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Updated over 5 years ago, 08/12/2019
Is "Stupid" Money Chasing Millennials in Your Market?
Have you heard of the expression "stupid money"? It is when a herd of investors or speculators seem to be overpaying for an asset.
In my market in Cincinnati and I guess almost everywhere in the country, "stupid money" seems to be overpaying for apartment buildings. We've seen cap rates drop several basis points in a short span of time.
At first, I thought "stupid money" is really dumb - overpaying for buildings but...it seems that it's not "stupid" at all. Money is flowing into apartment buildings because it seems Millennials across the country are now preferring to rent long term vs. buy.
In my local market, I've seen movement of people from the suburbs back into the city as well.
Keep in mind some of that "stupid money" is from institutional investors and private equity firms with full time acquisition analysts and market experts (not newbies like here on BP). For example, a lot of them paid 9% cap for buildings in C areas in Cincinnati less than 5 years ago and the cap rates are now 6-7%.
Crazy!
Have you seen this in your local market as well? "Stupid money" chasing the Millennials' trend to rent apartments as a long term housing solution vs. buying?
If so, share it here. Also, if you are, share how you are making money from apartment buildings today.
If I get quite a few responses, I might share how I make money with apartment buildings today...even if I seem to be "overpaying" for them.
@George Gammon Really appreciate the thought and defense of the newer investor! I could not agree more that there is a very high level of risk with this type of investing, and certainly do not recommend it to a new investor.
Personally, I invest in projects of this sort with a very small percentage of my wealth, for precisely the reasons you state and the high degree of risk associated with rising cap rates.
Most of my wealth is invested in two places - small multifamily properties that I own and operate with reasonable leverage here in Denver, CO, with a 30+ year plan to manage through the ups and downs and gradually build equity through long-term appreciation, loan amortization, and solid cash flow. The next largest chunk is in index funds. Then cash. Then, I have less than 10% of my wealth that I invest in projects like those that Ben mentions.
However, the numbers I use in the example are just that - an example. In real life, the curve is much more flexible, the numbers do not vary by nearly as much, and return is generated even with rises in cap rates as Ben mentions earlier. You correctly call out that an uninformed reader might take my example literally - I should have used real numbers. The real numbers supporting the syndications I'm invested in lead me to believe that I am not gambling - but rather clearly understanding the risks that rising cap rates could have on my investment, and even with that understanding, feeling that in the most probable scenarios, my investment will yield a good return.
My overall point with this discussion being that calling the money going into these projects "stupid" money can be a foolish mischaracterization that oversimplifies the market forces at play and underestimates the investors coming into the market. Smart, quality investors and operators are going into many of these priojects with eyes wide open and strong plan that leads to a high probability of yielding return. If you call that "stupid" you will not understand the market forces, sit on the sidelines, and miss one potential opportunity to build wealth in that market.
I can sit here and feel very comfortable with my overall investment portfolio, including that which is invested in high capex multifamily projects in appreciating markets with low cap rates, with a good understanding of the risks and rewards of my approach. Readers here who simply complain about the high cap rates and think that investors like me are crowding them need to hear my perspective and understand the forces at play.
Bottom line - I would agree with you that a new investor would be unwise to invest in such a project or maybe even market generally. I would agree that many investors should not invest most of their net worth in such a project. But, for many, this is a viable risk/reward type of investment and a calculated decision that has a history of yielding return for LPs. This "stupid money" may well generate good yield over the next 10 years, or it may get eaten alive in a rising interest rate and cap rate environment as you might fear.
For the record, interest rates can and have stayed low for decades in certain countries. Your historical data may be at contrast with what we might experience in the next twenty years. One could make an economic argument that our economy is in for a period similar to that which was experienced by Japan in recent decades. Or we might go belly up tomorrow. We'll have to wait and see, and to each his own in navigating the markets ahead.
Originally posted by @George Gammon:
Originally posted by @Scott Trench:
One interesting thing to note about low cap rates is that they actually dramatically increase the returns of a great operator buying multifamily, assuming the cap rates don't change.
Example:
Apartment for sale. $400K in NOI. 4% Cap Rate. $10M Price.
You buy it with some LPs. You put down 30%, $3M, and increase rents and decrease OpEx with $2.5M in Capital improvements. Financed $9.5M in debt. Property generates $600K in NOI at the end of year 2 going into year 3. You complete this over two years and sell at the end of year 3 with a full year of NOI at the new higher level.
Well, now your asset is worth $15M at a 4% cap rate. If you and your LPs put 30% in equity, $3M, then you liquidate $6.5M net of debt, plus your ~$1.3M in cash flow, for a total of $7.8M returned on $3M in equity (and that's before loan amortization). Pretty solid to 2.5X+ your equity in three years.
Now let's try the same project at a 10% Cap rate:
$400K in NOI. $4M Price. You put down 30% - $1.2M - and increase rents and decrease OpEx with a $2.5M in CAPEX to achieve $600K in NOI in year 3. You've financed the acquisition and CapEx with $5.3M and you plan sell at the end of year 3. In this sceneario, you will generate ~$1.3M in NOI during the hold, and your equity value increases to $6M. Not factoring in loan amortization, you'd generate $700K in proceeds net of debt from the sale, and $1.3M in cash flow during your hold period. That's $2.0M returned to investors on $1.2M down. This is a far less attractive (but still good) 66% return over three years than the case above.
Certainly, low cap rates come with increased risk - when cap rates rise, the investors playing the first game will get washed. That's a risk that is understood, and why you might not want to play this game with money you can't afford to lose. But, if they stay low, major acquisitions and remodels begin to make a whole lot of sense, in ways they never will in a 10% Cap Rate environment.
