trading at under three caps. And by the way, that’s not in markets we’ve talked about before, like San Francisco or Manhattan where you historically have had low cap rates. We’re talking about major metros like Austin, Texas, Dallas, Miami, even parts of Orlando.

So here’s the bottom line – we’ve got approximately $10 trillion and counting that’s been pumped and injected into the system. And guess what? That $10 trillion (T-Trillion) is looking for a home, quite literally. It’s looking for real estate. It’s looking for a home, and we’re all chasing yield. So it’s looking for a return on investment, and what better asset class to place money in for yield than real estate?

So the age-old question that we’ve brought up numerous times, is it a good time to get involved with multifamily today? I’ll let you be the decision-maker. But let’s talk about a few more things.

As you know, this segment of the show is dedicated to passive investors, people looking to invest in multifamily syndications, but also we highlight the active components as well, if you want to be a general partner or what to do in terms of attracting investors.  So in regard to the question of, is it a good time to get involved with multifamily? I’m going to first take that from a passive investor perspective, because that’s what I am and that’s what I do.

I think it’s more important than ever before in 2021 to be a conservative investor. Obviously, GPs need to be conservative as well when you’re looking at buying deals and hopefully not overbidding that crazily, where your numbers still make sense and you’re not chancing people’s money. But there’s a few things I want to point out.

The first one is break even occupancy. This is a metric that’s always been very, very important to me as a passive investor. What breakeven occupancy is – for simple math, because I’m not great at math, is if you took 100 unit multifamily apartment building and your breakeven occupancy is 70%, that means you could have 30 vacant units on the property at any given time, and that is where you start hitting a break even, meaning you’re not going to have any cash flow or return on investment.

So when you’re looking at a deal from a passive investor or a limited partner perspective, that is something to ask. I don’t see that a lot on proformas, but I think that’s so critical to consider; it’s a big reason I got out of single-family investing, because you’re either 100% occupied or you’re 100% vacant. I didn’t like that kind of risk profile. So I went into multifamily, as I mentioned in the example, that I could have maybe 30% of the residents not paying or not occupying the rentals, and I’m still not losing money like I would have been in a single-family home.

The second thing is loan-to-value. What I’m seeing with some newer operators – in fact, a newer operator just sent me their first deal the other day, and they were wanting my feedback on it. And the returns looked great, conservative to a point, but they looked fine from an LP perspective. The problem was, I finally got to their debt terms – they’re putting 85% leverage on the deal. Okay, that’s not very conservative; that is really pushing the upper end. And the reason they’re doing that is because, I’m sure, it was hard to find a deal, they just wanted to get their first deal done, and that’s a definite red flag for passive investors. I’m still investing today in deals with 70% to 75% leverage. But there’s other operators being even more conservative. Of course, the lower the leverage, the lower the return. So it kind of comes down to you and what you’re comfortable with. Maybe a 4% cash flow a year doesn’t excite you, so you’re looking for that 6%, 7%, 8%. If you’re looking for those numbers, it’s probably going to be levered up 70% to 75% at least.

Break: [07:09] to [09:12]

Travis Watts: Another thing I want to talk about is interest rates. So of course, as you know, we’re in a very low-interest rate environment. Everybody today is getting good interest rates, from residential to commercial, multifamily, single-family. The difference is this – look at the terms on the interest rates. Are they locking in for five years fixed rate, 10 years fixed rate? Is it a variable rate? There’s a good chance with the inflation that we’re seeing that the Fed could start raising interest rates sooner than later. If they do that, what effect will that have on the multifamily? Usually, that’s a negative effect.

So what I’m looking for from a limited partner perspective is that they’re buying an interest rate cap, which is a lot like an insurance policy… And it suggests that if they’re buying the deal today, they’re getting a 3% interest rate, but it’s going to vary based on what interest rates do. Well, then they’re buying a cap at say, 4%, which means if interest rates start ticking up, and they go 4%, 5%, 6%, 7%, and they start getting crazy like we saw in the ’70s and ’80s, you’re capped at 4%.

And the other thing is, look for, are the loans assumable? And what that means is, if you sell the deal to someone else, can they assume or take over the pre-existing loan? That’s obviously going to be a huge value to them if interest rates are 6% and they can take over your deal with a 3% loan on it.

The next metrics is, what are they anticipating for exit cap rates? Now, this is an interesting conversation, because what I used to say is 10 basis points a year, meaning that if you’re buying something at, say, a four cap today, and then you’re holding it five years, then you would project a 4.5 exit cap rate. These are just metrics to be looking at on the pro forma. Now, you don’t really want that to happen, of course; that’s just a form of being conservative. That means that the market has softened up in five years, and that perhaps your purchase price would be a little bit less. So it’s a form of conservative underwriting.

