I recently met with an acquaintance who owns thousands of doors across the United States. As we were chatting, he told me that he recently sold a property at $3 million above what they thought they would get for the property. Yes, $3 million. l couldn't imagine who would overpay so much, especially in a mature market.
Investors who have worked with me know how conservative I am when it comes to my willingness to pay for multifamily properties. While other syndicators have no qualms about overbidding on properties and don’t give a second thought to paying above the asking price in order to “win” the bidding war, I stick strictly to the numbers. I’m looking for a minimum 7% cash-on-cash return. If the numbers don’t meet my criteria, I simply walk away and look for other opportunities.
Most investors forget that you make money when you buy, not when you sell. So the key is to buy right, which means never overbidding on a property.
What Is Overbidding?
Overbidding is the opposite of being a conservative investor. It happens when you buy above the market rate, compared to similar properties in the same general area. Another telltale sign of overbidding is when you purchase a property at a higher cap rate than market cap rates.
Capitalization rates (which are calculated as net operating income divided by purchase price) show what your return would be if you paid cash for the property. The lower the cap rate, the higher the price you’ll pay for the property. Higher cap rates usually lead to higher returns, but a cap rate that is too high can be an indicator of risk in the investment. The national cap rate for multifamily is 5%.
Here’s something to think about: You may be overbidding on a property if you ignore signs that you should be more cautious in your investment approach. This can happen when an investor is new and inexperienced, and only sees the upside to a real estate deal while ignoring inherent risks.
A Closer Look At The Current Cycle
Has the multifamily cycle peaked? Some experts think it has. But there is still a strong demand for multifamily properties, along with a shortage of quality properties available for purchase. The factors that pushed multifamily property prices higher and caused investors to start overbidding are still in place. These factors include more retiring baby boomers electing to rent rather than purchase new homes, and millennials who are also choosing to rent rather than buy single-family homes.
So Why Do We Still Witness Overbidding?
Throughout my career in real estate, I’ve witnessed several key reasons why investors still overbid at this late stage of the cycle. Foreign investors are still bidding on U.S. properties, which is helping to drive up the price on multifamily properties, as well as contribute to overbidding. For foreign investors, making 3% cash-on-cash is better than 0.5% in their home countries. Institutional investors are also driving up prices by purchasing properties at higher prices, not only in the primary markets that they’re used to, like New York, Los Angeles and Chicago, but in secondary markets as well. They mainly make money on fees, and they have the power to lower their investors' expectations when it comes to returns. Hence, they are able to overbid.
Interest rates are at historic lows, which makes financing more attractive, and that fact allows investors to offer higher prices. In addition, novice investors are overbidding simply because they want to own real estate, and they are willing to do whatever it takes to acquire properties.
Another factor driving prices is the 1031 exchange. This tax-deferred exchange permits a seller to trade their asset for a similar one and defer their capital gains tax until the sale of the next asset — or even further down the line. So sellers are under pressure to acquire new properties and will do whatever is necessary to buy one, including overbidding, so they won’t have to pay high tax on capital gains.
Lastly, many investors are overly optimistic, thinking that higher rent premiums will help to justify the price they’re willing to pay for the property. That’s simply not the case. Many investors and apartment owners will attest to the fact that when rents are raised beyond the market average, tenants will elect to move.
Investing in a multifamily property is a major step, and now is a good time to exercise caution when purchasing real estate. The numbers have to support the purchase price and show solid returns. Many times, foreign, institutional and novice investors overpay for properties. Investors who need to deploy capital via a 1031 exchange and overly optimistic investors choose to overpay frequently. Staying disciplined is extremely important, especially at this late stage of the real estate cycle.
Written By: Ellie Perlman for Forbes