Just ask @Ben Leybovich how this is working out in Phoenix for him.
I'll try to be as diplomatic as possible. I think this post shows the dangers of starting an investment career after 2009, not living through the 1970's, and most importantly looking at investing through the lens of possibilities without considering probabilities.
Let's start with facts. All the numbers are 100% correct. And it's a very astute observation.
The reason I have such a strong reaction when I see posts like this is because, although very well intentioned, it has the potential to lead the less experienced on BP down a road to ruin. Think about what is being said here.
Insanely high prices are an opportunity because you can go dangerously far out on the risk curve to supersize returns, or losses, by trying to find a greater fool. Note: use money you can afford to lose. And what ever you do ignore probabilities.
Why go to all the trouble and work of increasing cash flow? Why not just borrow the 3 million and buy bitcoin? Better yet, why not just borrow the 3 million and go to the nearest roulette wheel? It would only take you a couple spins to get a 2.5x return.
Of course, if I seriously suggested buying bitcoin on margin or playing roulette on margin, everyone on BP would think I'm insane. At best they'd say, "that's not investing, that's gambling." My response, of course would be, "it's not gambling if you're using money you can afford to lose..." ;)
Serious question: What is the difference between investing and gambling? Investing is having an edge, or the mathematical probability of winning. So if you take the same course of action, the more times the action is taken the greater probability you'll have of winning. Gambling is not having a probable edge...or even being cognizant of the risk and probabilities. Therefore, although the gambler may win in the short term, if they play long enough they'll always go bust.
Is the casino (house) gambling or investing? Answer: Investing
Is taking a leveraged bet on cap rates staying 4% for 3 years, under the following conditions, gambling or investing? 1. Worldwide interest rates at 5000 year lows 2. 40 year low cap rates (40 year high prices) 3. There can't be any substantial supply increases over the next 3 years (remember, the cure for high prices are high prices.) 4. Multi family occupancy rates must stay the same 5. The US, currently in the longest period without a recession in it's history, with the yield curve almost inverted, which predicted the last 7 recessions. See chart
After looking at the chart above, given current economic conditions, do the odds of coming out ahead on the 4% cap rate bet, increase or decrease the more times you place the bet? Decrease? Then it's gambling.
The odds of hitting red on a roulette wheel 2 times in a row (about what you need to realize a 2.5x return) are 1 in 4.24. Given the land mines listed above, which would most likely derail the 4% cap apartment gamble, are your odds better or worse than 1 in 4.24?
The fact that, given a more complete picture, you actually have to think for a second which has better odds, the 4% cap rate greater fool bet or the 2 spins on a roulette wheel, is in a nut shell, why I take the time to post on BP.
George
I agree with you George. Buying at extremely low caps is risky.
By itself, it does not make sense and as you said, it's the Greater Fool Theory.
But having said that @Ben Leyobovich seems to be a very smart investor-operator and seems to know his market.
What I do is:
1) Buy at cap rates based on the market (if the market is at 6%, I don't look for a 10% cap like what some gurus teach, I buy at 7%...even at 6%, specially if I can reposition the asset to produce more income)
2) Add value to the building (improved interior finishes, better management) OR find the building's highest and best use
3) Get substantial rent increases and substantial NOI increase on year 1 through #2
4) By year 2-3, exit via either a sale or refinance,and get substantial cash (we're talking about $10,000 per unit)
5) do #s1-4 all over again and get more units after each cycle
I've been investing since 1999 but discovered the above model in 2006 and so far...have not lost any money for my investors even through the 2008-2009 recession. So the above model is a far cry from gambling and is truly investing.
@Marc Winter sorry Mr Winter but congrats on the two wonderful daughters!! Most millennials today have the worst work ethic of all of society. I target women like your daughters to date and it’s very challenging. Today’s people get married young, have kids young and miss all the fun of being a 25 year old. I would live my 20s over and over. So now I’m 39, just turned 39, and for the past 5-7 years I’ve been dating women who are divorced with children looking for their second husband. At least that’s what they say. Then I get dragged out to all the bars and clubs thinking I’m way to young to be here. But all the young girls are at my dates houses doing the babysitting. Your right life is cyclical and I’ve followed it how you should which is the best way to get the most out of life. However. It’s rare to see happily married couples of 10-20 years these days. My most recent ex married her high school sweetheart. They were together 19 years, got married and divorced in 2 years! Life has changed and so does tradition. For that matter no one has any clue what they want to do for the rest of their life at 17-18. If I have children I’d be happy for them to see the real world for a few years before they’ve decided to choose a career path. Most millennials mindsets today are live with mom and dad and save money so they can vacation and post pictures on social media. That’s why rentals and AirB&B, HomeAway are good markets.
I've thought a lot about this topic. A few points to consider: (1) in commercial property investing, apartments are the least-risky asset, (2) while there's been an influx of institutional capital, there's also been an influx of uneducated sponsors who have taken a few online courses or followed a guru, and (3) why do investors think they deserve great returns for an asset class that's just not that risky?
For B and C-class apartments, there is no new supply coming online. The supply is effectively capped in the near term, save for LIHTC housing. While not non-existent, the downside risk is low. The big risks, from a sponsor's point of view, are overpaying for the asset due to poor due diligence, not being able to cover capital calls in the future, and not being able to refinance if rates rise in the next 5 years. Also, there's operational risk: Can you manage the property effectively?
