Multi-Family Disaster
You know that trite saying about history rhyming? If it’s trite, it’s right. Here is a fun example for you.
I smell trouble in the Multi-Family space — specifically apartments. Apartments have been an incredible place to invest capital for several years. The idea is simple: there aren’t enough houses, many apartment complexes are older and need some updating, and apartments have pricing power. It turns out there is almost no limit to what you can charge someone for a 2 bedroom apartment (upwards of $2,000/mo. in many big cities). Banks refuse to give most renting individuals a mortgage — under the assumption that their income isn’t high enough to afford a $900/mo. mortgage payment — so they have no other options.
THE RULE: What the wise do in the beginning, fools will do in the end.
Go ahead and reach out to someone you know in the Multi-Family private equity space. Ask them 2 things 1.) What is your strategy? 2.) How do you pay for it?
I have these conversations all the time — the answers are always the same.
) What is the strategy?
“Our strategy is to buy older apartment complexes (1980’s-1990’s are most common) in cities with a high population. We renovate each unit as tenants move out, raise the rent, and then we sell at a higher price.” I’m not kidding you, EVERYONE says this. A 2–5 year investment horizon is the red herring. It is no surprise these types of investments occur under a private equity umbrella — just read my post on private investment problems here.
2.) How do you pay for it?
This one is the kicker… most will give a general answer; “we finance” or “debt and equity through syndication”. But if you dive a little deeper you will get to an answer that is truly disheartening — bridge loans. I heard anecdotally that +80% of Multi-Family transactions in the last 2 years were financed with bridge loans. What is a bridge loan? A bridge loan is a short term loan, usually 1–2 years, generally structured as ‘interest only’ with a balloon payment due at the end of the term. This type of loan is typically paid off by refinancing for a longer term loan. While bridge loans can serve a great purpose, investors are using them to buy time to make an overpriced property ‘financeable’ — they are gambling. The game has been so easy for so long that they forget they can lose.
The Disaster:
When the world is flush with money, it’s easy to make deals. When cash runs dry, it’s time to head for the exits.
For years Multi-Family investment companies have been able to purchase with bridge loans, renovate, increase rents or occupancy, and refinance or sell at the end of the bridge term. As time progressed, prices for these investments increased rapidly — with big returns comes increased competition. When an investment space gets overcrowded, in order to make deals happen, margins compress and ‘best case’ scenarios become ‘base case’ scenarios.
I fear that many of the Multi-Family transactions over the last two years are completely dependent on ‘best case’ scenarios, with the assumption that refinancing will be possible at the end of the loan term. Very smart people and driven deal makers are a deadly combination — spreadsheets get manipulated to allow for the highest possible purchase price, foregoing any margin for error. To justify paying astronomical prices, assumed interest rates upon refinancing must go down. It’s hard to think differently… the last few decades have made us all forget that interest rates can go up. What happens when interest rates increase? High flying money managers have to refinance at 5% rather than 3.5%. Pair the macro-economic reality of higher rates, with the probability that rents cannot be further increased without pricing out renters, and we get a recipe for disaster. Cash flows become negative and refinancing ceases to be an option. When the bridge loans become due, and refinancing isn’t possible, the only option left is to sell at any price.
This story mirrors the housing crisis of 08', although I doubt as many lives will be impacted. Red flags always go up when we see large loans outstanding, with a plan of refinancing or selling at a higher price in the near future. I find it highly probable that trouble awaits us. Most of you may never hear about it on the news… the chaos may even miss your twitter feed.
The story isn’t all bad! F or those of us involved in commercial real estate, it presents an amazing opportunity. If/when you see apartments going up for sale, be sure to contact me here. Sellers who need out are the best to work with. Our strategy is simple; buy low and HODL.
**All images produced by DALL-E (MINI)***