This article first appeared on BiggerPockets.com on 11/17/2019
Do you hear yelling?
The market is too hot. Oh, no! We are at the top. Oh, no!
It’s a bubble. Too late to buy. It’s a bubble. Oh, nooooo! Best to wait for the crash…
A few years ago these same voices were yelling:
There is no money. Oh, no! No one is lending. Oh, no!
So many good deals, but I can’t get any money. Oh, nooooo! I’ll wait for the market to improve…
Maybe some people are better at yelling than buying, or maybe they just like the sound of their own voice. Or maybe they’ve always known that they lack the intestinal fortitude to act, and all of the above simply make them feel as though they are participants in the marketplace while in reality, they are constantly looking for excuses to stay on the sidelines.
Whatever the reason, the market is never good enough for some.
The thing is, however, those of us who wanted to buy in 2009 found a way to buy, and those who want to buy in 2019 find a way to buy in 2019.
There Is an Obvious Caveat
If no one wants to lend, what kind of deal does it take to attract money? A really freaking good deal.
If the market is hot, what kind of deal should you buy? A really freaking good one!
So, you see, the rules have never really changed. All along, what it takes to play the game is a much better than average deal—the rest of the pieces fall into place. So, perhaps, the loud voices are simply indicative of folks not having enough chutzpah to source a good enough deal.
I Was One of the Naysayers
For a long time, it was truly difficult for me to wrap my head around the pricing. I was in Ohio at the time, but seeing people deploy at a 7 percent cap rate gave me nightmares. I thought they were stupid.
And then they weren’t stupid. All through 2013, 2014, 2015, 2016, etc., people made a killing.
I like to think of myself as a reasonable person. At some point, seeing the reality on the ground, I realized I was missing something.
So, What Changed My Mind?
Well, for one thing, I relocated from Ohio to Arizona. You’d be amazed how this changed my perspective. Seeing the way things are in the Southwest—the jobs, the infrastructure, the population growth—had an effect. I understood why so many people were so bullish on America, and I understood how that thinking impacted their investment decisions!
Additionally, once I removed myself from the Midwest, I was able to draw parallels, which brought things into focus for me even more. The fact that brokers were telling me that product is moving in Cincinnati, Ohio, at a 5.5 percent cap rate with virtually no value add still amazes me—Cincinnati is a nice town, but it ain’t no Phoenix for many reasons. That kind of thing really makes you think.
That said, I can very happily look at the right kind of 5 percent cap rate and sleep extremely well at night. In fact, a 98-unit we bought about a year ago on in-place financials was indeed a 5 percent cap rate (on a good month).
S0, where am I getting the peace to deploy millions of partner capital at 5 percent cap rate?
1. It’s in a serious growth market.
Phoenix MSA has been one of the top growth markets in the country for the last few years, and it’s the fifth largest city now. Maricopa County is the number one fastest growing county in the country for several years now. Finally, the asset is in the path of serious gentrification and capital improvements.
I wouldn’t do it in the Midwest. I will in Phoenix.
2. It’s value-add.
An important distinction here is that we are not coupon investors—we never, ever buy turnkey. Therefore, we are less concerned with the in-place cap rate and much more concerned with the cap rate after the re-positioning.
3. Market rents are too low.
This is where the benefit of recent exposure to various markets comes into play. According to people who research this stuff, the national average apartment rent in the U.S. was over $1,471 in 2019. In Phoenix, it was under $1,100.
So you ask: Why are people paying more to live in Ohio than they are in Arizona? And is this trend sustainable, considering Phoenix population is growing while the Midwest is not?
Under these circumstances, even just reaching the national average constitutes a 25 percent improvement to the top line, all of which flows through to the NOI. What is currently a 5 percent cap rate becomes a 6.25 percent cap rate just by reaching the national average on rents.
The question becomes: Is it reasonable to believe that Phoenix is capable of reaching the national averages as it relates to rents? A different way of asking this question could be: If you had to pay $1,300 for rent in Cincinnati or Phoenix, which would you choose?
If you don’t say Phoenix, I’ve got nothing more to say to you.
Well, anyhow, while some may disagree, more agree, which is why our population growth is what it is.
4. But seriously, it’s value-add.
Superimpose on top of the previous paragraphs a 25 percent value-add program, and you go from a 5 percent cap rate in Y1 to a 8.3 percent cap rate in Y3.
That delta is where we make money, ladies and gents. Because even after we inflate cap rates in the future, which we should do, there is still enough meat on the bone for yours truly to sleep well at night.
5. The market will never again be where it was.
Well, I don’t know much, but I do know this: While 2009 through 2013 were fabulous, we are not going to see that type of an environment again in our lifetimes. It took me a couple of years to realize this, but I firmly believe it—waiting for the return of that pricing is futile.
One Last Thing
Let’s say you are not convinced. Let’s say you’ve decided that the market is too high and you need to sit out, wait for a correction, and step into the game once prices come down.
Who is going to let you in that game?
Brokers representing sellers who need to get out in a recessionary environment will call those buyers who have a track record of closing deals. That’s not you—you haven’t been closing.
I realized this in about 2015. Prior to that, the last deal I bought was in 2013, and back then I already thought the prices seemed too high.
So, I sat on the sidelines. And then I realized, if I stay on the sidelines until the next recession, I may not be able to find my way back into the game. Which meant I needed to sharpen the sword!
Fundamentally, here are the bullet points:
- I am bullish on America, specifically the Southwest!
- I want to be ready to deploy big when the recession does happen, and it will happen. That means I have to be a buyer today!
- Deals that are worth doing have always been better than average deals. Sharpen your sword! You can still find deals.
- Some markets are better than others.
So you have any thoughts? Let me know below