Why isn't the Multifamily market more efficient?

Question

I've just started shopping around and running the numbers on multi family properties for sale around me. When I calculate cash flows the numbers I get are all over the place for very similar properties in the same area. Since its investors who buy most of these, shouldn't the market be pretty efficient? Seems like the prices should almost alway be in line with the returns and risk you could expect. Same goes for properties in other areas too. It's not that hard to invest remotely so I don't understand why everything doesn't balance out. Like, if you can get great returns in one Ohio or wherever, shouldn't demand go up and raise prices to match everywhere else? Same question on a small scale with individual properties being priced inconsistently.

Account Closed · Answer

To answer your second question about remote investing - I think that has in fact happened somewhat over the last 10 years or so. I hold property in Oklahoma but I live in Los Angeles. We branched out of California over a decade ago looking for safety from California's crazy up and down swings and also higher yield - and I found, like you, that some places/states seemed to have much much higher cap rates (higher cash flow) than others.

A decade later apartments have become really hot investments (ie everybody wants one) and prices are at historic highs everywhere. In addition the "spread" of yield between Oklahoma and California has decreased. In other words if you sell a building in California and buy in Oklahoma you are not going to get as juicy a bump in cash flow as you used to. I think the reason is precisely one you mentioned - people are far more comfortable with the internet than they used to be and more people than before are looking everywhere for yield.

If you can find an apartment complex which makes sense financially I say buy it. Over the long run you are likely to make a lot of money. One big advantage is the fact that you can't easily sell once you've bought - protecting yourself from the tendency to sell in a panic when things go in the toilet. With apartments you are in for the long haul and that is almost always a good thing for your investment returns.

Account Closed · Answer

Hi Jeff,

That's a great theoretical question, and one I used to ask myself when I was 15 years younger and fresh out of undergrad with "efficient market theory" "optimal capital structure" "modern portfolio theory" "increased returns are correlated with increased risk" and other articles of faith that had been passed off as fact by the professors in the economics department at my very prestigious college.

A decade and half later I no longer buy into the idea that markets are efficient - neither stock markets, nor real estate.

There is a deep divide between people who buy the theory and those who don't. For one of the most cogent arguments for the idea that "value" investing is real and produces superior returns over the long run read the billionaire Seth Klarman's legendary book "Margin of Safety."

To be really short I don't believe markets are efficient because I don't think the theory takes into account human psychology - herd mentality, panic and greed.

A value investor believes that a high price for an investment doesn't mean it's

Also, if you believe in value investing you do *NOT* believe that higher returns are found by taking on higher risk. You throw the theory of beta out the window (if beta is even measurable).

A value investor believes that buying an asset or stock at a low price gives a "margin of safety" - because you didn't pay so much that the item risks going down even further in price. And if you buy at a price at which you can make a decent return off cash flow and principal paydown alone, then someday you are likely to see above-market returns when the asset eventually appreciates after the market discovers what it is really worth.

But to specifically answer your question with regards to commercial real estate - you can throw aside the theoretical arguments about whether stock markets are efficient. Because even if liquid markets for securities could be efficient (which I do not think they are), that does not mean that real estate necessarily would be as well.

Commercial real estate is not a commodity item with perfect substitutes. In other words, one share of IBM stock is the same as any other share. The price will be identical in the same market at the same time.

But Apartment Complex A is not really the same as Apartment Complex B. They may be very, very similar but they aren't identical.

They could have structural differences, more wear and tear on one vs the other, aspects of the location of one that are superior to the other yet which do not become apparent until much study.

Then of course there is the fact that since they are not identical substitutes - individuals can price them wherever they darn wish and see if someone comes along willing to pay the price. So you end up with asking prices all over the board, a long purchase process and much negotiation along the way.

A big headache compared to buying a share of IBM? You betcha! But that's where the opportunity comes in - if you are willing to go through the headaches you are likely over the long run to have good returns.

Jeff Upton · Answer

Thanks, all of that makes sense. I've done plenty of research on stocks and other investment vehicles so i guess theres not as much overlap as expected. It's becoming apparent that RE is an entirely different animal in almost every way.

Ned Carey · Answer

@Bill Gulley I was going to joke that Adam must be getting pretty old by now. I guess another moderator assumed it was a fake name. Seems like Adam Smith could be a pretty common name.

I am not trying to solve them. I am trying to take advantage of them.

Bill Gulley · Answer

Yes @Ned

@Ned Careyundefined

I taught his theories in college.

Doubt it's the same Adam Smith with the invisible hand, a real name or a spoof, I don't know. What I bet though is that Dion will have competition for the longest post on BP sometime. :)

Real estate has never been considered an efficient market. Each property is unique, the utility is different, it's immobile, sales do not transact quickly at market value and valuations reflect the unique, functional economic benefits within communities.......real estate is not an efficient market.

Learn the basics of real estate before solving the market's inefficiencies. LOL  :)

Bill Gulley · Answer

Don't go into real estate with a stock market attitude because you'll lose! The key is knowing the market and changing with it or changing the market of a property. You can't do that with stocks. It's entirely a different game. :)

Ben Leybovich · Answer

@Jeff Upton - because investor's thinking is not universally rational or efficient :)

Doug N. · Answer

@Jeff Upton Please do your best to ignore the information(?) posted by the fake Adam Smith. A discussion of beta and the immeasurability thereof? Really? The efficiency of liquid markets for securities? Oh lordy - Sam Varnik would be proud. Yours is a question about MF valuations, not the Large Hadron Collider and theoretical particle physics. (Though Particle Fever is quite the good flick, check it out sometime!)

My suggestion is that you deep dive into @ben's posts where he talks about how he does MF valuations and why he is not actively in this market - he's the one to listen to.

Take it easy!

Ned Carey · Answer

@Adam Smith I wonder how many people here recognize the name.

I agree with you completely.  A concept many even experienced investors do not understand. In real estate you can turn risk reward on it's head. For a given property, the Greater the reward the lower the risk.

The key words there are "for a given property" but so many investors just can't grasp this concept.

Why isn't the Multifamily market more efficient?

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