.png)
We've all seen the headlines about failing banks, mass layoffs, rising interest rates, and persevering inflation. Investors have genuine concerns about today's macroeconomic conditions and for us, multifamily investors, the new supply of apartment units is putting pressure on rents.
Some investors are panicking and pulling their money out of the market while others continue to grow their money and build their wealth despite the doom and gloom they see on the news. At One-9 Holdings, we fall under the belief system that "time in the market beats timing the market" and we believe multifamily is a great long-term investment even in today's economy. However, this doesn't mean that we are aggressively submitting offers on any deal that crosses our desk. There are vital elements to consider before investing in today's economic environment. Here are a few factors we recommend investors consider before investing in 2023:
CONSIDERATIONS BEFORE INVESTING IN REAL ESTATE IN 2023
Supply & Demand
Supply and demand dynamics impact multifamily just like any other industry. It's important to remember that investing in multifamily real estate is investing in one of our basic human needs, the need for shelter, which makes this asset class recession-resistant. What's more, we are millions of units short of the need for housing in our country which contributes to the continued strong demand for apartments today. People will always need a place to live despite challenging economic circumstances. Historically, housing and food stamps are the last two expenses people forgo during periods of financial stress.
In Berkadia's 2023 National Apartment Forecast, they predict over half a million apartments will come online this year, and new supply will impact rents and occupancy across the board. We believe that the value-add strategy coupled with hyper-focusing on a market with strong job growth, population growth, lower than the national average unemployment rate, and positioned in a market with multiple large employers like San Antonio, TX, will help owners find continued success despite the new supply of apartment units. Forcing appreciation through the value-add strategy will allow multifamily owners to raise rents and drive value while staying under market rents.
In addition, factors such as expensive debt, lack of supply, and high prices of single-family homes prevent potential homebuyers from purchasing houses which contribute to the high demand for rentals today. The chart below provides a visual of the difference between the cost of owning a home and renting. Despite all of the headlines about rising rents, it is still favorable for folks to rent as the gap between owning a home and renting is at its highest point since 2008.
Source: (Roche, 2023)
The takeaway is that the demand for rentals is strong and will remain high for the foreseeable future. To help mitigate risk, it's important to implement a proven and effective business plan in a market with strong job growth, population growth, lower than the national average unemployment, and multiple large employers like San Antonio, Texas. Serving the target demographic by delivering a variety of housing opportunities will be beneficial for multifamily operators in the long term.
Time in the Market Beats Timing the Market
Much of the hesitation in today's buying environment is driven by fear of interest rates. Understandably, investors don't prefer to buy at potential peak interest rates especially after stepping out of 2020 when borrowing was cheap, and it seemed that no one could "lose" in the multifamily space. That being said, the chart below will show us that the last time the Federal Funds Rate approached 4% was in 2007 which is where it stands as of the time of this writing. It's important to note that the Federal Funds Rate was previously higher than 4% before 2007, and the Fed actually lowered the rate to 4% and then continued to lower the rate due to the Great Recession. Check out the interactive chart below.
If we take a peek at the '90s, the Federal Funds Rate exceeded 5%, and guess what? Deals still happened. Investors still made money. We agree with Forbes Council Member, Feras Moussa, that much of the fear today has to do with recency bias as we step out of a favorable lending environment.
So how do we move forward and buy profitable deals in today's environment?
Keep the long-term vision in mind, and remain committed to purchasing properties that fit your acquisition criteria.
Conduct thorough due diligence and if the numbers work with conservative underwriting, don't be afraid to submit an LOI to buy the property.
Abide by the Three Immutable Laws of Real Estate Investing as developed by Joe Fairless, which are:
Buy for cash flow.
Secure long-term, low-leveraged debt.
Have adequate cash reserves
It's more important to be active in the market than to wait on the sidelines for the perfect opportunity to arise. Stick to your proven business plan. Buy with the three immutable laws of real estate investing in mind, and underwrite conservatively to ensure success. You'll beat other investors who are waiting for the perfect time to invest by taking action now.
RISKS OF INVESTING IN REAL ESTATE IN 2023
There are always risks involved with investing, and before investing in real estate this year, it's important to note what some of these risks are. In today's economy, two of the primary risks include:
Interest Rate Risk
High interest rates mean that it's more expensive to borrow money. When it's more expensive to borrow money, it's more challenging for real estate investors to achieve positive returns. We'd typically expect to see seller's prices come down as a result of rising interest rates, but we're still observing a relatively low inventory and prices have remained high, resulting in a disparity between buyers and sellers.
Looking forward, we'll start to see more inventory come online and sellers will have no choice but to adjust their expectations. The impact for multifamily operators and investors is that we will have more opportunities to buy profitable investments.
Economic Instability
In periods of economic stress, apartment owners may experience increased vacancies and decreased profits from rental revenue. This risk highlights the importance of operational efficiency, attracting and retaining quality tenants, and setting aside adequate cash reserves to endure any market fluctuations.
HOW TO CHOOSE VIABLE INVESTMENT OPPORTUNITIES THIS YEAR
President Theodore Roosevelt once said, "Every person who invests in well-selected real estate in a growing section of a prosperous community adopts the surest and safest method of becoming independent, for real estate is the basis of wealth." Real estate investors have bought and sold properties through all market cycles and today's market conditions do not prevent wise investors from building wealth and becoming financially free.
