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Thoughts from Houston and the Importance of Forced Appreciation

Hats off to the guys from Disrupt Equity and Wolfe Investments for organizing a tremendous maiden event. Roughly 250 people attended the first Multifamily Investor Network conference with the overwhelming consensus that it was time well spent. Each session focused on education, insights, targeted networking, and as promised, there wasn’t a single sales pitch.

Following this great event, the team will take the show on the road, hosting similar events this year in Los Angeles, Seattle, and yes, Boston in October. Cove Investments will do its best to support the effort and will keep you posted as further details emerge.

The outlook from the trenches (operators, contractors, lenders, and investors) remains nearly universal in its narrative. Most agree that while fundamentals remain strong, we’re late in the cycle and valuations are relatively expensive vs. history. Basically, things are ok at the moment, but investors should temper return expectations; the next few years are unlikely to match the last few years.

Broadly speaking I don’t disagree with this view. That’s why we’re actively seeking lower leverage and more value-add opportunities to drive returns on our investments. The strategy of “forced appreciation” can create value somewhat (but not entirely) independent of market conditions.

In commercial real estate, to calculate the value of a property, you divide the net operating income (NOI) by the cap rate. Let’s run through an example assuming you have two properties. Apartment A generates $1M in NOI each year. All else equal, if cap rates rise from 6% to 7%, the value of the property would decline from $16.7M to $14.3M. That’s a nasty 14% decline BEFORE the impact of leverage. You can appreciate why we always check the cap rate assumptions used in the operators’ models.

Now let’s see how a value-add strategy can mitigate the impact of rising cap rates. Assume that Apartment B has a renovation program designed to drive rents closer to market, boosting NOI by 20%. Leaving the other assumptions the same, Apartment B’s NOI increases from $1M to $1.2M (maybe over 2-3 years). If cap rates rise as above, the value of Apartment B INCREASES from $16.7M to $17.1 (+3%), also before the impact of leverage.

Keep in mind that the simplified scenario above narrowly focuses on a rough exit price and ignores ongoing cash returns to investors.

It’s rarely wrong to be conservative in your assumptions. If you’re going to be wrong, wouldn’t you prefer to make less rather than lose more? That’s why we’re focused on cash flowing stabilized B/C class apartments in attractive markets, with value-add opportunities to force appreciation, and without too much leverage. These investments should be more resilient if the outlook deteriorates significantly.

While it’s not my base case, it’s worth considering a possible bull case for this space.

Experience tells me that when everyone has the same expectation, it rarely plays out that way. How many times over the bond market’s ~40year bull market have we expected yields to rise, only because they’d never been this low? How many times did we then proceed to make new lows?

US 10-Year Treasury Bond Yield Over 54 Years

Haven’t we been “overdue” for a recession for years now?

Consider this. What would happen if median incomes for blue collar workers keep rising even as the Fed cuts rates to respond to deflationary pressures elsewhere in the economy? It’s possible that rents rise faster than forecasted (supply remains subdued relative to demand) and that cap rates keep falling. Institutional (and individual) investors around the world may continue to seek the attractive yields offered by the US multifamily sector.

My point is that mean reversion is a behavioral flaw. It’s true that things do normalize over time, but it’s rare that we can predict that path. Even the “experts” can only do their best to make reasonable guesses and to highlight extreme anomalies.

There certainly will be a recession at some point. We know that eventually, cap rates will rise too – that’s why we plan for the worst and hope for the best. And that’s why prudent investors diversify their portfolios across multiple asset classes.If you’d like to discuss this or any other aspects of passive investments in apartments, please email us directly at info@3.223.194.162 or visit the Contact Us page.

Thanks for reading!