Don’t be the Greater Fool!
“Being overly optimistic in your forecasts can lead to artificially inflated NPVs (net present values). Thus, when in doubt, always look first to the marketplace for objective information about market rents and expenses, and a market-derived discount rate. A positive NPV may simply be an indication that either something has been left out of normal operating expenses, like reserves and replacements for a new roof or new fixtures, or market rents have been overstated” (Schilling, 2012, p. 142).
Responsibly Underwriting Investment Opportunities is the Key
In markets where cap rates are low, or in any other market, an investor must be diligent in their assessment of operating expenses and how multifamily listings have been underwritten. Operating statements that show no allowance for important expense items, such as, reserves and property management, can cause an advertised or stated cap rate to be inaccurate because it does not take into account these important variables. Likewise, if a property is an older building and the expense ratio is under 40% of its potential gross income (PGI), then chances are good that there is not enough is being allocated to the expenses of operating the property; because–in general–the older the building, the higher its’ maintenance costs.
When I see listings that do not show an allowance for important expense items such as the ones mentioned above, I see an overly optimistic assessment of investment value. When a seller is firm on price based on such deficient underwriting, I see a seller waiting for the Greater Fool to appear; and in a market where cap rates are low, there is a greater chance that they might be successful in finding such a person and/or organization, because there is a tendency in the market to be over-zealous following popular price trends–even when those trends do not make sense under fundamental investment logic; for example acquiring an apartment at a 4% cap rate.
“Price bubbles occur when today’s price depends solely on what other investors are likely to expect the price to be, and not on some forecast of future supply and demand. There is a good deal of evidence that price bubbles exist from time to time in most real estate markets” (Shilling, 2012, p. 38).
While it might be the trend of the day to acquire an apartment building at a 4% cap rate, it would not be the best place to be economically if mortgage rates were to suddenly rise above and beyond 4%. Additionally, real estate carries risk, and a 4% cap rate does not even begin to sound attractive for the level of risk taken to acquire, develop, and/or operate a sizable property. Perhaps this is the reason why more investors are turning to sub and tertiary markets for better yields that make sense. Considering the relationship between risk and return, a 4% cap rate is nonsense. As a rule, the more risk taken, the more return received; and rightly so. If more investors followed this rule, they would think twice before contributing to price bubbles in the inflated multifamily markets they help to inflate.
“Recognizing the existence of a price bubble is important. When an asset’s price exceeds the market fundamental price, rational investors generally will want to sell the asset because the utility gain would exceed the utility lost from holding the property forever. Eventually, of course, such a sell-off will lead to a decrease in demand, causing market price to fall. By contrast, when the actual price of the asset is less than the market fundamental price, investors can increase utility by buying the asset and holding it forever. This increased demand will eventually raise the market price, eliminating the negative bubble” (Shilling, 2012, p. 38).
Shilling, J. D. (2002). Real Estate. Mason: Cengage Learning.