I’ve written many articles over the last two years about my passion for multi-unit-residential real estate. My fascination with the asset class dates back to over four decades ago when I was a young child (yes, I am that old). I’m going to borrow a couple of paragraphs from my book:
“I was exposed to the apartment building business as a young child. I vividly remember visiting the small apartment buildings my grandfather owned in the early to mid-1970s. He was a European immigrant who arrived in North America in the early 1950s with a suitcase, a wife and child, and a few dollars in his pocket. He didn’t speak English when he got here, which made the transition all the more difficult.
Luckily, he found a job as a butcher, but it wasn’t an easy life. Still, he saved every penny he could and ended up putting that money into apartment buildings. Real estate became his salvation from the countless hours he spent chopping meat, taking orders, and waiting on customers in the butcher shop. Although I didn’t understand it at the time, I later grew to appreciate what it meant to own income-producing real estate property.”
Of course, just because my grandfather liked apartment buildings doesn’t mean that it makes for an excellent asset class. After all, my grandfather also literally kicked the tires of the cars at the auto dealership when he bought a new car. I’m not sure what kicking the tires did, but fortunately, I haven’t adopted that habit!
I bought my first building during the height of the 2008 recession, and since then have bought a few more properties in Canada and the US. I’ve stayed clear of buying another building in the last few years, as the compression of CAP rates makes it very difficult to justify the asset class.
I’ve been waiting patiently since 2016 for the tides to turn in the market. Not that I hoped for a recession, but the higher valuations made it difficult to justify the risk/reward.
Over the last couple of weeks, really since this virus started taking over the headlines, I’ve spent more time reading what the economic prognosticators have to say about the economy for the next twelve months than at any other time in my life.
What I’ve learned is that no one knows for sure what’s going to happen. Duh!
I’ve read reports from some of the smartest economists in the world, and just as sure as one person believes that the S&P will finish the year at 3,400, another credible economist asserts that the S&P will finish at 1,400.
Regardless of who’s right, if you followed the asset allocation strategy I wrote about in my 2018 book, you’re now in an excellent position. My book wasn’t prescient; I wrote it on the assumption that eventually, things would turn in the economy. It wasn’t a matter of IF, it was a matter of WHEN.
When is now!
Is now the time to dive into the real estate market?
I’m writing this article with the thought of the multi-unit residential (apartment building) market specifically. Not the housing market, the MUR market. And keep in mind, it’s not like I have a crystal ball sitting on my desk.
I’ve been keeping in daily contact with my property manager since this crisis started, mostly because we found out late last year from the fire department that the front and back doors to each of the apartments in one of my buildings doesn’t meet code and need to be replaced. I’m not sure why none of the other inspectors pointed that out over the past decade, but that’s a different matter entirely.
What I’ve paid particular attention to, other than the progress of the 42 necessary door replacements, are his thoughts on how we’re going to fare out with regards to rent collections over the next few months.
He wisely put together a list of each apartment and his thoughts on the person’s job stability and ability to pay the month’s rent. We spent the time focusing on the tenants who are going to have a problem, and what our position is going to be in that regard.
Fortunately, my property manager has an excellent rapport with all of our tenants. He’s addressed problems very quickly over the years and spends time listening to their problems and concerns. This should put us in an excellent position over the near-term, but, that doesn’t change the fact that some people have lost their jobs, need to put food on the table, and could have a problem paying their rent, and in most cities in North America, the courts have put a hold on evictions.
And the longer this goes on, the worse the problem is going to get.
And therein lies the million-dollar question (literally).
How long will the lockdown last?
And where will the economy and employment numbers stand once things start to open up?
Here’s where things could get tricky.
It wasn’t uncommon over the last year to see buildings listed and sell at a 2% to 3% CAP rate. Lenders lent under that assumption, and some were overly aggressive with their debt-to-equity ratio.
If a landlord owns a building with 10 units, for example, and one of their tenants has a rent problem, then the building (under the 3% CAP rate scenario) is now underwater after paying taxes, expenses, mortgage, and interest charges. If two of the units have a problem, then the problem is magnified.
