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Interest Rates are Going Up, So Cap Rates Are Too Right??

Interest Rates are Going Up, So Cap Rates Are Too Right??

Well as with most things in life, it’s not that easy of an answer. Interest rates are just one variable that effect multifamily valuations and the relationship is definitely not 1:1.

To begin with the historical rate spread between apartment cap rates and the 10 year treasury is approximately 2%, or 200 basis points (bps). However, the spread has fluctuated during different economic conditions, ranging from 0% during the financial crisis to over 3% as recently as 2020.

Figure 1 – Apartment Cap Rate Spread vs. 10Y UST Yield (Millionacres)

The rate spread should be thought of as the risk premium investors are demanding for real estate investments. Spreads themselves expand or shrink over time based on the different risk perceptions. If interest rates are rising this may not mean cap rates will also rise if the asset class remains in favor due to high growth expectations or a better relative risk profile. In fact, the Fed hiked 9 times between 2015-2019 and as the figure below shows, cap rates continued to decrease.

Figure 2 – Cap Rate Spread vs. Fed Funds Rate (Bawa)

Figure 3 demonstrates the various risk premiums demanded by debt and equity holders. The figure is for all commercial real estate, not just multifamily, but again demonstrates changing relationships over time.

Figure 3 – US Commercial Real Estate Rate Spread for Debt and Equity Holders

So although cap rates and interest rates generally follow a similar trend, the relationship is one of correlation, not causation. Think of the famous study showing a relationship between US ice cream sales and pool drownings. The two variables show a strong relationship but clearly hot summer temperatures is the driver, not bloated swimmers. In fact, Dr. Peter Linneman studied the rate spread relationship and statistically demonstrated that cap rates are not driven by either real or nominal interest rates. Instead, the driving factor is the flow of funds into commercial real estate which he expressed as increase in mortgage debt as a percent of GDP.

Figure 4 – US Cap Rates vs. 10 Year Treasuries (Linneman)

This is why savvy multifamily investors continue to be bullish in the near and medium term. We are experiencing record apartment absorption, inflation is pushing rent revenue, lenders have reloaded for 2022, and additional capital continues to enter the space. Although interest rates are likely to increase in 2022 and will pressure interest rate payments, numerous other factors continue to support multifamily pricing trends.

Shiny and New OR Bring a Community Back to Life?

Shiny and New OR Bring a Community Back to Life?

Where Do You Invest in the Real Estate Spectrum?

Shiny and New OR Bringing a Community Back to Life? Where Do You Invest in the Real Estate Spectrum?

Many of us are familiar with the one of the most basic rules of finance. The higher risk, the greater return an opportunity should command. This is called the “risk-return” profile consideration for investments and asset classes. Let’s explore some common profiles including Core, Value-Add, Opportunistic strategies.

 

Different industries categorize and indicate the risk-return profiles with their own nomenclatures. For example:

  • In the bond market you have the credit ratings (AAA vs junk bonds)
  • In stocks you have blue chippers (IBM) vs penny stocks (lesser known and not as stable)

 

In each of these, the names tell us that the more stable the asset, the less relative risk it has to its peers and therefore investors should also expect a lower relative return for its comparable safety to its peers.

In real estate we categorize investment opportunities into similar buckets which indicate to our community the risk return profile the asset holds for investors. Those buckets are:

· Core

· Core Plus

· Value Add

· Opportunistic

Risk Vs. Return profiles of each strategy illustrated

Let’s break these down a bit further:

CORE buildings will be at the top of the food chain. These assets will be in prime locations such as a downtown center in a major market city, they will be well maintained, highly desirable, have a strong tenant base, and will be strong cash flowing from Day 1. The relative risk is lowest.

Core Example – Picture of new luxury apartment building in desirable New York City central

location

VALUE ADD buildings often are already profitable but are under performing relative to its peers in the neighborhood. These buildings are typically a bit of an older product and are located in areas already experiencing growth, but not in the direct city center location. These assets often can realize an increase in value by improving the current condition, desirability, and/or tenant base.