If you plan to invest in real estate in 2023, here are three precautions to take before investing:
Buy for Cash Flow & Underwrite Conservatively
In any market cycle, it's essential to take a conservative approach to your underwriting to stress-test your business plan. In today's market, operators cannot project the same rent growth as they did in 2020 and they cannot push rents as aggressively in 2023. The solution is to underwrite conservatively and to buy for cash flow rather than buy for natural appreciation. Natural appreciation is outside of one's control and is driven by factors such as the real estate market and the economy. Whereas, forced appreciation involves an operator creating value by bolstering the property's NOI through increasing revenue, decreasing expenses, or a mixture of both. This is the driving strategy behind a value-add investor's business model.
Buying for natural appreciation as many investors have and will continue to do is like, as Joe Fairless states, "thinking you'll get rich at the casino by playing roulette and only betting on black. Yeah, maybe you can double up a few times, but sooner or later the ball will land on red or - even worse - green, and you lose it all."
This is why it is vital that multifamily investors buy for cash flow and underwrite conservatively. When investors buy for cash flow in a market with a strong demand for rentals, they are less concerned about what the market does. In many cases, if the market takes a downward hit, it'll likely increase the demand for rentals!
Secure Long-Term, Low-Leveraged Debt
A few years back, the industry allowed for favorable terms with floating rate debt. Some multifamily operators would buy a rate cap to ensure their rate stayed below a certain threshold. In today's economy, the standard is to obtain fixed-rate, long-term debt.
The less equity investors put into a deal, the more leveraged they are. The more leverage an investor has, the more expensive their mortgage payment will be. In a booming economy, it can seem advantageous to over-leverage, but what happens if the market falls by 5%, 10%, or 15%? If an operator buys a property with less than 20% equity and the market drops significantly, as it has in the past, one may find themselves in a position where they are forced to sell their property at a loss or even surrender the property back to the bank. What's our recommendation?
Secure a loan term roughly twice as long as your intended business plan and put at least 20% equity into the deal at a minimum. Market conditions today will, in some cases, call for 30%-50% leverage for the deal to pencil out, but the bottom line is to stay conservative and be cautious to avoid negative equity in the event that the market continues to fall. Buying for cash flow with long-term, low-leveraged debt will help owners avoid selling at a loss or surrendering the property back to the bank.
Have Adequate Cash Reserves
Having sufficient cash reserves will ensure that apartment investors will be able to cover unexpected and unforeseeable expenses. Especially as the economic conditions put added pressure on renters, it is crucial to allocate adequate funds for cash reserves.
A common recommendation is to allocate at least $250/unit each year to the operating reserves, and to reserve between 1% - 5% of the purchase price to an operating account for the first year to account for unexpected expenses. Today, depending on the property, market, and the operator's business plan, it may be worthwhile to allocate additional funds per unit in order to have adequate funds to cover expenses and to avoid a capital call.
SUMMARY
Today's headlines may deter many investors from investing in real estate for the foreseeable future. However, for those investors who plan to invest in real estate in 2023, we advise them to focus on the three immutable laws of real estate investing, operational efficiency, and keeping the long-term vision in mind to avoid selling at a loss or surrendering the property back to the bank.
Especially in times of economic uncertainty, stay up-to-date with economic conditions, don't be afraid to ask questions, and don't be afraid to take action as others remain on the sidelines waiting for the market to recover.
We want to hear from you. What are your concerns in 2023? What market metrics are you evaluating to help inform your investment decisions this year? Are you planning to wait for a more "favorable" time to invest or do you plan to take action this year despite the doom and gloom you see on the news? Let us know!
SOURCES
Fairless, J. (2018, May 30). The three immutable laws of real estate investing. Passive Real Estate Investing. Retrieved March 12, 2023, from https://www.bestevercre.com/blog/three-immutable-laws-real-estate-investing#:~:text=These%20Three%20Immutable%20Laws%20of,3)%20have%20adequate%20cash%20reserves.
Federal funds rate - 62 year historical chart. MacroTrends. (n.d.). Retrieved March 12, 2023, from https://www.macrotrends.net/2015/fed-funds-rate-historical-chart
Foster, S. (n.d.). Fed's interest rate history: The Fed funds rate since 1981. Bankrate. Retrieved March 12, 2023, from https://www.bankrate.com/banking/federal-reserve/history-of-federal-funds-rate/
Moussa, F. (2023, February 15). Council post: What to consider before investing in real estate right now. Forbes. Retrieved March 12, 2023, from https://www.forbes.com/sites/forbesbusinesscouncil/2023/02/14/what-to-consider-before-investing-in-real-estate-right-now/?sh=6b2ae48752b5
Perlman, E. (2023, March 6). Is Now a Good Time to Invest in Real Estate? Retrieved March 12, 2023, from https://www.bluelake-capital.com/post/is-now-a-good-time-to-invest-in-real-estate.
Rafter, D. (2023, January 5). More than 560,000 new apartment units? that's what Berkadia is predicting this year for the U.S. multifamily market. REJournals. Retrieved March 12, 2023, from https://rejournals.com/more-than-560000-new-apartment-units-thats-what-berkadia-is-predicting-this-year-for-the-u-s-multifamily-market/#:~:text=According%20to%20Berkadia's%20forecast%2C%20the,in%20more%20than%2020%20years.
Roche, C. (2023, March 2). Chart of the week: House prices vs. rents. Seeking Alpha. Retrieved March 12, 2023, from https://seekingalpha.com/article/4583749-house-prices-vs-rents