If we view the market in aggregate and assume a worst-case scenario with a four to six-month or even longer quarantine, a 12% to 16% unemployment rate, and a back-logged court system that can’t handle evictions on a timely basis, then we’re looking at many tenants who won’t be able to pay their rents.
There will be a bifurcation type scenario where the class-A buildings with higher covenant tenants might meet their rent obligations, and class-C with a high percentage of problems will not. But just as a rising tide raises all boats, a falling tide lowers them.
It is quite possible that despite the government’s best efforts, we will have a scenario where the landlords will be unable to meet their mortgage obligations and the lenders will be pushed into a foreclosure situation. It’s not going to be all buildings, of course, but, there will be a percentage of buildings that are problematic.
Once that starts to happen, and I’m guessing three to eight months, we’re going to see building values fall. Keep in mind though that with interest rates as low are they are, the returns will justify the risk.
My guess (and it really is just that) is that the MUR market will hold up better than many other asset classes. People still need a place to live, and for the larger cities, that will help keep values somewhat stable.
Values will fall though. Not immediately, but over the course of the next four months to a year. By December 2020, I expect we’ll see that MUR building values will have fallen by 10% to 25%. Let’s review these numbers and scenarios:
We’ve got a few counter-cyclical forces at play:
- Interest rates are extremely low, which increases building value
- Banks will be shy to lend unless there’s a much lower loan to value, which will make it more difficult for landlords to get into the market unless they have lots of cash. This will lower building values.
- Many people will move back in with their parents, or double-up with friends. This will lower building values as demand for units decrease.
- Landlords will be forced to lower rents to attract tenants on vacancy. This will lower building value because CAP rates are based on net income.
- The immigration tap, which was a driver of growth in the MUR market for many North American cities, has been temporarily turned off, and the longer it’s off, the less the demand will be for apartments.
Each rental market is unique, and even within each city, there are multiple sub-markets. I know that in Toronto, where I live, there are areas close to downtown where selling prices were approaching a 2% CAP rate, and other less desirable areas where the CAP rates were closer to 4% or even higher.
So, you’re going to see some areas where the values will hold much better than other areas. I expect every market will see a drop, some more than others, hence the wide range of 10% to 25% drop, and in some cases, I expect even more.
The Ugly Side of Inflation and How it Might Impact the Real Estate Market
Here’s what has me most concerned.
The governments of the world are spending an unprecedented amount of money to support their workers and businesses by backstopping loans, buying corporate, provincial/state, and municipal debt. At the same time, they’re handing out money to the unemployed. All this sovereign debt will need to be monetized somehow, and that’s by printing money and devaluing their currencies.
A dollar will still be worth a dollar in nominal terms, but, in real terms, we will see inflation well outside the traditional 2% range. In the 1930s, the US dollar was backed by gold. Each dollar was worth 1/20th of an ounce. In 1934 they redefined the value of an ounce of gold from 1/20th to 1/35th. An overnight 40% devaluation.
I’m not suggesting that we’ll see 40% levels of inflation, but, we will see ranges well outside that of what we’ve been accustomed to in the last 30-years.
So, how does this tie back to real estate?
In many jurisdictions, Ontario being one, the yearly allowable rent increase is capped at the inflation rate, not to exceed 2% per year. So if the inflation rate is 5%, for example, landlords can only increase rents by 2% maximum. Unless legislation is changed, which will prove challenging in a politically heated environment as we will be in for the foreseeable future, landlords will be squeezed, profits will diminish, and this will in turn impact valuations.
For jurisdictions where the rent increases aren’t capped, rents should more closely match inflation rates, and real estate will be a better hedge against inflation.
This economic situation won’t last forever. It will be a tough period of time, and then things will slowly return to a more normal level. My guess is that we’ll see building values drop starting in July, and continue slowly worsening until December, at which point things will start to get better.
If you’ve been wanting to get into the real estate market, your time is coming. Keep in mind, my guess is likely no better than the economists who can’t agree on where the S&P will end the year. It’s a guess, but all investments require a degree of uncertainty. If you’ve been waiting for the right opportunity, it’s time to start shopping and educating yourself on the market.
And last, your best defense in a high-inflation environment is gold, silver, equities, bonds, and then cash, in that order which is why a properly diversified portfolio is so important.