Value Add Example – Picture of an older, less frills building in a growing area of South Carolina

While OPPORTUNISTIC or DISTRESSED buildings will be the riskiest type of buildings. These assets will often already have very high vacancy rates or be completely vacant. They could be in less desirable neighborhoods, in need of significant updates or repairs. Development and redevelopment projects fall into this category as well because they start with no cash flow (or in some cases negative cash flow) and bare the risk of execution to become profitable.

 

Opportunistic Example – High rise residential buildings under construction being developed

To determine which bucket an asset will fall into there are several considerations such as:

  • · Location

  • · Age

  • · Cash Flow

  • · Vacancy Rates

  • · Tenant Profiles

  • · Desirability

  • · Amenities

  • · Needs for updates, maintenance

 

Investors should always be aware of which bucket they are investing in and align their investment goals with the appropriate risk return profiles. The value add and opportunistic buckets allow for a higher potential velocity of money (i.e. how long it takes to multiple) due to the higher returns and shorter hold periods. Of course the trade-off is that you take on a higher risk of capital and a much more active management approach is required to execute a plan. Core and core plus assets allow for a longer term hold with steadier cash flows. Neither one is right or wrong, just depends on your goals and stage of your financial life.

To learn more about investing in Multifamily, please contact us anytime.

 

Part of the Multifamily Scrum Series – Written by Matt Aquino

How To Buy Real Estate with your Retirement Account

How To Buy Real Estate with your Retirement Account

Saving for retirement can seem like a daunting task. We know that keeping all your money in a savings account is limiting because of the low interest rates. In fact, interest rates in savings accounts are generally less than inflation rates, meaning your savings account is actually losing value every day. In this article, we will discuss a few options that can help accelerate the growth of your retirement funds and hopefully have you sitting on a beach without having to worry about covering your expenses.

To help outpace inflation, and better yet, grow your wealth, many Americans utilize retirement accounts such as Individual Retirement Accounts (IRA) and 401(k) plans. These accounts offer the ability to maximize your retirement dollars by allowing you to invest in assets that are expected to outpace inflation. In addition, the accounts provide significant tax benefits for investors through tax exemptions or tax deferrals. The downside of IRAs and 401k plans is that most traditional accounts only allow for certain types of investments, including stocks, bonds, mutual funds, ETFs and CDs. These options can be great inclusions in any investment portfolio, but what most people don’t know is that there are accounts that allow for many investment options above and beyond these traditional investments.

There are retirement accounts that allow you to use your tax leveraged funds to invest in these same traditional assets, but in addition, allow you to invest in alternative assets, including real estate. Other possible investments include precious metals, cryptocurrency, water rights, livestock, and almost anything other than collectibles. Most people are not aware of these opportunities because the people on Wall Street make a considerable amount of money by keeping these options from the public.

First, understand that these accounts may not be the right fit for everyone. They allow more control and greater diversification of your retirement portfolio, but as such, the performance is going to be largely dependent on the decisions you make. So, please consult a professional and do your research before rolling over your 401(k) into one of these accounts. So, what are these magical retirement accounts that allow you to invest in real estate?

The three most common types of accounts that will allow you to invest in real estate and other alternative assets are the 1) Self-Directed IRA, 2) Solo 401k, and 3) Qualified Retirement Plan (QRP). These accounts offer both pre-tax and after-tax (Roth) options, Below is a brief overview of what I have learned through researching my own retirement plan. Please consult a tax professional to help determine what type of account makes the most sense for you.

Self-Directed IRA (SDIRA)

As suggested by the name, the Self-directed IRA is a type of IRA and therefore has the same contribution limits as a traditional IRA. For 2021, the annual contribution limit is $6,000 ($7,000 if you are age 50 or older). This limit does not apply to Rollover contributions or Qualified reservist repayments. More information can be found at https://www.irs.gov/.