So in today’s environment, you might still follow that advice, but what I’m seeing – and I just want to point this out for everyone to recognize – again, this isn’t a thing that is on every proforma; a lot of people are starting to pull it kind of away from investors where, of course, they’ll disclose it to you somewhere, but maybe not openly on page one of the debt terms. What I’m seeing is if someone’s purchasing an apartment building at a four cap today, capitalization rate, that they’re projecting an exit cap rate of the same, and sometimes even lower. That’s not very conservative, but it’s something to keep in mind, and it comes down to what you believe. Do you think cap rates will continue compressing? Do you think they’ll stay roughly the same for the next five years? Or do you think the market might soften? If you’re of the latter belief, that the market might soften up in five years, then you’re going to look for a deal where they’re projecting a higher exit cap rate than what they’re entering at today.

The last thing I want to point out are just general assumptions. A lot of people, they go through a boot camp or a training program, and they use general assumptions such as, “Well, rents are going to increase 3% a year for the next 10 years in a row.” Well, it’s probably not good just to generalize like that. Construction costs, historically, have been $8,000 per unit, to turn a unit around. Well, with wages and materials, and as I mentioned, lumber spiking 300% at one point this year, you might want to be a little more conservative on that. That’s definitely something to bring up or to look into when you’re looking at these pro formas. What are these assumptions? What are the assumptions on interest rates, on cap rates, on wages? …property management wages, maintenance staff wages?

I was talking to a general partner a couple weeks ago – they have had the same maintenance guy for years on their properties. I want to say about 10 years. When they first hired this maintenance guy, he was at $25 an hour, and today he’s at $55 per hour. So it’s definitely something to consider. Do you think wages are going higher, staying the same or decreasing?

I’ve also seen a lot of operators getting in a little bit of trouble with assumptions on property taxes, especially in Texas and Florida. They’ve been skyrocketing, they’re out of control, the insurance costs… So again, that’s fine, in a sense – nobody likes it, but it’s fine that they’re going up exponentially, but make sure that the assumption is every year, those are increasing; not staying the same, not decreasing, and maybe not at a super conservative rate, like 2% a year, maybe like 10% a year.

Alright, now, let’s zoom out for a minute, and let’s talk about the global perspective. I know we’re talking about all these US markets and US multifamily. But I just want to point out, if you just run a few quick google searches, it’s quite enlightening. Go look at cap rates, for example, in Hong Kong or Singapore or London; cap rates are even more compressed than what we’re seeing in the United States. And what’s important about that is that there’s a ton of foreign capital entering the United States… It has been for years – San Francisco, coastal markets, Miami, Manhattan. But right now, foreign capital is pouring in from all over the world, because quite frankly, as expensive as real estate might seem in America, it’s actually some of the most inexpensive real estate worldwide, especially in first-world countries.

I talked about this on the last episode, but you’ve got institutions also entering the space; companies like Blackstone, for example. They’re buying single-family assets, they’re buying up multifamily assets; again, big deep pockets, billions of dollars combined, probably trillions of dollars among all these different companies, all coming into the real estate space. In addition to pent-up demand from Joe Schmoe, your neighbor, looking to move as well. In addition to the New Yorkers, New Jersey and Californians, who have cashed out of their homes, they now have a million-plus, and they’re coming down to the Sun Belt region where, historically speaking, housing has been much more affordable, but is now being massively inflated with all these cash offers and outbidding each other.

And one new piece of information is, you’ve got these tech firms like these Zillow’s and these Redfin’s, and they’re launching new platforms that essentially would make real estate much like buying and trading a stock. It’s quite interesting, you should research iBuyers; just run a quick Google search, it’ll blow your mind. The idea here is that you’re basically eliminating the need for realtors, and you’re making a very, very fast closing process available to buying and selling homes where, let’s say, 10 years from now, in theory, I go onto, I find a home I want, I just click “Purchase,” I sign a few documents and boom, the home’s mine. I go move into the house 5-10 days later, something shorter than the traditional closing timeframes, and then let’s say, I live in it for five or six months and I go, “You know what? I want to sell this home.” I paid $600,000 for it. Now, it’s worth $605,000 – boom; click a button on Zillow, just sold my home; move out 5-10 days later. So it’s much like trading stocks. So that gives people a lot more flexibility. Obviously, a ton of pros and cons to that, but the point is, these companies are trying to gain massive market share right now, and they’re trying to buy a whole bunch of single-family inventory.

