This article addresses how the possibility for decompression of capitalization rates might result in a large decrease in the value of your assets and the means through which this potential risk might be avoided or minimized.
If you’re a passive investor in multifamily properties or any other commercial assets valued using this technique, you should know about this:
Value = Net Operating Income ÷ Cap Rate
This is relevant for many properties, including apartments, self-storage facilities, mobile home parks, recreational vehicle parks, senior living communities, industrial facilities, hotels, shopping malls, retail stores, and even cell towers.
So why do I choose to talk about multifamily?
Because of the “humility” I titled my 2016 apartment investment book, The Perfect Investment, I feel inclined to ensure that investors understand what they are getting into. If you spend more than it’s worth for anything, it’s no longer the “perfect investment.”
Having said all of this, many people who invest in apartment buildings are not overspending. Some dominate the competition and raking in millions of dollars for their investors. Last week, I went to Dallas to meet with a person who is currently working in this field.
However, when there are so many indications that a bubble may be developing, it makes me nervous. And there are a lot of assumptions regarding rent growth, continuing cap rate compression, high LTV debt, and aggressive interest rate projections. However, it is not the end of the story.
My primary worry is that syndicators and investors will make risky bets on assets already being managed by excellent operators who have improved and stabilized the situation. For many of them, the only way to survive in an environment with persistently low-interest rates is to pray and hope for inflation.
Even while I’m all for putting confidence and hoping for the best, this is not the most effective method for running a business. Even more so when you’re investing money you’ve worked hard for.
Why on earth do you believe that in order for me to be financially stable, an increase in my rent of 33 percent is required?
The reason for this is due to the probability of cap rate decompression.
This means the possibility that cap rates will increase in the future. That results in a decline in the prices of assets. This problem is made more obvious when cap rates are low (which results in high pricing) than when higher cap rates. The following is the justification for this.
The capitalization rate is the anticipated rate of return on an investment made in an asset in the same location, under the same conditions, at the same point in time, and with the same risk level as the asset in question. The capitalization rate is included in the denominator of our value calculation; hence, changes in the cap rate will have an adverse effect on asset values.
When the cap rate was ten percent, a one percent change in either direction resulted in a value change that was ten percent in either direction. Therefore, a decompression from a cap rate of 10 percent to 11 percent leads to a 10 percent loss in asset value.
Most assets, though, haven’t seen cap rates below 10% in a while. The current cap rates can fluctuate anywhere from 3% to 4% at any one moment. In recent times, we have seen a significant number of multifamily deals and other types of deals involving a percentage point or less.
So, what happens if your cap rate goes up from 3% to 4%? What kind of an effect does this have on the value? Let us suppose that the business has a net operating income of $500,000. The value of assets is calculated as follows using a capitalization rate of three percent:
$500,000 ÷ 3% = $16,666,667
It will cost you $16.7 million if you want an annual cash flow of half a million dollars. Furthermore, mortgage costs will drastically reduce owners’ net cash flow.
If cap rates go from 3% to 4%, an increase of 1% means:
$500,000 ÷ 4% = $12,500,000
So, the following is the math that supports the claim made in the title of this post. A bigger increase in a measure that is generally within the investment’s control is required to offset a decrease in value caused by a generally uncontrollable factor (cap rate), which accounts for 25 percent of the total (net operating income).
When you use the calculation for the capitalization rate of 4 percent and increase the net operating income by 33.3 percent, you may get back to the breakeven asset value:
1.333 * $500,000 ÷ 4% = $16,666,667
Because of this, you will need to increase rents by a third so that they are back at their original value. Now, this might be possible with inflation over many years. But what if inflation doesn’t rise in the way that you anticipate?
This might be worse by decreasing occupancy, rising concessions, and stagnant rental rates during a downturn in the economy. If you don’t think anything like this is even somewhat possible, I’m sorry to break it to you, but your perspective is in complete contradiction to the whole of financial history across all investment vehicles. Read Howard Marks’ book Mastering the Market Cycle for those who doubt. Listen to Brian Burke’s account of his worst deal of the year in 2008, or read about it here.