The SDIRA provides more control and diversification options than a traditional IRA, with all the tax-leverage benefits. To set up an account, you will need a reputable custodian. I recommend reaching out to a few different custodians to discuss their fee structures and hopefully find one that you feel comfortable working with.

Solo 401k

A Solo 401(k), aka One-participant 401(k) plans, provide another retirement account option for those looking to diversify their portfolio. However, these plans are limited to a business owner with no employees other than their spouse. Make sure to consult a tax professional to ensure that you qualify for this type of plan. If you do qualify, you can enjoy the 2021 annual contribution limit of $19,500, or $26,000 if you are age 50 or older, PLUS additional compensation based on your business structure. More information can be found at https://www.irs.gov/retirement-plans/one-participant-401k-plans. These plans can also provide additional benefit over a SDIRA if you plan to invest in real estate. With a SDIRA, if your account owns an asset that produces unrelated business taxable income (UBTI), you may be responsible for paying unrelated business income tax (UBIT). An investment that uses debt financing (i.e. real estate) will trigger the UBIT with your SDIRA. However, these same regulations are not required when holding an asset in a 401(k) plan, including a Solo 401(k). Much like a SDIRA, you will need a custodian to maintain your account, but luckily there are plenty of options out there.

Qualified Retirement Plan

In addition to the SDIRA and Solo 401(k), you can also invest in alternative assets using a Qualified Retirement Plan (QRP). The structure of these plans can vary widely, so you will have to do your own research if you find a QRP that meets your goals. I personally have a retirement plan that was set up by eQRP Co. I recommend reaching out to Damion and his team if you would like to learn more about their plans.

Any of these options will provide the opportunity to invest in a wide variety of assets, including real estate. Once you get the account set up, the real fun begins. Here is a step-by-step overview.

  • Identify the type of account that is right for you.
  • Set up the account through your preferred custodian.
  • Fund the account. You can rollover funds from an existing IRA or 401(k) or transfer after-tax savings.
  • Identify an investment. The options are almost limitless.
  • Work with your custodian to properly fund the investment opportunity.
  • Monitor your investments and reinvest your returns.
  • Work closely with your custodian and keep good records to ensure that everything is above board. You don’t want to go through the effort to set this up and then find out that you unintentionally triggered a tax event.

Thanks for reading! I hope you enjoyed learning about a few different retirement fund options that are not widely publicized. I provided a very brief overview of a somewhat complicated topic, so please reach out if you would like to discuss these different plans in more detail.

Part of the Multifamily Scrum Series| Written by Adam Lacey

Should I focus on multifamily or single family investing?

Should I focus on multifamily or single family investing?

The real estate market is hotter than ever (especially now during the summer season!), but how do you know where to focus your time, energy & money?  With a plethora of ways to get your money working in real estate, it’s easy to get overwhelmed when considering all your options.  A great place to start when building a strategy is to first determine a particular focus in Multifamily vs Single-Family assets. 

Before digging into the differences from an investment perspective, it’s important to understand why a property would be classified as Single-Family or Multifamily. 

  • Single Family Residence is defined as a structure maintained and used as a single dwelling unit. Even though a dwelling unit may share one or more walls with another, it is a single family residence if it has direct access to a street or thoroughfare and does not share heating facilities, hot water equipment, nor any other essential facility or service with any other dwelling unit1. 

  • Multifamily property is defined as any residential property that contains more than one housing unit


There are advantages/disadvantages of each, so it just depends on your short & long-term goals.  Do you want to take on an active investing role with more control?  Would you rather let your money work for you, while you enjoy the passive income? How quickly do you want to scale?  Here’s a simplified breakdown of the primary differences that can help determine where you should focus:

Multifamily Property – Pros

  • Higher Cashflow potential

  • Lower “hands on” property management time is typical with owners of larger properties

  • More units mean more rental income, it’s that simple!

