Big names in Real Estate have been raising hundreds of millions or billions of dollars to invest in multifamily properties since the 2010 dip.
Multifamily has been one of the hottest real estate product types in the last decade or so, even throughout COVID.
And with everything going on in the economy, many investors and researchers still believe that multifamily is one of the safest product types, even in today’s markets.
The question is, what’s all the fuss about? And why has multifamily been so successful in the last decade?
You’ve probably heard the basic argument that everyone needs a place to live, and yes, that makes sense, but that would be a cop-out answer. 🙂
If you have followed me for a while, you know everything I do is anchored in data, so let’s see numbers to understand the drivers of multifamily growth.
If you don’t like data, you’re probably not going to like this newsletter because we’re going to take some data and put it in a model to understand the key drivers.
Essentially, I am just breaking down the why behind the growth in the last decade or so and then touching upon how it might play out in the future to inform your strategy.
Let’s dive in:
First off, I dug through Zillow’s research data and discovered historical rent statistics.
But I also mainly focused on pre-COVID long-term trends to understand the supply and demand dynamics without the short-term ripple effects we saw during COVID.
Cities such as Portland, Oregon, Orlando, Florida, and Denver saw more than 5% increases.
But focusing on rent alone is not enough. We need to check expenses growth as well during this time.
In real estate, many expenses are directly related to the Consumer Price Index or CPI. If we look at data from the US Bureau of Labor Statistics, we can see the CPI growth during the same period.
This suggests that over time rents grew faster than expenses meaning a net profit growth but let’s validate it through a mock model of a hypothetical property we bought in 2010 and sold in 2020….. taking a few key assumptions into account.
Let’s start with the expense ratio assumption.
Expense Ratio = Expenses(not including Debt)/Total Rent
Typically, I see between 30-40 percent for class B turnkey multifamily properties.
So in my model, I set it at 40% to be conservative.
Then, I set the purchase price at $1 million.
What I needed to do from here was make an assumption about what the going-in cap rate would have been in December of 2010 if a buyer had purchased that $1 million apartment building at that time.
With that, a $1 million purchase would generate $71,800 in net operating income in the first year of ownership.
I also need to know what to expect for my exit cap rate in 2019 end so we can asses the total return.
Let’s take the avg. of 5.37 and 5.11 = 5.24% as the exit cap rate.
With purchase and sale metrics behind us, let’s add debt to the property.
I’ll be conservative here and say that we bought the property with 35% down, meaning your overall returns will be on the lower side with the higher initial investment.
The historical data on the US. Department of the Treasury website, which tracks daily treasury yields as far back as 1990, should give us an idea of interest rates back in 2010
On December 31, 2010, the ten-year treasury was sitting at 3.30 percent, which would be my interest rate index for my loan.
I added 175 basis points, which I believe is a fairly conservative spread, to bring my total interest rate on loan to 5% on the $650,000 loan.
And let’s say closing costs = $15,000
So a quick recap
Purchase Price = $1M
Downpayment = $350,000
Closing costs = $15,000
Interest Rate. = 5%
Amortization = 30 years
Expense Ratio = 40%
For simplicity, let’s assume the property was bought on Dec 31, 2010, and was sold on Dec 31, 2019
At the end of those nine years, I’ll have paid down $105,524 in principal, and my ending loan balance will be $544,476.
Assuming a 5.24 percent exit cap on the next buyer’s year one net operating income, I’ll receive $1,958,286 in sale proceeds.
After deducting the sale cost and my loan, my net sale proceeds will be slightly more than $1.35 million.
Here’s the really interesting part:
My IRR is 22.3 %, my average cash-on-cash return is 11.67%, and my equity multiple is a massive 4.76X, and that is with conservative assumptions with higher downpayment and not even looking at high-growth cities.
For example, with Orlando’s rent growth, we’d see a whopping 30.67 percent IRR, a 17.69 percent average cash-on-cash, and an equity multiple of 8.25 X.
The crazy part is that this doesn’t even include things like renovations, which could add a 10% to 20% increase in revenue in the first one to two years.
Please note these would be laughable metrics in today’s environment. We were at a relative bottom in 2010, and from all signals, we are at a relative peak or just passed it in the current environment.
But what’s my point?
In the last decade, I think US apartment investors have been extremely fortunate, and even those who haven’t done much to their properties have seen significant value growth simply through rent growth and cap rate compression(7.18 to 5.24 in the above example)
With that said, interest rates are at a high, and it is challenging to believe that cap rates will compress in the coming years.
So what would happen now if interest rates and cap rates instead rise in the next few years?
Well, now we have a model from the past, so let’s put some numbers in and see what would have happened.
Assume interest rates rose as they have in the last 2 years, and cap rates rose 100 basis points from 5.24 percent to 6.24 percent in nine years, investors would see an IRR of 11.19 %, COC of 6.52% and equity multiple of 2.32x.
But now inflation has been rising, and generally, rents will increase with inflation so personally, it would be safe to assume that the 11.19% IRR is on the conservative side and will likely be more, provided you don’t overpay.
The bottom line is we may not see the massive returns that we saw in multifamily in the next decade, but we’re still likely to see strong returns for people who buy multifamily and hold long-term.
Hence, I feel highly confident in continuing to focus on multi-families like I have.
That’s a wrap.
Thank you once again. I really do appreciate people reading.😊