So the pricing for these assets should take risks into account. But if risks aren't anywhere comparable to new development--and I'd argue they're not--then why should investors be rewarded with 20% IRRs? I don't think they should be. Thus, capital will continue to flow into this asset class and continue to depress returns in any market with strong long-term growth prospects. Of course there's always the possibility of a black swan event. But even in a moderate recession most apartment investors won't lose their shirts.
Then the question becomes: How do you not overpay? First, do more due-diligence than you think you should. Second, sensitize rents for a downside case in which you need to modestly reduce rents to keep occupancy levels high. It sounds elementary, but most investors just plug in a 3% growth rate and call it a day. But if you know you can cover your mortgage if you drop your rents $50/mo and occupancy decreases by 5%-10%, then you should feel pretty comfortable.
In my opinion (which may not mean much), 5-year IRRs will settle in the low teens for light value-add assets, compared to many sponsors today pitching 20% deal-level IRRs. And by light value-add, I mean standard unit renovations and some general exterior capex.
@Michael Ealy the traditional convention has been “dumb money”.
Inexperienced investors are always drawn to appreciated assets in sustained bull markets due to their lack of ability to properly judge risk or understand market cycles. This is true of all types of investments, whether a it’s stocks, RE, Bitcoin, or tulip bulbs. This is exactly what buffet spoke about when he said “ buy when other people are selling and sell when other people are buying”
@Michael Ealy What you said above:
What I do is:
1) Buy at cap rates based on the market (if the market is at 6%, I don't look for a 10% cap like what some gurus teach, I buy at 7%...even at 6%, specially if I can reposition the asset to produce more income)
2) Add value to the building (improved interior finishes, better management) OR find the building's highest and best use
You didn't say - I go into a market trading at 6 cap and try to steal at 10 cap. You said - I go into a 6 cap market and buy at 6 cap. And then value add.
The profit is in the Delta of your value-added cap rate to the market.
Great, this makes sense. Now, let's add another dimension to this.
In a 5 cap market, creating an additional $50,000 of NOI capitalizes to $1M of value. But, in an 8 cap market, creating the same $50,000 of NOI capitalizes to $625,000.
If it takes the same effort and money, which makes more sense? Naturally, the lever is much more powerful in a lower cap rate environment. Agreed?
@Marc Winter
I think the millennial mindset is more about quality of life than some sort of generalized short sighted financial obstinance.. The world is massive: there are people to meet, conversations to be had, businesses to start. All this opportunity can some times outweigh what you pay for a small space, especially when it means you're now in the network. Consider the fact that this metaphorical person might bike or walk to work, eliminating the financial liability of a car. Or increased job security due to the density of employment.
Is city living really another trend? Maybe in a couple years it will disappear along with $12 avocado toast and thrift shop wardrobes. Maybe it's the architect in me, But when I think of quality of life I think of everything I need for my survival within a reasonable proximity to where I live. I think of having a smaller carbon footprint by not relying on a car to get where I need, or sharing resources and infrastructure from a central network.
I recently bought a house in an "up and coming" (gentrifying) part of Philadelphia. I see young families here, as well as Middle aged and elderly people. If the school systems are decent then why leave? So we can have more "space" for our "stuff"?... Who needs stuff anymore when your smart phone is a flashlight, GPS, calculator, and computer. We can certainly learn a lot from a minimalist lifestyle.
I think the choice to live in a city is rooted in personal values that differ from other generations. I guess in the next decade or so we'll see just how sustainable city living is, or if it really is just a place to party and dump your cash. just figured I'd pass along my two cents,
Cheers!
Matt
Originally posted by @Mike Dymski:
@George Gammon great feedback. We have been aware of the risks for five or so years now. I am more interested in what people are doing about the risks. Moving six, seven, or eight figures of net worth into cash is not an option for most people. I am interested in how you and others are investing to mitigate the risks. I have been excruciatingly selective, re-allocating from value plays into cash flow plays, using prudent debt, and always adding value.
Mike, let me be very clear, I'm by no means suggesting a move into cash. If you believe there's a reasonable probability of 1970's style inflation in the next decade, the last place you'd want to be is cash.
And let's not forget, interest rates in the US ARE NEGATIVE. I don't think real estate investors realize interest rates are under the rate of inflation, especially if you measure inflation the way they did in 1970's. So if the rate of interest in a bank account (or anything else) is less than the rate of inflation, holding cash has a 100% chance of losing money (or purchasing power.) In other words, if the interest rate is lower than the inflation rate, real rates are negative.
Bottom line, I'd never suggest investing in something that has a 100% chance of losing money, and that's what you get right now with cash.
So what am I doing? How do I structure my portfolio using my framework, which is quite obviously, vastly different than most on BP. ;)
First, I look at what's cheap. The only thing that's cheap right now in the US is 30 year fixed rate debt. To my surprise most investors on BP don't realize a 30 year fixed rate mortgage would never occur in a free market. It can only exist if it's subsidized by the taxpayer. This is why the US is the only major market I know of that has 30 year fixed rate debt.
No bank would keep that loan on their books because it's almost certain to lose money. If it's almost certain to lose money for the lender, it's almost certain to make money for the borrower.
So I want to buy US assets with 30 year fixed rate debt.
Which assets? I like SFH's in linear markets, like KC, where I can buy a starter home in an A neighborhood for under the cost of construction. Example: 1200 sq ft, 3 bed 2 bath, for 150k, rent's for 1400 a month.
What I really want to stress is my frame work, because that's what so different from most, even though many times I come to the same conclusion. In the example above, my starting point is asking myself "what's cheap?" Once I determine something is underpriced historically, so there's a good chance it mean reverts, I get interested.