  • Economies of Scale

  • Capital expenses are spread across more units, lowering per-unit costs. This also helps with reducing property management expenses

  • Forced Appreciation Multiplier

  • Multifamily properties are valued using a “Cap Rate”, which can exponentially increase the property value with a slight increase in income or decrease in expenses. (More on Cap Rates in another article)

  • Non-Recourse Debt Available

  • With agency lending (Fannie/Freddie), there are non-recourse options available to qualified borrowers.  This is because the lender views the property as an operational, profitable business and reduces their risk, therefore reducing the risk of the borrower. 

Multifamily Property – Cons

  • Higher Barrier to Entry

  • More capital is required for larger Multifamily deals.  This can be overcome through the syndication model, creating passive income for equity partners.

  • Difficult and can be time consuming for the General Partnership to Finance (lots of “hoops”!). 

  • Commercial loans require larger down-payments (lower LTV), more cash reserves, and more investor experience in many cases.  The lender underwriting process can further slowdown the transaction as well. 

Single-Family Property – Pros

  • Lower Barrier to Entry

  • Lower price-points and favorable lending terms make single-family homes easier to purchase without high capital requirements

  • Less Tenant Turnover

  • Tenants typically stay longer when renting a home vs an apartment. There is also less frequent unit turnover inherent with less units.

  • More Control Over Tenant Selection

  • If you choose to self-manage your Single-Family portfolio, you can select your tenants to ensure they are meeting your specific criteria (within your state’s non-discrimination guidelines, of course).

  • Quicker/Easier to Finance

Single-Family Property – Cons

  • Vacancy is Costlier (one home vacancy can eliminate ALL of your income!)

  • With a single-family home, vacancy is lost income with no ability to spread the costs over other tenants. Growing a larger portfolio can help to offset this risk, however.

  • Slower to Scale up – In order to scale up, investors need to be able to find, purchase & lease-up a home before it can generate income. This process can be difficult to execute quickly as an active investor or without first building a team.

So, in summary, selecting your investing strategy will depend on your risk tolerance, access to capital & personal wealth building goals. Regardless of your strategy, wealth building through real estate investing will take patience & effort but can be extremely rewarding.

Part of the Multifamily Scrum Series – Written by David Turner

Investing in Real Estate vs. the Stock Market

Investing in Real Estate vs. the Stock Market

Investing in Real Estate vs. the Stock Market

Of the two types of investing, investing in stocks and shares seems on the surface to be more accessible to many than the world of property investment.

So, why would you consider investing in real estate?

Both types of investment have their pros and cons but the beauty of investing in property lies in the low risk, stability, and predictability of the investment.

When you add incredible tax advantages, hedge against inflation and control of investment to the list of positives then choosing to invest in tangible bricks and mortar over stocks and shares makes much more sense.

Let’s take a brief look at some of the pros and cons.

Stocks and Shares – Positives and Negatives

Negatives

1. Volatility

During a dip in the economy, you may be subject to the disappointment of diminishing funds as the profitability of the company drops.

Stock prices experience extreme short-term volatility, depending on the day’s events. Most smart traders do not react to these volatile market cycles but take a long term approach; however, the unpredictability of stocks can take its toll emotionally.

2. Risk

Stocks are volatile by nature because they depend greatly not only on the economy but also on the performance of a company and more importantly on the performance of the flawed individuals that run those companies.

If a company goes bankrupt then the money that you have invested in those stocks is completely dissolved.

This is a bigger risk than many are willing to take; many investors prefer to have their capital tied up in an investment over which they have a greater degree of control.

Negative publicity can also affect stock prices unexpectedly and in this day and age of instant news and of fake news, the volatility goes through the roof.

For example, on January 29, 2013, Audience ($ADNC), a voice processing company, found itself in muddy waters, literally, after a Twitter account named @MuddyWaters published a tweet about a false report in which the company was being investigated by the Department of Justice. The tweet set the company’s stock into a 25% drop. Muddy Water’s published a tweet after, clarifying the hoax.

  1. Ambiguity

Accurate stock analysis calls for a great deal of study. Even many honest experts admit that they are barely scratching the surface when it comes to accurate in-depth analysis.

