THE MULTIFAMILY CRAZE
By Ashley Wilson
There has been a lot of focus on the volume of multifamily transactions over the past few months. This is in large part due to the low interest rates. With low interest rates comes inflated pricing. Why do you ask? Because it comes back to a saying, "Your purchasing power is directly correlated to your cost of capital." Historically, that reference was with respect to the equity side of the capital stack; however, today (even with the incremental interest rate increase) the effects are being seen with the cost of debt.
Current multifamily owners are not blind to this situation, with many quoting Trading Places..."Sell Mortimer, Sell!" Last quarter (Q4 2021) was one of the highest volume of properties for sale compared to any other previous Q4. The start of 2022 does not show any signs of slowing down so one may be wondering who is buying? It goes without saying, but will anyway, you can find a good deal in any market condition. However, the volume of deals, that are overpriced and still selling, are cause for a further look. And one thing you will find is the increased presence of 1031s.
The origination of 1031s was based on a concept that reinvesting gains into another like kind asset, means that those gains were never really realized. Coupled with the government's desire to keep money in real estate, the birth of 1031s for real estate investors allow gains to be rolled into another investment and defer the tax hit on the original investment. So how does this impact the current multifamily pricing? Answer: more sales equals more 1031 opportunities. Here is just one example- a couple of weeks ago I was speaking to an investor who was looking to 1031. He was willing to overpay by $2m dollars as otherwise his tax hit would cost him $3m!!
When extrapolating this across the volume of transactions that are/have occurred over the past several months, it is very evident that interest rates aren't the only component impacting pricing. 1031 exchanges might not be what is grabbing headlines but it certainly is impacting multifamily pricing, and in turn, compressing cap rates even further.
And then there is this.
Approximately 4,300 apartments ($148.9 BILLION) traded hands in Q4 2021. This marked the largest quarter of transactions in a little over 20 years (73% higher than the previous peak which was Q3 2021). Thus, it is no wonder there is so much attention on multifamily. Like anything, there are multiple factors impacting the allure to this sector. Thus, interest rates, cap rates and 1031s, aren't the only factors impacting the industry; inflation, idle money and foreign capital are also major contributors to this story.
Outside of the multifamily sector, the topic of inflation is on everyone's minds. Predictions may vary, but the fact remains it is here, and it is here to stay. Making matters worse is the recent rise in oil prices. Specifically, every $10 per barrel rise in oil prices translates to .2% increase in inflation in the US. In the end the past two years of the largest printing of capital in US history is not the only factor contributing to inflation, albeit it was a major contributor.
One major impact of the increased volume of printed money resulted in the average American having more savings than ever before, achieving a record high in April 2021 of over 32%. Typically it is mainly financially savvy individuals who know that idle money loses value; however, with all of the attention on inflation more people became attuned to this concept. Armed with this new knowledge more people than ever before not only sought out investments, but placed more capital in those opportunities.
This phenomenon was not just attracting domestic investors but foreign investors as well. Foreigners recognized the increased power their capital had oftentimes due to exchange values alone. Further, as Canada continues to impose foreign investor tax (for example the 20% land transfer tax for foreign buyers in BC, and Ontario's 15% tax to foreign buyers), it is no wonder that foreign investors are only seeking out America.
These six factors are creating a perfect storm. And with every storm there tends to be fallout. It is more important than ever before to take industry standard underwriting guidelines and throw them out the window. Why? Because we are not in an industry standard period.
One example that should be discarded is the cap rate expansion when it comes to the hold period. The traditional school of thought is to increase your going in cap rate by 10 bps per year held. This belief is going to catch a lot of people in years to come when they exit, as a lot of the current going in cap rates are falsely represented. The major reason groups are resistant to changing this practice is because their offers become less competitive, and thus they acquire less deals. Savvy investors know that your ability to exit is as important, if not more important that your ability to acquire. Focusing on accounting for a greater than a 10bps per year held, or alternatively using stable cap rates as the basis before adding the expansion will ultimately result in more opportunities to not only exit, but to exit profitably.
These are just six components impacting the multifamily market, but there are several more. If just one of these factors were at play it would be a lot easier to operate. However, the combination of all six factors is what makes the situation more complex. And like anything, only time will tell which components had the greatest influence forever impacting the future of the multifamily landscape.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.