A keynote:
Caveat: Someone will claim that increasing rents by 33% will generate more than a 33% increase in NOI since operational expenses don’t rise at the same rate. Excellent point. You got me.
However, I would suggest that your operating expenditures (OPEX) and your capital expenses (CAPEX) will likely see considerable inflation. And the developing labor (and material) shortage can probably boost your prices even more than projected as the employment market for maintenance and comparable trades continues to decrease.
However, if you keep trying to make this argument, I will agree that you may be able to reduce the 33% number somewhat. You might assume that the rate is 18% if you’d like. This presents a significant barrier in the near future. Particularly in the event that the short-term involves a refinance.
Oh, and before you exhale with satisfaction at “just” 18%, keep in mind that cap rates might potentially relax by more than 1 percent. What will happen if they increase from 3% to 5%? The issue that I’m about to present to you here will become twice as difficult to solve.
There are five possible outcomes if cap rates are decompressed.
Yesterday, I had a conversation with a buddy about this idea. He told me that it was more theoretical than practical. Really? Decompressing cap rates could have five potential repercussions, therefore let’s talk about them.
1. Difficulties arising from the analysis of the refinancing
If cap rates go up, it might be bad for syndicators who only have a limited time to keep their properties or a short time before they need to refinance. Since the appraisal is directly dependent on the cap rate, a situation such as the one described above, in which the asset’s value drops by 25 percent, might present potential difficulties.
2. Challenges posed by changing interest rates in refinancing
Cap rates generally rise along with interest rates, which is a problem for investors. Therefore, decompressed cap rates combined with increased interest payments resulting from additional debt may be a double whammy for a company.
3. Capital calls – The necessity for new equity in a stale transaction
Because of this, a capital call will likely be required from the investors. The introduction of fresh equity. However, investors may already be skeptical about the viability of this transaction, and they may be hesitant to accept the offer to risk their good money on something that may not pan out. You run the risk of getting into some deep water here.
Here, investors may rely on Warren Buffett’s experience:
On the other hand, a “chronically leaking boat” may not be what you and I picture. However, the things that we believe don’t really make a difference. Since the investors have worked hard for this cash, their opinion will be given precedence in this situation.
Aside from that, let’s admit it: business transactions almost never happen exactly as anticipated. And if (when) you have additional concerns, such as not meeting occupancy objectives, rent goals, or revenue predictions, this refinancing/capital call issue may seem to be the last straw in an investor’s evaluation.
4. IRRs that are lower
II’m not a big supporter of using internal rates of return for most agreements since I find them difficult to calculate. These IRRs are often misunderstood and maybe manipulated due to this misunderstanding. The obsession with the internal rate of return (IRR) sometimes leads to thinking in the short term, which is typically not the best strategy for building wealth over the long run.
A syndicator’s projection of IRRs at a specific level may be affected by cap rate decompression and its ugly twin, increased interest rates. Why? The following are four potential reasons for this:
- Investors can’t get their money back right away because they can’t refinance out lazy equity.
- Because of increases in interest rates, cash flow has been decreased (with floating rates on the original debt or higher rates on the additional debt).
- Lower prices if you want to sell within a short time.
- Short-term incapability to sell anything. This delay has the potential to minimize IRRs drastically.
5. Affect on potential future agreements – investors’ perspectives
Do you, Mr. or Ms. Syndicator, intend to remain committed to this endeavor for the near future? I hope you do. Because individuals who choose a path and remain committed to it over an extended period often accumulate the greatest amounts of wealth.
I can promise you that this will leave a black mark on your track record if you engage in risky activities with risky debt and are forced to deal with the consequences described in points 1 through 4 above. And it will make it much more difficult, if not difficult, for you to obtain further cash in the years to come.
I would also suggest that you, Mr. or Ms. Passive Investor, assess business opportunities very carefully using this lens. Ensure that you are not entering into a commercial transaction with these risks. In addition, you need to check that your syndicator does not have a record of or a propensity for playing with this kind of fire.
Do you actually know how to assess the dangers that are involved? Investing in a group that has the collective expertise to evaluate these operators and transactions is a great idea if you are unsure of what you are doing in this area. Also, I highly recommend that you pick up a copy of The Hands-Off Investor, an excellent book written by Brian Burke.
