YouTuber Makes Some BIg Assumptions About Multifamily

[Kent Parks]

I was checking the news updates on my phone when I saw a gentleman in my feed that I have come across several times over the years of doing CRE research. The video/article caught my attention by the title, "When Cap Rates Are Lower Than Interest Rates"

After a careful listen, I was immediately struck by all the assumptions that were made along with all the current changes in the Multifamily market that was left out of this hypothetical deal.  Interest rates are continuing to rise and market rents have risen to a level in most markets that I don't see sustainable. I will leave this video for you to watch and would like to hear your feedback as a community.

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[J Scott]

While I don't necessarily disagree with his premise, that it's possible to make money buying multifamily properties today, many of his assumptions are either flat out incorrect or horribly presented.

There were two things in particular that he completely messed up:

First, when cap rates are less than interest rates, there is one huge negative risk, and he never mentioned it. When cap rates are less than interest rates you have negative leverage on your debt. 

Meaning that for every additional dollar that you borrow, your leveraged return is decreased.

The more money you borrow, the less return/ROI you will achieve. But as he pointed out himself at the beginning, if you were to make an all cash purchase, your return should theoretically be equivalent to your cap rate.

So the key to making a deal like this work is structuring your capital stack correctly. Using the right blend of debt and equity.

Secondly, as the guy in the video mentioned, money is made on deals like this through forced appreciation.  But, the guy in the video implied that you should be able to raise your rents 5% per year without any cost. That's not the definition of forced appreciation. And that's ridiculous. 

Yes, we saw that during COVID, but we may never see that again. In most markets, typical rent gains are between 2% and 3% per year.  Over the next year, in many big cities, rent gains could be negative.  And over the next couple years, they will likely return to near normal.

So it's unlikely that we're going to see 5% rent gains in most markets long-term. And his assumption that we will is horribly flawed.

Now, it is possible to see 5% or more rent gains per year, but it's not going to be free rent gain like this guy implies. Those rent gains will come through buying properties that are distressed, mismanaged, and already charging less rent than what that market is seeing.

Generating 5% or more per year in rent gains comes from spending time, money, and effort to reposition the property through physical and management improvements. This costs money. 

The guy used the term forced appreciation, but if it was true forced appreciation, he would have talked about the fact that your $2 million dollar investment into that property was actually more. Perhaps you spent $500,000 making these improvements. Or a million dollars making these improvements. Or more.

Forcing appreciation is spending money to increase income.  But, again, assuming that you don't need to spend any money and rents are just going to increase 5% per year is ridiculous.

While these were the two big errors in the video, there are plenty of other little things. For example, the $220K and appreciation is not a true $220K benefit to the investor. If an investor is in the 30% tax bracket, that would be a $66,000 benefit, and it would only be temporary. When the property sold, that depreciation needs to be repaid/recaptured.

And his assumption that $100,000 would be paid down one the loan in 5 years is likely way too aggressive. Commercial loans often have interest only periods, and even when they are amortized, you're not going to see this much principal pay down this early on a typical commercial loan.

Long story short, his answer was pretty much correct, but I wouldn't be taking advice from him on how to achieve it.