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Disclaimer: This article was submitted by our sponsor MLG Capital
Investors like to quote Warren Buffett’s old adage: “Be fearful when others are greedy, and be greedy only when others are fearful.”
While this line of thinking is simple in principle, when the going gets tough, it can actually be a lot harder to go against the grain than people think. In 2021 and early 2022, when prices were at their peak, money flowed into private real estate, but now that prices have cooled significantly, investors tend to be more nervous. This is understandable in many ways – real estate is an illiquid asset and there is undoubtedly some weakness in the market right now. While much of the market sits fearfully on the sidelines, MLG Capital believes now is the time to get greedy. Here are two powerful forces we see at work in the market:
Limited competition on the buyer side
In 2021, there was a huge pool of buyers for any type of real estate deal when it came to market. There were the large institutional players, the smaller syndicators, family offices, private equity groups, and everyone in between. In today's market, the dynamics look a little different. Many of the institutional asset managers saw their bond portfolios collapse with rising rates in 2022, forcing them to rebalance to maintain their desired portfolio composition. In addition, many groups have experienced significant redemption requests, forcing them to be net sellers and not be active on the buy side. Many smaller syndicators have seen their funding channels dry up as investors have become more nervous, and many are also struggling with challenges in their existing portfolio.
This puts family offices and more established private equity investors like MLG at the buyers' table when deals come to market. Fewer buyers generally means a less competitive sales process, which can shift the advantage to the buyer and lead to cheaper prices.
Due to more limited competition and higher interest rates, MLG can buy at higher capitalization rates than we have seen in a long time.
Historic new supply causes temporary weakness, but demand remains strong
Back when debt was still costing 3-4% through 2021 and 2022, developers couldn't get their projects off the ground fast enough. Multifamily buildings take about 24 months to complete. So, toward the end of 2023 and the beginning of 2024, an oversupply of new apartments will come onto the market, putting downward pressure on rents, increased vacancy and higher concessions. In many markets, occupancy rates have dropped from 94-96% to 90-92%.
However, markets always work in cycles. Looking ahead to the next few years, housing starts will drop dramatically as developers cannot absorb the increased cost of construction combined with financing that can cost 8-10%. Therefore, the supply of new construction is expected to decrease, but the demand drivers are still very strong, especially with so many people unable to afford a home.
What does this mean?
We believe there is an opportunity today to do deals that have temporarily lower NOI at higher cap rates. Let's think about what that looks like mathematically.
Consider a 100-unit multifamily property that charges $1,000/month in rent. Assuming 95% occupancy and 60% operating margin, the NOI would look something like this:
$1,000/month x 100 units x 12 months x 95% occupied x 60% profit margin = $684,000
Let's say in 2021 someone paid a 5.0% capitalization rate for this property (although many paid much less, sometimes in the 3% range!). That would equate to a value of $13,680,000
Now let's say we want to buy the same property today, but instead of 95%, the property is now only 90% occupied and instead of a 5% cap rate, we can pay a 6% cap rate. Since revenue is lower, let's say we're only operating at a 55% operating margin. The NOI would look something like this:
$1,000/month x 100 units x 12 months x 90% occupied x 55% profit margin = $594,000.
Let's assume the property can be purchased today at a 6% capitalization rate. That would result in a value of $9,900,000. That's a loss of 27.6%!!
This is where the opportunity lies in today's market. Due to reduced competition, there is a window of opportunity for deep-pocketed buyers to acquire higher quality assets at temporarily lower prices. Markets are cyclical; at some point, all the capital that has been relegated to the sidelines will come back, leading to more competition and lower capitalization rates.
At some point, historical supply will be absorbed and the market will normalize, occupancy rates will improve, and rents will start to rise again. Let's go back to our scenario and assume that occupancy rates rise back to 95% and operating margins rise back to 60%, and the same property returns to an NOI of $684,000.
Even if the capitalization rate remains unchanged at 6%, the property purchased for $9.9 million is now worth $11.4 million. If the capitalization rate drops to 5.50%, the property would be worth $12.4 million.
The market is currently filled with fear, but MLG Capital believes there is an exciting window of opportunity to be greedy. We believe all investors should continue to invest in real estate, through all cycles. Timing the markets is not a sound long-term investment strategy, but investing through market cycles with a proven sponsor like MLG in real estate sectors that have attractive long-term fundamentals and combining those investments with a conservative debt approach is a sound strategy. Please contact us if you would like to learn more about MLG or our market view!
Create your very own Auto Publish News/Blog Site and Earn Passive Income in Just 4 Easy Steps