When you invest in stocks you effectively own a portion of the company that you are investing in. If that company manages to thrive then the value of your stock rises and you win. When the company struggles, you lose.

Positives

1. Passive Income

The entire process of investing in stocks can be automated.

Of course, when it comes to investing in property, you don’t have to be the one dealing with tenants’ problems. When you invest in a property deal that is syndicated by someone else then this means that your real estate investment income will effectively also be 100% passive. You are several steps removed from the day to day management of the property.

2. Liquidity

Buying and selling stock is a relatively straightforward and speedy process with low transaction costs. No tangible asset is being exchanged so the transaction is quick and inexpensive. The process of actually buying and selling stocks is obviously much more straightforward than buying and selling a property which often takes two or three months or more.

3. Diversification

Due to the relative ease of buying and selling stocks, it stands to reason that it would also be fairly simple to spread your capital across different stocks. This is a way to combat the volatility of the stock market where the prices of individual stocks fluctuate daily. Clearly, it would take a much greater investment of capital to diversify your real estate portfolio in the same way.

Real Estate – Positives and Negatives

Real estate is a tangible asset and as such for many investors, feels more real. A great appeal of this type of investment is its stability.

For many millions of people, this kind of investment has generated consistent wealth and long-term appreciation.

Real estate investment provides a very consistent and stable rental income. Having a home is a vital necessity for all people, and as a result, rental investors are relatively protected even during economic downturns.

Negatives

1. Lack of liquidity

With property, you can’t just sell it at the end of the trading day. You can’t go back on your decision to invest in a property at the click of a key on your keyboard.

It may be necessary to hold the property for several years to realize the anticipated big returns.

It’s interesting to note however, that most stocks dividend yields hover around 4% or less annually.  When you invest in a multifamily real estate deal, you start receiving income almost immediately. Investors are getting distribution checks every month from rental income and routinely the average annual returns even after fees, inflation and taxes, are above 10%.

2. Lack of diversification

If you’re putting all of your money into real estate you might be limiting your diversification.

In contrast, with stocks, by means of an index or mutual fund, you can have easy diversification.

However, diversification can be achieved in real estate investing; well-qualified advisors can help you to spread your investments across different communities and different types of property.

This is another advantage of syndication.

3. Transaction Costs

As we have seen, stock trading has much lower transaction costs than real estate.

Real estate is a longer-term investment and transferring property is expensive. There are title fees, attorney fees, agent commissions, transfer taxes, inspections, and appraisal costs.

Real estate is a tangible asset and as such for many investors, feels more real. A great appeal of this type of investment is its stability.

For many millions of people, this kind of investment has generated consistent wealth and long-term appreciation.

Real estate investment provides a very consistent and stable rental income. Having a home is a vital necessity for all people, and as a result, rental investors are relatively protected even during economic downturns.

Positives

1. Cash Flow

Property investment provides an opportunity to invest for cash flow which means buying a rental property for the income it generates each month.

With skillful management, this cash flow income can be increased significantly after your investment.

The passive income from your real estate investments can dramatically improve your quality of life.

Rental properties give a steady source of cash that keeps up with inflation.

With smart investment advice, real estate investing will bring a consistent stream of passive income.

Many investors are often able to earn cash flow completely tax-free.

2. Tax Advantages

The government gives many tax advantages to those that effectively help them with their responsibility to provide suitable housing for the populace. Owning real estate brings many tax advantages, not least of which is depreciation.

Depreciation is a key tax advantage with real estate investment.

Real estate investors earn back the cost of depreciation over a period of time after the initial purchase.

Because you are depreciating an asset that increases in value, you receive a tax credit accordingly.

This tax credit is received in addition to property maintenance and other costs that you can take away from the rental income you receive.

When you add in ‘bonus depreciation’ and ‘1031 Exchange,’ the tax advantages are truly extraordinary.

