Investment Thoughts

Real-Estate Investing: Thinking Beyond Commercial
by Tim Hickok

Multiple factors converge to make multifamily housing worth another look.

Perhaps you feel burned by the stock market, you’d like to play it safe with your investment funds but you can’t get any yield out of the bond market in today’s climate of paranoia. It may be time to consider an investment that acts like a bond, and holding it not only gets your money back, but possibly a nice capital gain, to boot: income-producing real estate.

This article will focus on my area, multifamily, but deals are out there for other asset classes. I have heard of banks dumping office space (my least-favorite asset class) for ridiculous prices since the meltdown, and friends in the strip-center arena have picked up baskets of centers for less than the loan amounts. These deals are harder and harder to find, as the expected commercial real estate meltdown has not actually materialized. In multifamily, we have the luxury of having access to Fannie and Freddie, which have really picked up the slack since the commercial real-estate securitization market went moribund.

It is important to see where multifamily prices are now compared to other investments, and to historical norms. At present, the stock market is selling at fairly cheap multiples compared to historical levels, at 12 times forward earnings for the S&P 500. The bond market, on the other hand, is on a tear, and a 10-year Treasury will run you 50 times what it will return in yield. Since apartment loans are based on the longer maturity Treasuries, bond yields do affect how much an investor can borrow—and consequently, how much he can pay the seller.

In investment real estate, the capitalization rate is a good gauge of how valuable investors feel an income stream from rents actually is. This “cap rate” is a number that would be equivalent to the yield from the net operating income of the property were it not encumbered by debt. So the lower the cap rate, the higher the price being paid for the income stream. In the early part of my career, projects could be purchased for roughly 10 times their income, or a 10 percent cap rate. Now, with lower bond yields and more investors seeking income, cap rates have dropped as low as 4 percent in some desirable locations on the coasts—since the inverse of 4 percent is 25, we can say that in selected markets, investors are paying 25 times income, or almost twice the S&P 500 price/earnings ratio. It’s better here in the Midwest, with cap rates in the 5.75–7 percent range, but historically, prices seem expensive.

An investor should assess why he might want to bite the bullet and jump into income property. Do you believe that the present “fiat money” policies and deficit spending will lead to inflation down the road? If so, you could anticipate future rent escalations. Apartment rents in particular have been excellent inflation hedges, and I can think of few investments where cash yields increase faster than apartments with fixed interest costs (at today’s low rates) and top-line revenue increases that keep pace with CPI increases. Be advised, though, that to the extent that inflation tends to increase bond yields, cap rates may also go up. But, since gross revenue should be more than twice as large a number as ongoing costs, the income portion of the cap-rate equation should more than offset the lower price multiples of the inflationary environment.

Demographic trends should also be considered, and they are favorable for multifamily. The Echo generation is just graduating from college, and recent grads tend to be renters. Their Baby Boomer parents are beginning to retire, and here again demography favors multifamily. These factors look good for at least 10 years. For some years, I have been referring to this predictable age-wave confluence as “Apartment Nirvana.” Rents are going up even now without inflation due to demographics, the single-family housing crisis, and lenders’ reluctance to make any loans, even multifamily.

There are a number of ways to play this market, from Real Estate Investment Trust shares to the purchase and renting of single-family houses. If you like the hands-on approach and can quit your day job, consider the latter. REIT shares have fared much better than the S&P since the meltdown, and as a consequence, yields have suffered. Still, multiples nationally are 17 times funds from operations or a 5.8 percent yield to the investor. If you can use the tax benefits of real estate, a publicly traded master limited partnership may be for you. Add the benefits of depreciation to the yield and the numbers can get pretty attractive. Consult your CPA and be prepared to receive an IRS form K-1 instead of a 1099.

Conditions in our market favor landlords more than at any time in years, and yet prime properties are continually becoming available for purchase. Do your homework, develop a future macro thesis, and, if you decide to invest, make sure your management is experienced and has the ability to maximize operating income not only via top line expansion but skillful control of operating costs.