How to Avoid Overpaying for Multifamily Properties

How Far Can They Go?

I’m talking about the prices on multifamily properties. I’ve seen investor overpay for properties and I keep shaking my head in amazement. Yes, we all want to get deals, but I will not pay the price for wanting to buy a deal ‘just to buy a deal’.

You see, right now it appears that there isn’t a limit on how high the prices on multifamily properties can go. There are a lot of reasons why prices have spiraled up, and many reasons why they probably won’t slow down anytime soon. 

What’s Happening in the Multifamily Market?

Multifamily properties are the “hot buy” now. It used to be single-family homes, purchased, renovated and flipped for a quick profit. Now, people have shifted their attention to multifamily assets because the potential to make money is far greater than a single-family home. It depends, of course, on how astute the buyer is.

Are continually rising multifamily prices the new normal? Ask many experts and they’ll all say, “yes.” Why? Demand is huge. There is a continuous stream of renters entering the market, so occupancy rates will remain strong. In fact, baby boomers and Millennials prefer renting a multifamily unit over buying a single-family home. this is due to a need to downsize, or be prepared to move if their job requires relocation. And if prices continue on the track that they’re on, it means that appreciation, and profitability, will continue to fuel the buying frenzy.

The old “buyer beware” sign comes into play. Yes, multifamily properties are in strong demand, but everyone now knows about them, and the market is becoming artificially inflated. Even seasoned syndicators and investors are overpaying for multifamily properties, because that’s what it takes to land one.

Reasons for Overpaying for Properties

A closer look at multifamily deals can reveal some of the reasons that prices continue to climb, and people continue to overpay. 

Just to clarify, a 1031, also called a like-kind exchange, is basically a swap of one investment property for another. While most property swaps are taxable as a sale, 1031’s either have no tax or limited tax due when the exchange happens. The only requirements are you have to designate a replacement property within 45 days, and you have to close within 6 months. If you exchange your investment for another property you don’t have to report any capital gains, and your investment will grow tax deferred. You can do this as often as you like. Ultimately, you’ll have to pay one tax, but by that time it’ll be a long-term capital gain.

How does this impact multifamily property prices? if you use this particular strategy, the seller must purchase a new asset. Because there is a time pressure to designate a new property within 45 days, the seller may be willing to overpay on a new property just to beat the deadline, and not pay capital gains. This pressure can drive up the price of other properties.

• Foreign Investors

There has been an influx of foreign buyers purchasing multifamily properties over the past several years, many from China. They are willing to overpay and settle for a small return just to have their money in stable U.S. currency.

Here’s another problem for U.S. investors: suppose an investor is looking for a cash-on-cash return of 6% to 10% or higher, but they’re competing with a Chinese investor who would gladly take a 1% or 2% return just to have his or her money in U.S. currency. The only way the investor could get the property is overbid the price, often at a substantial number. You can see how foreign investors are causing price increases on multifamily properties.

• Novice Investors

Earlier I mentioned that multifamily properties were hot, replacing single-family flips. Unfortunately, that brings in all types of investors, including novice ones who mistakenly overpay thinking they have to get in on the “hot” trend.

It’s not just novice single investors; many new syndicators are overpaying as well, based on assumptions that have no basis in fact. What is needed are experienced pros who understand realistic property values and who are not willing to plunk down lots of cash just to acquire another asset. 

Most new investors look to comparables when looking at property prices, but prices are not only hard to find, they’re also not very reliable when everyone is willing to over pay for properties. Another measure to use is cap rates, which are used to compare properties. The problem is that multifamily properties run the gamut from small to large, so how can you compare say a 30 unit property to a 220 one? 

One way is to determine an average price per unit. That provides a way to compare different properties no matter their size, age or classification. Once you have your average price per unit, you can compare it to other properties that have sold, giving you a good range of property values. However, even if your analysis shows you’re much higher than the range, the property may still be worth acquiring based on its potential in the current market.

• Unrealistic Expectations

Whether it’s a 4-unit multifamily property or a 200+ unit, sellers are now getting cap rates in the 5% to 6% range. And it’s not only happening in large cities like Los Angeles or Chicago, it’s happening in cities all across the country. Properties that were estimated to sell at $5,000,000 are selling at $7,000,000, This is surprising to some, but savvy syndicators aren’t surprised, and know how to determine a realistic maximum price.

There was one deal I walked away from because the seller kept pressuring me to increase the price, and basically told me, “I will sell it to the first group that will make a higher offer.” We were one of 3 groups in the final bidding, and I told the seller that, respectfully, I can’t go any higher since it won’t support my investment criteria.” The reason: a higher price will drop my IRR to a level that I’m simply not interested in. The broker called me the next to tell me that even though the deal was awarded to another group because, as he put it, “they blinked first, and I respect the fact that you stood your ground.” There was no question that he was suggesting that group had overpaid for the property. 

Some new investors and new sponsors count on cap rates continuing to shrink, overlook poor cash flow and expect ever-increasing appreciation to make their deal work. They will be sadly mistaken. These are the same people who expect that economy to continue to boom and rent increases to approach 3% to 5% each year. That is also an unrealistic expectation.

The fact is these unrealistic expectations is what are driving up multifamily prices, and it turns out it’s bad for everyone.

How High is too High? 

If you enter a deal where the price is escalating and people are overbidding, how much should you be willing to overpay? It’s all based on risk. The riskier the deal, the higher return you should expect to receive.

Everyone has minimum investment criteria, and that criteria shouldn’t be shoved aside just to acquire a particular property. As an example, suppose you’re looking at acquiring a multifamily property that is in serious disrepair. You may have to rethink the return you expect based on the level of risk involved in the property.

Summary

Investors should always look at traditional performance criteria when looking at real estate deals. However, the way the multifamily market is exploding and the prices investors are willing to pay make some of the traditional ways of looking at deals moot. In this market, you have to remember that you can over pay for a multifamily property and still make a substantial profit..

There are ways you can avoid overpaying for a multifamily property. Be conservative in your underwriting, and account for a moderate rent increase. If the market is anticipating a 5% rent increase, plan for a more conservative 3% increase.

Another tactic is to make sure your exit cap is higher than the cap rate that’s in place at the time of purchase. This is important for two reasons: there’s no guarantee when you forecast future cash flow of the property, and this uncertainty may pose a risk to the investors.

Also, the depreciation of the property over the holding period needs to be addressed, including the physical depreciation and potential functional depreciation of the property. This is important because market forecasts don’t take depreciation into account, especially the loss of value of a property due to aging.

Finally, don’t give in to bidding wars. You spend so much time on a deal you may agree to take a cut in your returns because you want the deal at all costs. But you may end up bidding against yourself, because many times you won’t know if you’re already the highest bidder.

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About Ellie Perlman