Tuesday, January 18, 2011

Multi-Family Euphoria Is Back

I was churning through the headlines this morning on Globe St.com which reports on commercial real estate activity across the country. 

I noticed a sale this week for an apartment community in Santa Monica, CA that was sold at a cap rate under 4%.

A cap rate means the return an investor is willing to receive to purchase the property.  If a building has an annual net operating income of $40,000, an investor who wants a 4% return (cap rate) would pay $1,000,000 for the property.

The current interest rate on a 30 year treasury bond is 4.56%.  That means that an investor who buys $1,000,000 of 30 year treasury bonds will receive $45,600 a year in interest payments.  At the end of 30 years they will get their $1,000,000 back from the government.

There are risks involved with purchasing an apartment.  Tenants could lose their job and stop paying, someone could fall and sue the building owner, an apartment could flood or catch on fire, or a water main could break bringing an unexpected cost. 

A treasury bond is considered a risk free investment.  An investor is paid every month by the federal government.

The argument against treasury bonds being risk free is that interest rates could rise or inflation could eat away at the value of your bonds.  An apartment owner can raise rents to counter inflation.

This is true.  However, in inflationary times expenses such as heating, cooling, insurance, taxes, and salaries have an impact on the expense column of apartment owners.  Will rents rise at a faster rate to offset rising costs?  Maybe.

What does this mean?

It means investors today are paying non-sensible prices for multi-family properties.  In many areas across the country investors are paying at cap rates in the low 5's. 

As our economy rolls back over and interest rates begin to rise during the next leg down of our current depression, investors buying at these ridiculous prices will be slaughtered once again across the board.

(I believe that 30 year treasury bonds at 4.56% and an apartment building return at 5% are both terrible investments.  I am just trying to show the overvaluation of apartments for the purpose of this discussion.)

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