Apartment Prices Ready To Collapse

Last week I was watching CNBC interview Richard LeFrak, one of the largest holders of apartment buildings in the United States.  He shocked me when he casually mentioned that investors are now paying equal or greater prices for apartment buildings as they were during the peak of the bubble in 2007.

He then said it was an excellent time to invest due to strong fundamentals.  In 2009 and 2010, when prices were significantly lower, he was on CNBC saying that he was on the sidelines.  What could have changed?

GlobeSt.com, one of the major publications for commercial real estate news, released an article today titled "Survey: Apartment Cap Rates Get Lower".

They go on to say that investors are now paying 4% cap rates and lower for properties in major cities and there is a bidding war for these properties.  From the article:

“There’s so much capital chasing too few deals—we call it “homeless capital,” said Bill Montgomery, President, Acquisitions & Investment, Sares-Regis. “REITs have been buying all the core properties and pension funds have had a hard time competing. We’re seeing money flowing into value add and development projects.”

To quickly review, a cap rate is the return on investment an investor pays for purchasing a property.  If the property was purchased for $1 million and the annual income (after operating expenses are paid - not including financing costs such as the monthly mortgage) was $100,000, then the cap rate is 10%. 

$100,000 / $1,000,000 = 10%

A investor's decision on the return he needs to purchase a property is weighed against the return he could receive by purchasing a competing asset (the opportunity cost).  A 10 year government bond today pays only 1.97% pushing investors further out the risk curve in order to obtain yield just as they did in 2005 - 2008 leading into the financial crisis.

More from the article:

While development isn't coming back in a lot of real estate sectors, it is happening in multifamily, Montgomery contends. But that comes with increased costs. About 63% of respondents say construction costs increased by 5% over the last year.

However, that bet might be worth it, according to Tom Toomey, President and CEO of UDR, Inc. “We expect to see six million new renters over the next three or four year period," he said. "So why wouldn’t you want to invest more, build more, redevelop more—just seems like a great time and the numbers are stacked up in our favor.”

Let's look at a broad, easy, "answer" to this six million renter shortfall:

In the third quarter there were 6.1 million empty homes that were for sale or rent, according to the Census Bureau, or 4.6% of all U.S. homes.

If you were a renter, would you rather live in a small apartment with neighbors on every wall or would you rather live in a large home?

The reason this inventory is not being soaked up by new renters is because it is being held off the market by banks as shadow inventory.  This is creating the mis-perception by developers that there is a shortage of inventory.

Let's look at a specific, real life example to illustrate this point.  I live in downtown Charlotte, NC.  The downtown area is small relative to the rest of Charlotte, and it is surrounded by a highway called 277.

Rents in this 277 ring have risen steadily over the last two years with high rental demand and low inventory available.  The largest condo high rise in the city was completed in 2010 with luxurious new finishes and incredible amenities.  Why does this matter if the units are currently for sale and not for rent?

The building now sits almost completely vacant. 

The developer is in a battle with owners who signed contracts and refuse to close, and he refuses to drop prices.  This is shadow inventory in downtown Charlotte.  If the market continues to fall he may relent and give the property to the bank.  The bank could then sell the property to an investor who could turn it into a rental property flooding the city with new apartments. (This has already happened in other buildings)

This covers the development portion of the apartment mania, but what about the cap rates?  What about the prices investors are paying for existing buildings?

I have covered this topic more extensively in the past but I will review it again briefly.

When our treasury bond (government debt) bubble begins to deflate interest rates will rise.  Interest rates on a 10 year treasury bond may cross above 4.....6......8......% and maybe keep rising (think Greece, Portugal, Ireland, Spain, Italy, and soon Japan, the UK, and the United States)

An investor will have the ability to decide on a risk free government return at 8% (or higher) or a risky asset such as an apartment building at 4%.  Cap rates on apartments will rise in tandem with government bonds creating a collapse in prices on these buildings. 

In addition, the great majority of the apartments today are being financed through Fannie Mae and Freddie Mac; the American tax payer. This will end when Americans realize that they have all the real estate they need with the shadow inventory.

Investors purchasing today will face significant losses, unable to see the future atmosphere of interest rate pricing.  This will provide an extremely attractive entry point for investors who have capital (and courage) to make purchases.