AMA - Wait For A Correction?
Dr. Kevin Hsu from NYC asks,
“ I’m curious your opinion on something I heard Jeremy Roll and various other experts say on podcasts in 2019 - that the market is very hot in Multifamily in the past several years, cap rates getting compressed, and the best thing would be to wait on the sidelines for the correction and then jump in.”
Kevin, that’s a great question. There are two schools of thought when it comes to investing. The first is to treat the marketplace as an auction. Properties sell to the highest bidder. In an auction environment, there is a mindset of scarcity. The idea is that there is limited supply of deals, and more money chasing deals. In that environment, the fear of missing out creates an emotional reaction in many buyers.
You’re proposing to not be an anxious buyer and that’s absolutely the right attitude. You never want to pay too much.
You’re absolutely right that prices for investment properties are being bid up in the market to valuations that don’t make sense. In our business we have not engaged the market in the that most investors are. We’re not willing to pay too much.
A simple example was of a property in South Dallas that we looked at last year. It was over 100 units, and decidedly a C-Class property. It’s not in a great area. In fact it is in the middle of an industrial area backing on a manufacturing facility, with a warehousing and trucking property on either side. This is never going to be a B class property, not in that location. The asking price put it at a 5% cap rate. Not only that, the seller was demanding 30 days due diligence, and $200,000 non-refundable deposit even to accept an offer. I have no idea if the seller got their price or their deposit. The argument for the high price and the incredible terms was that the market was supporting those conditions. But it made no sense to me. I would never pay that much for that property.
It’s true that the money is made in the buy, not in the sale. If you pay too much for the purchase, you’re really setting yourself up for failure.
You can go find deals, or you can create them. I personally prefer to create the deal. When you’re finding deals, there is a lineup of people bidding for the same deal. It’s truly an auction.
In that environment, it’s tempting to wait things out until there are better prices in the future. But nobody can predict the future. Will you wait 6 months, two years, five years? What if prices don’t fall enough in a downturn to make the numbers work?
I prefer to have a clear financial model for what makes a deal work. You can either
- Find those deals. They do exist, but there are not that many.
- Create them.
So how do you create deals? Well, you look at the supply and demand imbalance in the market and you figure out what a project needs to look like to make the numbers work. You figure out how much profit you need per unit, what your construction costs would be, and ultimately what you can afford to pay for the land in order to make that all work. I’m finding that I’m able to build new product for 25%-30% less than the equivalent product is selling for in the open market.
Yes, these projects take longer, and yes there is the additional risk associated with new construction. But when you can build brand new product that is in demand, in the right location, at the price you want, the risks can be managed. That’s proven to be a good tradeoff for me. That doesn’t mean it’s ideal for everyone.
There are a handful of opportunities that appear as the result of special situations. These are things like an older property owner aging out of the ownership process. Sometimes, these opportunities come off-market through relationships with brokers.