The Downsides of an Upmarket

Or why a winning market can be a losing proposition.

Bloomberg Businessweek’s latest issue (Oct 28th) has a very interesting national map of average home price, by county, compared to median income around the country. Noting in the opening “Home prices in the US are up 25% in five years, according to the S&P CoreLogic Case-Shiller index”. It also details which states have the ability to implement rent control and details on a few cities that have already implemented rent control. This brought up for me all the issues that arise as a market heats up. Those things that make it harder to buy and sell and less attractive to be in the countries hottest markets.

Keeping it ‘Affordable’

From a tenants perspective rent control seems rather like a nice idea. Limiting the increases in rents can help keep the cost of living more in line with incomes in expensive communities. From the investment perspective rent control can have a chilling effect on investment and development.

Consider that the value of investment multifamily is directly linked to the income generated from the property and in rent controlled cities the municipality is saying “you cannot raise the rent”. The byproduct of which, in theory, is to keep a lid on the valuations of those same properties. Another stark result of rent control is the chilling effect on investment and development of new multifamily properties. This type of economic subsidy has the perverse effect of keeping housing stock low and thus rents high. It also reduces the number of investors willing to consider acquiring an asset in a rent controlled city thus reducing the market demand for these assets.

“Sure I’ll Sell my Property…”

Another, more hidden, issue that arises in hot markets is that there just isn’t much that is available to buy. When markets heat up, prices go up and as owners we all enjoy that, but the availability of properties goes down. Towards the peak of hot markets it can be hard to find anything even listed for sale. This has a chilling effect on the volume of transactions.

Keep in mind that the system of commercial real estate ownership is structured in such a way that once you have equity in a property and decide to sell you are going to want to exchange your equity from that initial property into another, via the 1031 exchange process, to avoid taxes. This, by its very nature, requires you to exchange into a more expensive property, which when the market has ample options can look like a good idea. You can trade up to a larger, better cash flowing property.

The difficulty arises when the market has few options that merit consideration. This then puts the brakes on an owners willingness to sell as they are aware that finding replacement properties is unlikely. This can, in time, cause a slowdown in the market as exchange buyers are sidelined, leaving only those cash rich buyers able to participate.

This kind of market necessarily benefits the likes of private equity investors who are not tied to disposition in order to purchase. This change in the makeup of the buyers can also push pricing well out of reach of local investors. A well capitalized private equity fund that is looking to buy up nice assets will, undoubtedly, have a wider price target and deeper pockets than just about any local buyer. This pushes prices up even further and keeps local buyers waiting for a correction. A natural part of the cycle but not a fun one if you are looking to sell your 5,000sf strip mall and buy into a 10,000sf one.

This is a very insidious side effect that is currently taking shape in many western markets (CO; UT; etc) and has already affected nearly $20m in transactions for me personally. I can only imagine the ripple effect. Factoring that my deals would have yielded four direct transactions and likely at least that many again for those buyers and sellers on the other side of these deals. I know that at least one of the buyers was an exchange out of another sale where their buyer was an exchange buyer. It’s easy to get lost in a weird mirror world with a long chain of contingent exchange deals.

Keep in mind that on a macro level this is just money moving around and none of it is new money coming into the market. An economist likely would say this is an indicator of some type. I would simply speculate that it is another indicator of markets that have peaked.

The silver lining to this, at least initially, is that smaller buyers are forced into considering less than desirable assets and how they can be upgraded to increase their value. Included in this effort is the repositioning of dated office buildings and old industrial sites into residential, which from a city’s perspective is a boon.

Aesthetically Challenged

Hot markets also have an effect on the buildings being developed. As prices rise they’re not usually uniform, meaning ground prices can rise faster than finished buildings. This discord (along with labor and materials costs) can have a rather ‘ugly’ effect on development.

Look closely at any hot market and you will see the phenomenon of newer buildings using every last square foot allowed by code as leasable / saleable space. This happens in response to high ground prices in relation to the finished market price for a given space. We can call it ‘squeezing’, since the developer is trying to ‘squeeze’ every last dime out of a building site. This type of building has the serious side effect of creating large and architecturally repulsive boxes. Places that have maximal saleable space and minimal aesthetic value.

The precedent set by these projects can have long lasting effects on a city as well since these buildings contribute to the overall feel and sense of place created in a city. Canyons of crappy boxes do not make a place anyone wants to spend much time.

And Then What…

What is being seen in many of the markets that have experienced incredible price growth in the past decade (San Francisco; SLC; NYC; Boulder; Denver; etc) is a strange decoupling of the financial preconceptions underpinning commercial real estate as an investment.

There is a point, financially, where an investment doesn’t make sense. Typically each individual investor determines their desired return and focuses on securing assets that deliver that return. In hot markets the prices are shoved upwards and it is not unusual to see capitalization rates of 3% and lower. I have worked on a number of deals where the actual cap rate was negative. Meaning it was going to cost the buyer money every month to acquire the property. So why would an investor buy such an asset?

In short, these investors want into a market so badly that they decide that other factors are of greater importance than the property acting as a cash flowing asset. There can be outsized appreciation in a particular market that, when considered over the holding period of a property, can offset a lack of cash flow. For instance if a market is blasting along and producing 10%+ appreciation year over year and the property is only producing 1% cash flow, an investor can justify it saying they’ll get they’re value at sale. If rents are rising at a similar clip a buyer can bet on the future cash flow. It is a bet and is very reliant upon an investors time horizon.

There are also those individuals and companies who are no longer looking at commercial property as an investment but are looking for a trophy. Every city has these buyers / owners and they typically retain the most visible properties in a given market. They do not care much what the cash flow is or will be. They want to be able to say to people: “That is my building”. These buyers can make a mess of markets when the proportion of them becomes dominant. Because they are not tied to economic drivers in pricing their buildings they will typically trade at prices where there is zero investment value for a buyer. From one ego to another.

Who is Actually Making Money Then:

Value-add investors are the ones making money in these markets. Those with creativity, backing and a taste for risk who are able to consider what a particular property could be and then make it happen. The most successful of these are developers with a strong financial grounding. The margins are very thin and these types are able to carve out profits in places the typical investor doesn’t even look. Can there be another two stories of residential added to a particular building; can you take an old transfer building and make it into a food hall. These are the types of value add that are yielding returns.

Not a path for the faint of heart as investors of this ilk are able to buy properties at market prices and add enough value that when they sell they make a healthy return. If they bet wrong they’re likely filing for bankruptcy as the numbers are substantial and the pressure intense.

Hot or Not

Hot markets can be great for making money, if you’re in the right place with the right tools at the right time. They can also be infuriating when things do not work. Understanding that, just because a part of a market is rocketing along doesn’t mean you’ll be able to grab a piece of it is critical. You will miss more waves than you ever catch.


Wise Acreage

Short Advice on Real Estate and Life

Cash is King

If you want to know your worth in this world make a list of the people who will starve when you dieAnonymous

All human knowledge is uncertain, inexact and partial.Bertrand Russell

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Always take the high road. It’s far less crowded.Warren Buffett