Sell it now for big profits or maybe keep it for even better returns…
Today’s multi-family market is historic. We are seeing some of the lowest capitalization rates throughout much of the US. Investors are scrounging for deals to purchase and banks are hungry to lend. Add to that low interest rates and the perception that rents will continue to increase and we have the perfect storm.
Investors in the Twin Cities are looking to purchase and are willing to pay. Many are looking for a “value add” deal, but even the purchase price on those acquisitions are at record levels. The real question is how much value can be added and is it worth the risk? Buying an apartment that is outdated can be a real profit center, but that is only if the purchase and terms are just right. Unfortunately many investors are paying a high price for those deals and after upgrading them are left with lower cap rates that what they started with and no equity.
The markets throughout the US are seeing high employment, for instance Minneapolis-St. Paul market continues to boast high employment rate – currently around 96.5%. Coupled with that is the diverse economy and educated work force. With the Twin Cities boasting 16 fortune 500 companies and dozens of local large employers, average household income is at $69,000, much higher than the national average.
Also of good news is the population growth in many large cities of 2%-5%+ per year over the past few years and into the future. Add to it the fact that Millennials are staying tenants for longer periods that generations before. Additionally, baby boomers are starting to downsize and many are becoming renters in either senior housing complexes or market rate apartments. All of this is leading to higher absorption rates and continued rental rate increase.
Lastly we are currently experiencing steady growth in rental pricing and lower vacancy, which has been boosting the net operating income and allowing for investors to purchase properties that have not kept up with the times, however, this is now becoming much more difficult to find.
How long can this go on is the real question? This current cycle of increased value in apartments started near 2010. In 2009 the twin cities saw an average of $60,000 per unit on buildings sold. Currently we are seeing an average north of $120,000 price/unit on buildings sold. Rent continues to increase, which is great for the bottom line, but this is making it less affordable to rent. When will the millennial generation decide that it is time to buy and when will others start to find a roommate in order to be able to afford to live? As the generation that we are all counting on to boost our rental income decides to buy and others double up, where will rents and vacancies go? As rates continue to increase, will investors be able to purchase for such high prices? Many factors in my mind could lead to a collapse or at least a correction in the Apartment market:
1. Un-employment rate increase
2. Interest rate increase
3. Rent rate decrease
4. Vacancy rate increase
5. Concession’s increase
6. Single family market values dropping
7. Historical trends that markets have 10-15 year swings
The question in my mind is not if this will happen, but when this will happen? Buying a property at market rate may create some cash flow today, however, if the market drops the investor may be out of luck. Even if the cash flow can pay the bills, the investor may not be able to sell. After 5 years their balloon mortgage that they got at 4.5% is now due or needs to be refinanced. If rates are at 7+% the asset is now a liability.
What can you do?
1. Buy in markets that have potential to increase in value. Looking for lower priced markets, with affordable rents and growing economies is a great way to hedge against future loss.
2. Buy value add properties. Buying properties that have issues today that your team can fix through physical renovation and management strategies will increase your net operating income (NOI). This in-turn will increase the value of the property. The key is not to refinance all the value out of that property.
3. Get long term debt on the property. If you can obtain 10 year or better balloon on your note, then you will have ample time for principal reduction. The last thing you want is to have a cash flowing building that you bought at a 7 cap and in 5 years when the market has corrected you are not able to refinance because the current market is selling at an 8 cap. That can happen after the 10 year mark as well, but if you followed step 1 and 2, then you are sure to have enough equity to weather the storm.
My suggestion is to weigh your options. Is this the best market to buy in or sell in? In markets like this you can profit a great deal as a buyer if you can buy a building and add true value to it by increasing the net operating income (NOI or gross profit – gross expenses) and sell it before the market crashes. This is a game of calculated risk, but can yield huge profits for those fortunate enough to sell before the crash. Be careful of buying for future value increase based on market conditions vs forced appreciation through a value play. Also be careful of thinking you can renovate a property to add value. That may not be the case in the sub-market you chose. The best strategy is to buy for cash flow and use all other strategies as the icing on the cake.
As a seller, one needs to decide if the profit is worth exiting. You also need to decide if you feel the market will continue to increase or be stable while you hold on to your asset and if it does decrease if you can sustain a prolonged downturn. Considering the potential tax implications of selling and the loss of tax advantages and income is important as well. If you want complete a 1031 exchange, understanding what asset class you will purchase is important and what market you will purchase in. Are you going to swing to commercial such as industrial, office space, retail or will you stay in apartments and perhaps invest in a market that has appreciation to gain?
To your success