Break: [16:39] to [18:42]

Travis Watts: Real quick, just transitioning back to foreign investors and just institutional buyers in the space… Think of it this way – everybody’s chasing yield, as I pointed out. And yield meaning passive income, cash flow, dividends, interest, etc. Everyone wants their money to grow and everybody wants that monthly passive income, right?

So look at the environment of the banks and money market accounts, savings accounts, CDs at the bank, US Treasuries, most bonds – they’re paying 2% or less, generally speaking, as an annualized yield, so apartments are still very lucrative. Even if you paid all cash for an apartment building with a four cap, that means approximately a 4% annualized cash flow, without any kind of leverage or debt, so in other words, a much more conservative play, in 4%. This is why we’re seeing compression of cap rates, because the alternatives are so much lower that everyone’s transitioning to real estate and saying, “Hey, four is still pretty strong.”

And that kind of circles back to the question of this episode, “Is Now a Good Time to Get into Multifamily?” Well, it depends. If you’re looking at a pro forma and you’re seeing a 4%, 5%, 6%, 7% or 8% annualized cash flow, or you’re seeing a 10%, 11%, 12%, 13% or 14% internal rate of return – well, ask yourself the simple question, “What’s your alternative?” If you’re not going to invest in something like that, what are you going to do with your capital? And if instead your alternative is, “We’ll make 0.01% in the bank, or make 2% in a bond”, knowing that interest rates are probably going to be going up in a few years, maybe it does make sense to invest. I don’t know. I can’t make that decision for you. But I’ve made the decision that in today’s market, I’m still personally an investor in multifamily. But that’s just my take. I’m not telling anyone else what to do. As always, not a financial adviser, CPA or attorney; please seek licensed advice.

And bringing this short episode full cycle, and here towards the end, the last thing I want to talk about is migration trends. For years, I’ve been talking about on this show and on other podcasts and on my blogs that we’re going to start seeing Californians and New Yorkers and people in New Jersey, these high tax, very expensive real estate areas start coming down to the Sun Belt regions – the Arizona’s and the Texas and the Florida and the Georgia and the Carolinas, and all this kind of stuff… Which – it has been happening, incrementally, but the pandemic has really accelerated that happening. And the tax changes have really accelerated that happening. And just the ability to work from home. If you don’t have to drive and commute and pay tolls and taxes just to get into Manhattan and go up your 40 stories to your office, if you could just work from home, then why live in an environment like that, that’s so expensive, if you could just move out to upstate New York or somewhere else, where it’s far cheaper?

So here’s what I want to point out about migration trends that we haven’t really discussed before, and it’s kind of a new change actually, that’s happening, it’s kind of unfolding right now as we speak again, about Q3 of 2021. That is the shift back into the suburbs; a lot of people are leaving city centers. We’ve known this for some time, we have talked about that before, and a lot of migration’s happening still in the major metros. What I’m talking about is Dallas, Texas, Orlando, Florida, Miami, Tampa, etc. But you know what else is happening, is right now, as we speak, the biggest explosion is happening, from what I’ve seen in Red, in the submarkets of the major metros. So going back to those examples I just shared, we’d be talking about Irving, Texas, which is a sub-market of Dallas, or Winter Park, Florida, which is a sub-market of Orlando. Glendale, Arizona as compared to Phoenix. Lawrenceville, Georgia, as compared to Atlanta. All of these are just several miles out of city centers. But this is where we’re seeing massive rent growth and appreciation. And I think this is kind of the new play for 2021. Again, I’m not saying that people aren’t moving to Austin and Dallas and Orlando and Miami; they certainly are. But for those looking for a little more affordability, they’re really pushing towards the sub-markets. A lot of companies, a lot of CEOs over the last 12 months have been rethinking business strategy. Do we really need this commercial space? Do we really need these offices? Do people really want to be cooped up together long-term? As we know now with the vid, this is going to come in multiple strains. This could be something like the flu that’s year after year, so people are going to become more health-conscious, more aware. Are you going to want to be packed into tight cubicles, especially after working from home for so long? I think a lot of employees want that, and I think a lot of employers are looking at that as a huge cost-saving measure. So we’re in a world of change right now, interesting times that we live in, but these are a few snapshots of what’s going on in the multifamily sector. Basically Q3 2021. Hopefully, a couple new insights, a couple new things you didn’t know. I really encourage you guys to go out and search the iBuyers; so it’s just kind of like iPhone. So the letter i, lowercase, Buyers. This is referring to the institutional players entering the space and the new technologies coming out about buying and selling real estate. Something to keep an eye on, for sure.

As always, thank you guys so much for tuning in. This is Travis Watts with the Actively Passive Show. We will see you next week.

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