Then I'll try to figure out the best way to express that bet. i.e. 30 year fixed rate debt is cheap, what's the best way to express the bet? Use 30 year fixed rate debt to buy something that has the least downside.
But before I pull the trigger I stress test investment thesis as rigorously as possible and then assign probabilities to specific outcomes. I want to not only understand my upside, but more importantly, understand my downside. This is another area in which my framework is vastly different than most on BP, and this thread.
As an example, in 2012 I retired as a long time entrepreneur and went all in on real estate. Before I did, I studied as many real estate crashes as I could. I got hyper focused on Japan (because there were so many similarities), and saw their prices came down about 60%. See chart below. At the time US prices had come down roughly 50% (see chart below) so I figured the probability was high (85%) my max downside was another 10%. I was ok with the risk because I had a 25% equity buffer as a result of buy/remodel/rent instead of buying turnkey.
My favorite chart in 2012.
Please don't be confused!! I'm NOT saying the US real estate in 2012 was "cheap."
THE CASH FLOW I WAS BUYING WAS CHEAP relative to other asset classes, remember interest rates were 0%, the SFH's in the midwest bought at foreclosure was a way to express the bet with limited downside. The SFH's themselves where NOT cheap, but fairly priced if you go back to the year 1900.
Literally everyone I knew thought I was crazy but I put over 75% of my net worth into SFH's in 2012. I still own many of the rental props I bought in 2012, they've doubled in value since (based on my cost basis) but the 100% capital gain is the very last thing one should focus on, and usually it's the first thing people focus on.
A savvy investor will first focus on the cash flow (or whatever the rationale for the investment was), then they'll analyze capital gain IN RELATION TO THE DOWNSIDE RISK taken initially. In other words, a 100% gain was made by taking a 10% risk to principle. Yes, the probability of taking a 10% haircut was very low, especially considering the buy low rehab model, BUT the probability of the 100% appreciation was even lower!! Look at the charts above again.
The 100% appreciation was pure luck. If I would've made the bet based on the hope of appreciation only, it would've been a dumb bet, regardless of outcome.
THIS IS WHAT EVERYONE MISSES.
The common line of "thinking" is "ok this bet can go up by 2x, but is kinda risky, hmmmmmm well I'll just invest a portion of my portfolio, or money I can afford to lose." THEY COMPLETELY IGNORE PROBABILITIES AND ONLY SEE POSSIBILITIES. That's not investing, that's pure 100% unadulterated gambling. Go to any gamblers anonymous meeting, or simply ask someone playing a slot machine, "why do yo do it?" They only see the possibility of winning and not the probability of winning/losing.
And to my point in above posts, if your odds are nearly identical, why not just play roulette? At least you'll get a free room and buffet.
If someone is truly investing, they should be talking about the potential upside, downside, specific probabilities of each and the historical data backing up how they're coming to those conclusions. FYI, going back only to the GFC is NOT historical data. How foolish is it to think the only event that can possibly occur is one that just happened 10 years ago? By definition a crisis or bubble can only happen if the majority don't see it coming. How many on BP talk about the GFC? 100%
Why I get so worked up about it is real estate investors try to pass this off as "investing" just because it involves real estate and not a casino. They make the all to common mistake of looking at a large return, making the bet, then rationalizing the decision. In fact, I think most would be well served by putting this quote next to their computer as the browse BP... ;)
Let's get back to your original question, what to do or what am I doing?
Other than buying midwest starter homes under the cost of construction with 30 year fixed rate debt, (not because they're cheap but it's a way to acquire something cheap, the debt, with the least downside.) I'm buying in South America, specifically Colombia. Why?
Exact same reason I bought SFH's in the US in 2012, or suggest buying starter homes with 30 year fixed rate debt now, to own something cheap with the least downside possible.
Without getting into great detail, which I'm happy to do if someone would like the info, the Colombian peso became historically very cheap vs. the USD in 2015. So step 1: I found an asset thats cheap. The next step was to find a low risk way to place the bet (please note: my framework is identical).
SFR's in Medellin, had some of the lowest prices, cost per sq ft, anywhere in the world, especially when compared to the rest of SA. Additionally, a whopping 3% of Colombians have mortgages. In other words everyone owns their residence out right. Think of going to a state in the US where everyone had 100% equity...what would your downside be? There several other reasons RE in Medellin was low risk. Again, if anyone would like me to expand with more data, charts and probabilities I'm happy to do so.
But remember buying rental properties in Medellin is just a way to express the long peso investment thesis. The peso is what's historically cheap, the RE is just the lowest risk way to play the peso.
So what were the results? Of course, like in the US, I bought distressed older properties that needed to be remodeled, I always prefer to put in a little work to have an added equity buffer. Cash flows have been about 8%-10%, the pesos gone no where, and the apartments have appreciated by roughly 30% in real terms.
A perfect example of getting it wrong, but still making money because the framework was correct. And that's the whole point of every one of my posts on this thread.
Real estate investors don't necessarily need to change their portfolio but they need to change their framework for analyzing investments. If they don't, the more times they invest the greater their chance of going bust, just like the guy at the slot machine.
Hope that helps,
George
@Michael Ealy Hope the flight wasn’t too bad. It sure is a plus being close to O’Hare so you can catch a non-stop to PEK or PVG.
