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August 2022

Do any of the red-hot markets look scary to you today? As investors we have to keep our crystal balls shiny because projecting into the future is required. What trends and events will affect our investment, both local and national. Which sources of data are reliable. And what metrics should we be tracking.

Markets like Phoenix, Las Vegas, and Tampa have clearly been red-hot but may be poised for changes. Zillow says some of these cities saw the biggest shares of price cuts for single family homes over the last three months, and days on market, a key indicator of buyers’ willingness to pay what sellers are asking, is increasing faster in these markets than others. Redfin says some hot housing markets like Seattle are seeing active listings doubling, more houses on the market than any time since 2009.

But as we know, the multifamily market does not mirror the single family market. In fact, if a person can’t buy in a market, they will have to rent or move to another city. However, underlying causes of these trends do tend to impact both single and multifamily in similar ways. Look at 2008, how the abundance of sub-prime mortgages led to owners not paying their mortgage, moving out, and foreclosing. There wasn’t a sudden demand for apartment rentals. There was job loss, and renters felt it hard. They moved in with friends and family and home foreclosures were joined by rental vacancies.

In recent years the underlying trends of a strong economy, limitations on development, trillions of new dollars showering us drove both housing prices and rental demand.

Housing shortage? Are there really that many people moving to these areas that there will continue to be a high demand for houses and rentals? Some don’t agree. Data suggests a much higher number of people today own two or more houses. Are they renting the others out? That is most likely the case. When there’s a downturn there might be a rush to sell them, and then a glut.

Rates coming down? Maybe not. Factors that drove rates higher still exist. Listen to 10 economists provide 10 different opinions and you get a better perspective that this may be a longer term problem, and that there is an uncomfortable chance that rates may continue to rise.

For any market we’re thinking about investing in, we have to keep these trends in mind. We have to read what the economists and demographers are writing, and we have to make informed decisions. If your market starts showing these early indicators of trouble, it could be a long term trend so stay out of its way, or it may have a number of much stronger trends that will ensure your success.

But don’t take forever studying it! Be decisive, take action or decide to wait and keep your powder dry, but don’t let lethargy take over.

Memphis, TN – I have had some jaded perceptions of Memphis, and fully recognize that very few of the anecdotal stories I’ve heard over the years are completely true. It is an interesting city with a rich history, and it is a prosperous city. Very few cities have I heard such strong love/hate perceptions.

Start with growth. It doesn’t benefit from Nashville’s resurgence over the last several years, and the legacy of Elvis has not been enough to attract a diverse business culture. Growth is less than stellar, population declining somewhat over the last 10 years and jobs growth has not rebounded like most cities. In the seven years prior to 2020 jobs growth averaged about 1% and in the last two years, about 3%. Not bad but we would need to see if it is sustainable. And the city is large, over 600,000 people, larger than Atlanta! The size of a city makes it a magnet for job seekers and companies looking for workers.

The knocks on Memphis are that it is a high crime area, not owner-friendly with many renter protection laws, and little to no zoning so good investment areas and bad investment areas are scattered around the city. But that doesn’t mean it shouldn’t be considered. It only means do your due diligence, drive the area, talk to the brokers and property managers, get to know the area. Paths to progress exist in every city, and Memphis is no exception.

How is rent growth? Up a screaming 40% over the last year! That’s pretty wild, enough to get us excited but again sustainability is questionable.

If you really know this area, you could have some awesome opportunities in Memphis, and if you don’t, you should make friends with someone who has lived and invested in this area for a few years, who really knows the neighborhoods. That’s how you’ll make money here.

Negotiating through higher interest rates

A multifamily property my partners and I sold last year had an interest rate of mid-4s. We were happy to get it, and that was a good rate at the time. Our investors did very well at exit, even with the higher rate loan. We actually assumed the Freddie Mac loan, purchasing it only a few years earlier. Before that, even higher rates were the norm, but we bought good deals when we found them. I bought my first real estate with a loan rate of 13% and those loan terms were a steal at the time.

Rates are a very easy piece of a deal to reconcile. Today we are petrified of loan rates of 5% or more. Good borrowers and good properties can qualify for lower rates but often a good real estate investment opportunity is not producing much cash flow – yet. We chase these deals and should expect to pay higher loan rates.

While some buyers complain about the high rates, others know that the problem exists with a market that is slow to adjust. We like real estate because we’re not going to see the value of our investment drop by 3% in one day, 10-20% in a few months like our stocks can – and have. People need places to live and swings in valuations are longer term. We like that.

That also means that as rates rise and cash flow shrinks, valuations are not as quick to follow. Sellers believe the world hasn’t changed and, as with any market, there are less-than-savvy buyers out there who will pay those crazy prices, relieved that they got the deal. Maybe even institutional buyers who are flush and need to park money in real estate. Hoot hoot for them but disappointing for the rest of us.

If you think rates will be back in the 3s by next year, good for you for being an optimist. We all like optimists. But anything short of that means you’re in trouble, and that’s a risk that long term investors won’t take. Instead, factor the higher rates into your deal and adjust your pricing expectation.

Sellers are starting to understand this. In fact, cap rates have started to rise in some markets. Again, this is a slow process, and even if cap rates don’t rise, lower valuations can make your deal work.

Your loan rate is a simple variable in your underwriting. Adjust it upward and watch your cash flow and valuation decrease. But don’t factor in other assumptions like a refinance at a lower rate, a lower cap rate at sale, or, as we’re all tempted to do, a higher rate of rent growth. There are even other tweaks we can make to sweeten our deal but don’t go there. The deal has to stand on its own strengths based on conservative underwriting.

Do negotiate good loan terms, though. Talk to multiple funding sources and brokers. Look at more than the interest rate, such as amortization period. Did you know that increasing your amortization period from 20 years to 30 years can lower your annual mortgage payment by nearly 20%? Use longer terms to reduce risk and not get stuck having to refi into a more expensive loan. Talk to the experts so you fully understand your options.

Then talk to your seller or their broker, show them your numbers and how you can’t make the deal work at their valuation. You’ll probably lose the deal at first, but more and more sellers are coming back to their early offers after a month or two. Stand tight. Many top syndicators today have gone lengthier periods without a deal. That’s okay. Just stand your ground, don’t increase your risk tolerance.

This market presents different challenges than it did a year ago, but it will adjust.

Cardinal Oak Investments acquires, improves, and manages under-valued commercial apartments. We buy B and C class properties of around 100 units in the Southeast and Midwest. We look for properties whose amenities, aesthetics, and appeal have fallen into obsolescence, whose care reflects tired management, and whose location is where a stable workforce wants to live.

And we partner with like-minded investors looking for stable assets that produce good cash flow and strong appreciation.

Founded and managed by John Todderud, Cardinal Oak Investments has acquired properties on both coasts and in between creating annual double-digit returns.

For more information, schedule time with me or contact us.

Please note: Past performance is no indication of future performance.

August 2022

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