And the band plays on…

Thank you for joining us for this issue of The Multifamily Memo.?

It is reported that the eight-member band on the Titanic played on for 45-minutes to keep the passengers calm as the ship sank.? None of the band members survived the sinking.? Are some of today’s owners and lenders destined for the same fate as Titanic’s band?

Human investment psychology is still a great mystery – prone to emotional roller coasters that many times run counter to the Spock-like logic espoused by the investing greats such as Warren Buffet, Howard Marks, and Sam Zell.?

Even if we know the best investment decisions are based on rules and math, most investors have trouble executing during times of uncertainty based upon what the cold hard facts are indicating.? Only the most disciplined can overcome this most basic aspect of human psychology (fear) to make the most of their investment circumstances.

While we believe most knowledgeable owners and lenders are logically aware a pricing reset is in process to reflect the new normal in interest rates, they have not been able to overcome emotional rationalizations to do what is in their best interest.

Why do we say this?? If historically accurate pricing indicators (see cap rate spreads chart below) are showing owners and lenders the potential for more losses the longer they wait – why wait?? After all, it would be in their best interst to mitigate their losses.

Why sell tomorrow at a higher cap rate?? For the less experienced, they may not understand that cap rate expansion will greatly outpace any likely interest rate cuts.? For others, they are caught up in emotional aspects of their investment - it is painful to take losses.? Even worse is realizing, in hindsight, you could have reduced your loss - just ask any true seller if they are better off pricewise today than they were last year and an honest answer wil be a resounding no.

Even though many multifamily investors/lenders have never been through a downturn, there are are numerous historical indicators to draw on in making sound, data-driven, investment decisions.? One is the time lag between the start of a market downturn and its trough.? The chart below does an excellent job of explaining to the “I don’t see any distress” pundits the timelines usually involved.

Charles Dicken’s passage from The Tale of Two Cities “It was the best of times, it was the worst of times” eloquently captures the investment environment during times of secular shifts.? Unfortunately, for the acquisitions done with short-term floating rate debt during the pandemic-era, these are the worst of times.? That does not mean investors and lenders caught at the market peak should not maximize their positions – this means selling at a better cap rate today to mitigate losses (even if it means taking on some emotional pain).

The truth in times of secular shifts in the market is that, unlike the Titanic’s band, it is better to survive to play another day then to vanish into the annals of history.

That is a wrap for this section.? Let us continue with the “best of times” component of secular market shifts in our Expert Insights section.

Expert Insights:? Disciplined Investment Analysis – A method to mitigate risk while pursuing opportunity

Successful multifamily investing is at its core, pretty simple – buy an asset today that will be more valuable tomorrow because of the expected increase in the cash flow it can produce.? This is where understanding investment and market analysis comes into play.? Since over 90% of real estate investing involves debt, an astute understanding of the capital markets is also required.

These skills can (and should) be acquired prior to embarking into the world of multifamily investing.? Once acquired they should be augmented with a keen understanding of historical indicators of market cycles.? Unfortunately, many of the new investors since the GFC of 2008 neglected the study of real estate investing from a historical perspective.? If they had, they would have avoided getting caught at the peak of the cycle.

This is where disciplined investment analysis comes in.? It prevented us from getting caught at the peak of the cycle.? Is it a guarantee that you never get caught – absolutely not, but it is a way to apply historically proven risk adjustment metrics to gauge market attractiveness.? How did it prevent us from getting caught in the market frenzy that began in fall of 2020?

1. We were acutely aware that typical cap rate spreads for multifamily were ~ 3%.? This is the premium added to a property’s cap rate to account for the liquidity, market and interest rate risk.? During the frenzy of 2021 we saw class C properties being bought at a 3.5% cap.? To us, this was close to the spread (the additional premium) you add to the cap rate, not in any way the cap rate you should be paying going in.
2. We were also aware that the median benchmark 10-year Tresury yield since the GFC was right at 2.9%.?? This meant that unless you believed interest rates would stay at the pandemic-era lows (virtually zero), you would have to account for a reversion to mean in your underwriting’s exit cap rate assumption.? What this told us, was exit caps should be calculated by adding the historical cap rate spread to historical 10-year Treasury yield.? At the time, this produced an exit cap rate of 5.9%.? Which in our opinion is, from a 15-year historical perspective, the lowest cap rate you should ever pay for a stabilized multifamily property outside the Core classification.
3. The historical spreads in cap rates between the different classes of properties (class A, B & C) disappeared.? Historically, class B require a .5% higher cap rate than class A, and class C requires a 1.5% higher cap rate.? All classes converged around the 3.5% cap rate range during the peak indicating extreme frothiness in the market.?

While discipline spared us from investing at the wrong time, it will also allow us to prosper at the right time (quickly approaching).? As discussed in the first section, most investors are terrible at maintaining discipline.? Instead, the majority are easily swept up in the influence and pressure of the decisions being made around them.? This will cause most to miss the upcoming opportunities.

When the dam holding back the overwhelming wall of debt maturities breaks there will be little in the way of borrower/lender disputes – just capituation.? As the rush for the exits intensifies, pricing will be pushed lower than its historical norm presenting discliplined investors with a once-in-a-generation opportunity as the following chart shows.?

In multifamily investing, you have good and bad, dark and light, wisdom and foolishness.? The contradictions abound.? This is the truth of human investment psychology.? Disciplined investment analysis might not be a complete cure, but it can provide some welcome relief.

That is a wrap for this issue. ?We hope you have found it enlightening and invite you to contact us with any questions or thoughts.? We are always happy to help.

Finally, if you have not already, be sure to Subscribe for more insights gleaned from over four (4) decades of navigating market cycles.? We look forward to bringing you more of the information you need for successful multifamily investing.