For the sake of argument lets table the “millennials are broke” debate (which is a dubious claim, Zillow found that homeownership increased for each successive level of education, even as student debt went up. Pair this with the fact 47% of millennials have a post secondary degree, compared to 30% in 1990 kinda throws a wrench in the idea that student debt is part of the problem)
This means that at best millennials will be delaying home ownership, not forgoing it. So the investment edge to take advantage of the increased demand is constrained by the duration of the time millennials delay home formation. After that time they will start to leave apartments for homes, which has a negative impact on apartment’s terminal value unless an equal number of renters enter the market.
The value drivers of this investment thesis then hinge on a two part question; how long will this generation delay household formation and will the rate of formation experience an uptick to account for any biological constraints once the millenials reach their mid 30's? I don't have an answer to either question, but taking the idea to its logical conclusion means that apartment users will either have to buy with such a massive margin of safety that they can absorb the inevitable decrease in NOI or sell before that decrease happens. The former is a tall order, but can be done; the latter is nothing more than the greater fool theory of investing. Either way this fact that millennials are renting at higher rates is not all sunshine and roses for investors.
As for the big vs small money debate. To your first point: my money is on neither, I bet on incentives. If big money is incentivized to buy a bad deal, then they will. If they are rewarded for continuing myths that the markets only go up and punished for writing about the truth, they will continue to ignore that the emperor has no clothes. History is replete with examples of poorly aligned incentives over-riding morals/values/reputation/logic/common sense/data: Portfolio insurance, LTCM, Allied Capital…
On your final point, how does one tell who is the smart money and the dumb money without the benefit of hindsight? The idea of Batesian Mimicry suggests that only those who are the smart money can tell the other "smart money". That doesn't bode well for everyone else... That was the point of my original point; each investors needs to take stock of their own knowledge, skills, abilities, and goals to find the investing style and methods that suits them. That holds true if you own 1 unit, 1000 units, or are a REIT. This concept of making investment decisions based on who is most successful, however you define it, number of units, $ per door, driving a lambo,at the moment is absurd. To start with, it is rife with psychological misjudgments, not to mention that it absolves the investor of doing any real thinking about the nature of their thesis. After taking stock of themselves, a lot of people may find that REI or investing in general simply isn't for them.
Congrats on the 42 unit, seems like a great opportunity. $500k profit could be stupid or it could be a tremendous investment, I don’t have enough info to make a judgment call. I do know that there is a difference between profit and free cashflow so until you refi or sell, 93% of that profit exits only on paper.
I notice that you mention the number of apartments you have in the majority of your posts. Why is that?
@Michael Ealy
Why are all millenials so sensitive.
@Michael Ealy
Market I purchase in was 55-65 a door needing 5k in repairs. Same properties are going for 85-90k a door and now some 120k a door. There is just no inventory. It is a little frustrating. From buying at 8-9% stabilizing to 10-11 and now its just brokers calling offering these ridiculously priced buildings with their 6% bs pro formas. Its a little scary. Historical since recession shows appreciation justifying the price increases but lets be real... In 5 years when those refis come calling where
Are these values going to be? Im not familiar with Cinci but here in Miami the swings are hard. Not being pessimistic and value add cushions risk but its getting very hard to find good deals.
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@George Gammon perfect thanks. I have a similar mindset with a different asset class due to scale, job, and kids.
@George Gammon Do you have that 2012 chart in 2019 form? I was wondering where it looked today. I've been looking at a lot of the same information you and Mike have, but finding more up to date charts has been challenging. Basically, I'm trying to determine what real estate asset classes are overvalued compared to their historic norm and by how much. My general 'gut' feeling from tons of reading and podcasts is that:
multifamily is overvalued compared to historic norm
entry level housing is red hot but upper level housing is turning very cold
retail doesn't seem as hot as the other sectors, or at least it's not being talked about nearly as much
But I haven't seen many charts that would articulate this data.
Originally posted by @Ben Leybovich:
@Michael Ealy What you said above:
What I do is:
1) Buy at cap rates based on the market (if the market is at 6%, I don't look for a 10% cap like what some gurus teach, I buy at 7%...even at 6%, specially if I can reposition the asset to produce more income)
2) Add value to the building (improved interior finishes, better management) OR find the building's highest and best use
You didn't say - I go into a market trading at 6 cap and try to steal at 10 cap. You said - I go into a 6 cap market and buy at 6 cap. And then value add.
The profit is in the Delta of your value-added cap rate to the market.
Great, this makes sense. Now, let's add another dimension to this.
In a 5 cap market, creating an additional $50,000 of NOI capitalizes to $1M of value. But, in an 8 cap market, creating the same $50,000 of NOI capitalizes to $625,000.
If it takes the same effort and money, which makes more sense? Naturally, the lever is much more powerful in a lower cap rate environment. Agreed?
Agree but as always, there's a BUT. With that argument, everyone should be flipping million dollar homes because the work is the same but the profit is way higher. In low cap apartments and million dollar homes, the profit potential for both is high but so is the risk.
Investing has to factor in not just the potential return but also the risk. The lower the cap rate when you're buying, the higher the risk you're in negative cashflow territory when interest rates rise (assuming of course you use leverage) or you're in negative cashflow territory when you get higher than expected operating expenses (which almost always happens even with the best operator).
Even experienced operators get into trouble when they run out of money - and that happens when they bite off more than they can chew, specially when the market changes. Brian Burke is fond of saying you have to "stress-test" your investment. What if the rent drops 10%? What if caps increase 1%? What if interest rates rise 1%? If the investment is still profitable even after stress-testing it, then sure, buy at 4.8% cap.
