How are multi family affected by the 18 year property cycle?

[Noah Mccurley]

I ask this question because multi family properties are valued differently from single family therefore I would assume the cycle for multi family is based on a raise in rents ,by the landlord, increasing the value and not a raise in the value or number of comparable properties being sold as it is in the single family market. Basically, I am just wondering what the cycle looks like and is based on for multi family property?

[Brian Burke]

@Noah Mccurley welcome to BP!  First, I'd disagree that there is such a thing as as "the 18-year property cycle".  If markets were actually that predictable everyone would sell at 17.75 years and buy back at year 19 and the whole concept would be a self-fulfilling prophecy.  Markets trade in different cycles, and different asset classes of real estate trade out of phase with one another.  For example, apartments might be doing great while retail is suffering, or single-family homes might be taking off while office is stagnant, etc.  Or multifamily is Phoenix is strong while multifamily in Omaha is weak.  That type of thing.  Sorry, I'm not picking on Omaha!  :)

It is true that multifamily is valued by the income stream that it generates.  However that is only one side of the mathematical equation.  Value is expressed by dividing the income stream by a cap rate.  So if the property generates $100,000 per year and the prevailing cap rate for that type of property in that area is 10%, the property is worth $1 million.  $100,000/0.1=1,000,000.

So if the income goes up the value goes up, right?  Not necessarily.  The denominator in the equation above is the cap rate.  Many people think (incorrectly) that the cap rate is something they want.  In other words, "I want a 10% cap rate and the property generates $100,000 of income so the property is worth $1MM."  Well, perhaps that's what it's worth to them, but the cap rate is set by the market at large, not by one individual investor.  

And the cap rate does move.  If real estate is highly in favor, cap rates drop (which forces up prices).  And if real estate is considered toxic the cap rate inflates (which forces prices down for the same income stream).  Think 2008.  People hated real estate in 2008 and 2009 and cap rates went up.  Then by 2012 people saw that real estate was safe and that forced cap rates down.  Other factors such as interest rates, availability of debt financing, and many other things enter the fray when it comes to prevailing cap rates.

And some might argue that in a recession rents don't drop and thus neither do prices.  Setting aside the cap rate variable for a moment that still isn't true.  While landlords hate to drop rents, and resist it like the plague, make no mistake that during a downturn your income will fall even if you don't drop rents.

Vacancies will increase, credit loss from non-paying tenants will increase, eviction costs will increase, you'll have to offer concessions like free rent or temporary discounts to attract tenants and keep the property full.  And yes, you might even have to drop rents to stay competitive.  Ask me how I know this.

So I can't tell you exactly what a cycle will look like, but I can tell you they are painful and some element of the above factors will be at play.  You can prepare for it, though.  Buy the right properties in the right areas (not "area" like Main and Main, I mean areas like U.S. cities where there is a lot of job growth and a likelihood that it will continue).  Don't over-leverage.  Stress-test your income.  Have multiple exit strategies.  And most importantly, don't over-leverage.  By the way, did I mention not to over-leverage?