Self-storage facilities can be profitable businesses.
Are you sick of paying too much for single-family and multifamily homes because the market is too hot? One option that is often ignored is investing in self-storage, which is a decision that can increase one’s income and increase one’s wealth.
There are three methods to avoid the coming crisis
1. Safe debt
One strategy for avoiding this problem is investing in relatively risk-free debt. What is “safe” debt? It might be debt with a low LTV. There is also the chance of having long-term set rates. Hopefully, both are true.
There are a few strong reasons for a developer to use 80% loan-to-value, floating-rate, three-year term loans. This is particularly true for new construction.
But let’s face it… Although real estate developers are among the richest businesspeople in the United States, some probably end up in the poorhouse. Some of them became billionaires while they were in their thirties or forties. Now they spend their retirement working as greeters at Walmart. (Working as a greeter at Walmart is not problematic.) However, this is not how most of us see our golden years.
What happens, therefore, if you buy an asset with a low cap rate that starts to decompress in the second year after you purchase it? You could run into major challenges in the third year if you are forced to refinance, particularly at a higher interest rate. On the other hand, you can be in good condition if you have debt with a longer duration and a low-interest rate (for example, 10 or 12 years). The possibility remains that you may not be able to refinance your home to access your equity as quickly as you had expected, but the fact that you will be able to keep your investment for a longer time at lower interest rates can make up for a lot of other mistakes, particularly in the presence of inflationary conditions.
2. Intrinsically valuable assets
In this graphic, self-storage and mobile home parks are compared to big apartments (those with more than 50 units). A real estate asset’s value is generally determined by the vendor, who is often a qualified operator, and this is why this is important.
There are around 53,000 self-storage assets in the United States, and independent operators hold approximately three-quarters of them. Of those independent operators, almost two out of every three only own a single site. In most cases, this indicates that there is potential for financial gain associated with acquiring the asset.
Even more heavily reliant on mom-and-pop entrepreneurs are mobile home parks. There are 44,000 parks in the United States, and up to 90 percent fall into this category.
Believe me when I say that mom-and-pop offers like this often have a lot of meat on the bones despite their modest appearance. Learn how to locate deals that have real intrinsic value in this article.
You can discover mom-and-pop businesses in every asset class; although, as you can see, it is probably simpler to locate them outside of the multifamily real estate sector.
Investors’ value from acquiring and enhancing a mom-and-pop business is significant. In addition, and this is of the utmost importance for the purpose of risk reduction, this may help you build a larger margin of safety between your monthly income and the amount that must be paid to service your debt. One of the fundamental ideas involved in real estate investment is the Debt Service Coverage Ratio, which refers to this particular concept.
3. Don’t put your money into property investment
A third strategy to protect yourself against this potential tragedy is to entirely steer clear of real estate investment. It is highly recommended that you stay away from the stock market and any other equity investments. These methods will allow you to steer well clear of the risks and dangers of investing in real estate.
Bank and money market accounts (current yields: 0.5% to 0.7%) provide you the chance to earn interest on your savings. You also have the option of investing in the United States government. Now, you may qualify for long-term rates that are more than 2 percent. Various debt products potentially have greater interest rates available. There are municipal bonds that yield anywhere from 2% to 3%, and there are debt funds that have a greater level of risk but also provide higher returns.
You might put your money into precious metals or cryptocurrency, but in my opinion, these so-called “investments” are more like gambling or buying insurance than actual investments. In any case, I believe it’s a good idea to get some kind of insurance.
Even burying money in the ground is an option. However, a well-respected ancient Jewish rabbi advised against engaging in this behavior in both one’s personal life and one’s financial dealings.
Concluding remarks
Each investment has a risk-return relationship. In addition, some of the risks that are associated with these low-risk investments are concealed from plain view. Part two of this essay will cover this topic in more detail. A bit of advice: the ravages of inflation might force you to lose money with each low returning loan payment you make.
So, let me ask you this: what are your thoughts? Do you understand and agree with the reasoning and mathematics given here? Or is the author similar to the story of the boy who cried wolf?