BOTTOMLINE, there's a lower limit to how much one is willing to pay based on one's experience, skills, financing, operating team, etc. It also depends on the property or building itself (older properties as you know will cost more to operate over the long run due to deferred maintenance and continual cap ex). Lastly, it depends on the area as to whether it has potential to grow/increase in terms of its economy, how dependent is the location to one or a few industries/major employers, etc.
Originally posted by @George Gammon:
Originally posted by @Mike Dymski:
@George Gammon great feedback. We have been aware of the risks for five or so years now. I am more interested in what people are doing about the risks. Moving six, seven, or eight figures of net worth into cash is not an option for most people. I am interested in how you and others are investing to mitigate the risks. I have been excruciatingly selective, re-allocating from value plays into cash flow plays, using prudent debt, and always adding value.
Mike, let me be very clear, I'm by no means suggesting a move into cash. If you believe there's a reasonable probability of 1970's style inflation in the next decade, the last place you'd want to be is cash.
And let's not forget, interest rates in the US ARE NEGATIVE. I don't think real estate investors realize interest rates are under the rate of inflation, especially if you measure inflation the way they did in 1970's. So if the rate of interest in a bank account (or anything else) is less than the rate of inflation, holding cash has a 100% chance of losing money (or purchasing power.) In other words, if the interest rate is lower than the inflation rate, real rates are negative.
Bottom line, I'd never suggest investing in something that has a 100% chance of losing money, and that's what you get right now with cash.
So what am I doing? How do I structure my portfolio using my framework, which is quite obviously, vastly different than most on BP. ;)
First, I look at what's cheap. The only thing that's cheap right now in the US is 30 year fixed rate debt. To my surprise most investors on BP don't realize a 30 year fixed rate mortgage would never occur in a free market. It can only exist if it's subsidized by the taxpayer. This is why the US is the only major market I know of that has 30 year fixed rate debt.
No bank would keep that loan on their books because it's almost certain to lose money. If it's almost certain to lose money for the lender, it's almost certain to make money for the borrower.
So I want to buy US assets with 30 year fixed rate debt.
Which assets? I like SFH's in linear markets, like KC, where I can buy a starter home in an A neighborhood for under the cost of construction. Example: 1200 sq ft, 3 bed 2 bath, for 150k, rent's for 1400 a month.
What I really want to stress is my frame work, because that's what so different from most, even though many times I come to the same conclusion. In the example above, my starting point is asking myself "what's cheap?" Once I determine something is underpriced historically, so there's a good chance it mean reverts, I get interested.
Then I'll try to figure out the best way to express that bet. i.e. 30 year fixed rate debt is cheap, what's the best way to express the bet? Use 30 year fixed rate debt to buy something that has the least downside.
But before I pull the trigger I stress test investment thesis as rigorously as possible and then assign probabilities to specific outcomes. I want to not only understand my upside, but more importantly, understand my downside. This is another area in which my framework is vastly different than most on BP, and this thread.
As an example, in 2012 I retired as a long time entrepreneur and went all in on real estate. Before I did, I studied as many real estate crashes as I could. I got hyper focused on Japan (because there were so many similarities), and saw their prices came down about 60%. See chart below. At the time US prices had come down roughly 50% (see chart below) so I figured the probability was high (85%) my max downside was another 10%. I was ok with the risk because I had a 25% equity buffer as a result of buy/remodel/rent instead of buying turnkey.
My favorite chart in 2012.
Please don't be confused!! I'm NOT saying the US real estate in 2012 was "cheap."
THE CASH FLOW I WAS BUYING WAS CHEAP relative to other asset classes, remember interest rates were 0%, the SFH's in the midwest bought at foreclosure was a way to express the bet with limited downside. The SFH's themselves where NOT cheap, but fairly priced if you go back to the year 1900.
Literally everyone I knew thought I was crazy but I put over 75% of my net worth into SFH's in 2012. I still own many of the rental props I bought in 2012, they've doubled in value since (based on my cost basis) but the 100% capital gain is the very last thing one should focus on, and usually it's the first thing people focus on.
A savvy investor will first focus on the cash flow (or whatever the rationale for the investment was), then they'll analyze capital gain IN RELATION TO THE DOWNSIDE RISK taken initially. In other words, a 100% gain was made by taking a 10% risk to principle. Yes, the probability of taking a 10% haircut was very low, especially considering the buy low rehab model, BUT the probability of the 100% appreciation was even lower!! Look at the charts above again.
The 100% appreciation was pure luck. If I would've made the bet based on the hope of appreciation only, it would've been a dumb bet, regardless of outcome.
THIS IS WHAT EVERYONE MISSES.
The common line of "thinking" is "ok this bet can go up by 2x, but is kinda risky, hmmmmmm well I'll just invest a portion of my portfolio, or money I can afford to lose." THEY COMPLETELY IGNORE PROBABILITIES AND ONLY SEE POSSIBILITIES. That's not investing, that's pure 100% unadulterated gambling. Go to any gamblers anonymous meeting, or simply ask someone playing a slot machine, "why do yo do it?" They only see the possibility of winning and not the probability of winning/losing.
And to my point in above posts, if your odds are nearly identical, why not just play roulette? At least you'll get a free room and buffet.
If someone is truly investing, they should be talking about the potential upside, downside, specific probabilities of each and the historical data backing up how they're coming to those conclusions. FYI, going back only to the GFC is NOT historical data. How foolish is it to think the only event that can possibly occur is one that just happened 10 years ago? By definition a crisis or bubble can only happen if the majority don't see it coming. How many on BP talk about the GFC? 100%
Why I get so worked up about it is real estate investors try to pass this off as "investing" just because it involves real estate and not a casino. They make the all to common mistake of looking at a large return, making the bet, then rationalizing the decision. In fact, I think most would be well served by putting this quote next to their computer as the browse BP... ;)
Let's get back to your original question, what to do or what am I doing?