3. Hedge against Inflation

Depending on the type of securities you hold, Inflation can be problematic. Real estate investing serves as a hedge against inflation. The value of the property is tied to inflation as replacement cost goes up and the rent of the tenant is adjusted upward.

Summary

Investing in multifamily properties brings excellent returns with low volatility and many other financial advantages.

A great advantage of investing through syndicates rather than making a self-directed investment is that you get to leverage the investment company’s expertise. 

With a syndicator, you can bank on the knowledge and skills of several real estate professionals. 

Many investors don’t have the time or inclination to learn every aspect of owning and managing real estate investment, for example, negotiating purchase agreements, financing a purchase, negotiating leases and managing the property.

We look forward to supporting you in your desire to expand your wealth and reach your goal of financial freedom by means of multifamily real estate investment.

Multi-Family Property Classifications and Your Investment Strategy

Multi-Family Property Classifications and Your Investment Strategy

Multi-Family Property Classifications and Your Investment Strategy

What is meant by the multi-family property classifications A, B, C, and D? In investment terms which of these property types are classified as core assets and which can be considered core-plus assets? If you are looking to pursue a conservative investment strategy or if you prefer a more aggressive one that has the potential to deliver a higher yield in which class of multi-family property should you be looking to invest? All these questions and more will be clearly answered in this article.  

Classification – Class A

Class A multi-family properties are buildings that are less than 10 years old. If they are more than 10 years old, they will have been extensively renovated. The fixtures and fittings will be of the very best quality. The amenities will be comprehensive and of a luxury standard. While Class A properties tend to generate a lower yield percentage, they can grow exponentially and they tend to hold their value even in major economic downturns. In terms of their investment profile, they are considered to be core assets. An article on multi-family investing at millionairedoc.com explains why Class A apartment buildings, with a ‘core asset’ risk profile, offer a lower yield percentage:- “Owners purchase these properties using lower leverage, therefore with lower risk.  REITs and institutional investors purchase these assets for income stream.  The lower risk profile results in lower returns in the 8-10% IRR range.” A property in the Class A category would not likely have a “core plus” risk profile unless it were slightly downgraded in some way perhaps by a less favorable location, housing type or a number of other factors.

Classification – Class B

Class B properties are older than class A properties. Usually, class B properties have been built within the last 20 years. The quality of the construction will still be high but there could be some evidence of deferred maintenance. The fixtures and finishings will not be as high quality and the amenities will be limited.

Classification– Class C

Class C properties are built within the last 30 years. They will definitely show some signs of deferred maintenance. The property will be in a less favorable location and it will likely not have been managed in an optimum way. Fixtures and finishings will be old fashioned and of low quality. Amenities will be very limited. Both Class B and Class C properties can be candidates for a ‘value add’ investment strategy. By bringing deferred maintenance issues up to date or by upgrading the property by means of an interior and/or exterior renovation there is an opportunity to increase the tenant occupancy and receive a higher return on your investment. In his article, ‘what are the 4 investment strategies?’ Ian Ippolito explains why pursuing a value add investment strategy is a higher risk:- “Much of the risk in value-added strategies comes from the fact that they require moderate to high leverage to execute (40 to 70%). Leverage does increase the return, but also increases the risk, and makes the investment more susceptible to loss during a real estate cycle downturn.”  

Classification – Class D

Class D properties are generally more than 30 years old. The property will be showing signs of disrepair and will be run down. The construction quality will be inferior and the location will be less desirable. The property may be suffering due to prolonged and intense use and high-level occupancy.
Both Class C and Class D properties can be candidates for an ‘opportunistic’ investment strategy. Because these properties require major renovations they are the highest risk investments but they can also yield the highest returns.

Summary

In overall terms, the US multi-family real estate market continues to give excellent returns for well-informed investors. This article has clearly explained how different types of multi-family properties are classified. The article has also given an overview of how each class of property fits the different types of investment profiles. We trust that this information will assist you in assessing your multi-family real estate investment goals. For further assistance please connect with our team.