Other than buying midwest starter homes under the cost of construction with 30 year fixed rate debt, (not because they're cheap but it's a way to acquire something cheap, the debt, with the least downside.) I'm buying in South America, specifically Colombia. Why?
Exact same reason I bought SFH's in the US in 2012, or suggest buying starter homes with 30 year fixed rate debt now, to own something cheap with the least downside possible.
Without getting into great detail, which I'm happy to do if someone would like the info, the Colombian peso became historically very cheap vs. the USD in 2015. So step 1: I found an asset thats cheap. The next step was to find a low risk way to place the bet (please note: my framework is identical).
SFR's in Medellin, had some of the lowest prices, cost per sq ft, anywhere in the world, especially when compared to the rest of SA. Additionally, a whopping 3% of Colombians have mortgages. In other words everyone owns their residence out right. Think of going to a state in the US where everyone had 100% equity...what would your downside be? There several other reasons RE in Medellin was low risk. Again, if anyone would like me to expand with more data, charts and probabilities I'm happy to do so.
But remember buying rental properties in Medellin is just a way to express the long peso investment thesis. The peso is what's historically cheap, the RE is just the lowest risk way to play the peso.
So what were the results? Of course, like in the US, I bought distressed older properties that needed to be remodeled, I always prefer to put in a little work to have an added equity buffer. Cash flows have been about 8%-10%, the pesos gone no where, and the apartments have appreciated by roughly 30% in real terms.
A perfect example of getting it wrong, but still making money because the framework was correct. And that's the whole point of every one of my posts on this thread.
Real estate investors don't necessarily need to change their portfolio but they need to change their framework for analyzing investments. If they don't, the more times they invest the greater their chance of going bust, just like the guy at the slot machine.
Hope that helps,
George
Excellent reply George. I love the data-based approach of finding what's cheap and then determining the least-risky way of buying what's cheap.
For me, apartment buildings is less risky. Here are just the reasons why:
1. Economies of scale and the resulting lower impact of vacancies on cashflow
2. The interest rate I get for apartment building (because of my experience, net worth and credit) is actually lower than if I buy single family homes. So if 30-yr debt is cheap for houses, it's actually cheaper for me (may not be true for others) for apartment buildings. The origination fee I pay is also cheaper for apartments because of their amounts vs. houses.
3. The more units I get, I can spread around my cost of property management, specially the more units I have in one building or one complex. A 100-unit complex for example - I can pay a salary equal to 3% of rent (and have quotas for the PM to meet otherwise, he/she is fired). You can't do that with 100 houses spread out across the city.
Now, should everyone on BP buy apartment buildings? NO. Again it depends on many factors - skills/experience being one, the local market being another and availability of supply/ new builds as another factor, etc.
Originally posted by @Alan Grobmeier:
@George Gammon, great info & great post.
However, with 21T in debt, state & local pensions defaulting, can our government afford anything other than ZIRP without causing another Great Recession?
I see low interest rates ‘forever’ on the horizon. How can they do anything else without causing chaos?
Alan, great question.
Can our government afford anything other than ZIRP? Short answer: No, they can't even afford ZIRP. In fact they can't afford the debt with NIRP.
The US government has to default on it's debt. Let me say that again, the US GOVERNMENT HAS TO DEFAULT ON IT'S DEBT.
Question is will they default the old fashioned way by renegotiating the debt or not paying, or will they default by paying the creditors back with dollars worth less than the dollars the government borrowed?
My guess is they'll pay with cheaper dollars. In other words, they'll have to create inflation.
This gets at the heart of your point about interest rates being low forever. Sure the short end of the curve can be low forever but the Fed doesn't have total control of the long end (10 year, 30 year.) Central banks have suppressed the long end of the curve by buying those bonds but they have to "print money" in order to buy the bonds.
This is highly inflationary because you're dramatically increasing the money supply. See chart of US
So why hasn't the world (US) seen more inflation? It has. It just hasn't shown up in the CPI but it's shown up in asset prices.
The point is, inflation is the only thing that can save the US from its fiscal issues, while at the same time, it's the catalyst that will most likely crush the US economy.
If/when inflation, the Fed's doing everything in its power to create, gets out of control, the US economy will be in serious trouble. Let's think it through. Artificially low interest rates create mal investment (investments that wouldn't have been financially viable under normal market conditions/rates. Remember fed funds rate average about 5%+. See chart)
If fed funds rate is 5% and we have a steepening of the yield curve, where does that put the 10 year, or mortgage rates? Maybe 7.5%? How about commercial loans on all these multifamily complexes being built? Maybe 8.5%? Think about how many investments have been made since the GFC and ZIRP...how many would be able to service their debt if they had to roll it over at 8.5%?
If that were to happen the Fed would most likely do more QE to bail out the economy but that creates more money, which adds fuel to the inflationary fire. The only solution then is Volcker style crushing inflation with 20% interest rates. Unfortunately, this time around that won't be possible because of the US couldn't afford the interest payments on the 23 trillion in on balance sheet debt. Compare our current debt to gdp ratio to 1980. See chart
The US currently pays about 500 billion a year in interest, and at a 2% interest rate. At a 10% it would be 2.3 trillion, and let's not think about 20%. ;)
How would the gov pay for the massive deficits? By issuing more bonds, but more bonds increase the money supply putting more upward pressure on rates. You can see the vicious cycle.
So the short answer to your question is the Fed doesn't have total control of the long end of the curve. The long answer in the next decade, the Fed might not have control of the any part of the curve.
Most peoples rebuttal is the US will be Japan, interest rates will be low forever.
What I preach till I'm blue in the face on BP is you have to look at probabilities NOT possibilities. Is it possible the US turns into Japan? Sure, but is it probable? And let's not forget, US becoming Japan is our BEST CASE SCENARIO. In other words, the most optimistic outcome is a 30 year depression.
Those who make the Japan rationalization, are usually people who'd be crushed by higher rates, and rarely have studied the similarities (other than they had a big crash too) or the differences. I could go on and on about the differences, but lets look at one major metric.
Japan has been the largest creditor nation in the world 28 years running. The US is the largest debtor nation in the history of the world. Let that sink in...
How can Japan have a 230% debt to gdp and be the largest creditor nation? Their public debt is owned by the central bank and other various institutions. So they own a lot of other countries assets and owe very little to other countries (even though they owe a staggering amount to themselves.)
The US is the opposite, it owns almost no foreign assets and owes foreign countries more than any nation in the history of the world.
This means all those dollar assets held be foreigners can be sold fast if the conditions are right, creating the velocity needed to create inflation when combined with the massive expansion in our money supply. Foreigners don't own any Japanese assets to it would be much harder to create a rush of selling needed to increase velocity and/or inflation.
And this is just one difference between Japan and the US.
Please don't get me wrong. Japan has got problems, HUGE problems, but problems are significantly different than the US.
Which takes us back to probabilities. There's a 100% chance of 1 of 3 outcomes over the next decade.
1. Inflation (1970's)
2. Deflation (Japan)
3. Nothing (US stays locked in this moment in time forever)
Let's just assume there's a 33.3% chance of each outcome. That means there's a 33.3% chance many on this thread go bust. And a 66.6% chance things get really bad, BTW what happens to pension funds if the US turns into Japan for the next 10 years? Answer...they go bust.
Bottom line is investing in the US right now is extremely dangerous, especially for those whistling past the grave yard needing ZIRP forever to stay in business. If your business model requires ZIRP, you are part of the mal investment. Don't build your investment framework around ZIRP. ;)
George
@George Gammon, another great post/response!
But I don’t think it's going to quite work in the way you have described.
I think you have a GREAT chance of seeing 2 of the 3 'choices' happen during the next recession. Some recessions are deflationary followed by inflation (Great Depression for example). Some recessions are inflationary in nature, and then the fed puts the brakes on everything by increasing interest rates (70s-80's Jimmy Carter comes to mind).
My point is that most of the time the average person is 'shook' out of their stocks by a massive drop. THEN they are shook out of their commodities (precious metals for example) by selling them into a deflationary economy to cover their interest payments or margin calls on other assets. It quickly becomes a losing proposition.
The average person, under these circumstances, is basically screwed. They lose everything. As a result, going to ca$h looks like a good option.
But nowadays that is not a good option either. The US banking system is just waiting to go 'Cyprus' on us. They've told us that our money in the banking system is nothing more than an IOU. We don't even 'own' our money. The govt has said they aren't going to do another GFC bailout of the banks. So, that leaves you and I as the only option for the next 'bailout'.
In addition, the second that the Feds start raising interest rates (if they do so), the RE market will catch a cold. And probably a full blown flu if we get anywhere close historic interest rate norms. Values of properties will plummet. That makes just about anyone with a LTV over 50% today will in an 'extreme leveraged' position in the years ahead.
That, obviously, makes United States RE not a 'safe haven'.
Gold/Silver will get blown up by a 'whiplash', going down during deflationary times. And then going into a 'runaway' situation as everyone piles in while looking for a LAST safe haven. It will keep your buying power. But can you afford (or buy it) to hold it thru a deflationary cycle prior to the hyperinflation?
As a result, it would seem to me that the ONLY safe place to keep your wealth would be under your mattress (again).
As the song by Bon Jovi: The more things change, the more they stay the same. ;-)
Thanks for all the work you put into your responses; it is refreshing to read about something else besides an endless debates about syndication, wholesaling, or turnkey.
I enjoy looking at your thought process and research, I am especially fond of your focus on upside to downside risk, the hallmark of a true investor.
I will push back on one idea of yours though, that the US must default on its debt. What about long term growth as an option?
Tyler Cowen has a good summary in on of his recent Bloomberg articles (once you ignore the political focus) Germane section:
as they often assume, the economy is going to keep growing strongly, a
been low, and even falling over the past year, while economic growth has been
running over 2%. If it continues to exceed the government’s
inflation-adjusted borrowing rate (currently negative for T-Bills and
close to zero for longer maturities), the U.S. will be able to grow out
of its debt...
Now what are the probability of that happening? I could not even begin to take a stab at the base rate, never mind an updated prior rate; however, it is an option.
What are some things that get in its way? Obviously a protracted recession, the rise of another reserve currency, our aging population doesn't help things at all, the Fed stopping its balance sheet reduction.
Also, given you love of data, you may wan to check out this NBER working paper. It has some interesting long term investment data.
Late to the thread and not sure if this was covered.
CAP rates are tied to the alternatives. The bond rate is the base asset. If bonds go up by 1%, the CAP rate and everything else that performs like a bond will shift. How much of a shift depends on a number of factors.
The key is people with cash who want security and an income will look across a number fo asset classes. It is a relative decision.
