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"The pessimist complains about the wind; the optimist expects it to change, the realist adjusts the sails."
The Golden Opportunity in Multifamily: Condominium De-Conversions
The current multifamily landscape has changed drastically over the past 12 months. Value-add opportunities have become extremely difficult to acquire as the inventory has been picked over, and sellers have unrealistic expectations because of the supply and demand dynamics of the market.
Additionally, with cranes covering the city as developers are keen to cash in on burgeoning demand for luxury rentals, the market has begun to push back on pricing as the supply increase is beginning to outpace demand from tenants. This increased supply did not flatlined rents in 2015; they continued to grow at 5%+ while wages have grown a meager 2.1%.
As renters face a greater allocation of wages to their cost of living, the homeownership rate continues to dwindle as renters cannot save for down payments and home prices continue to climb (up 9% year-over-year) and builders face headwinds to build entry level product (existing home inventory is down almost 6% since June 2015). These two datapoint alone explain the chart below which shows the homeownership rate in the U.S at 62.9%, the lowest level since 1965.
All this is slowly changing; the July 2016 National Multifamily Housing Council's (NMHC) survey on the apartment market noted a continued loosening in the apartment market mainly in the upscale rental market. Mark Obrinsky of NHMC noted, "Given that most new supply is Class A, we're not seeing the same shift in supply-demand fundamentals in Class B & C apartments." In other words, the high-end market is beginning to cap off. The chart below is a measure of apartment market tightness. While the index is loosening, it's not indicative of Class B & C as most of the developments we've witnessed in the past five years have been geared towards the upscale market.
While many are screaming the multifamily market is overdone; they are far from correct. There is an opportunity to uncover. Since 2014, ROC Realty Group has been dealing with condominium de-conversions. The idea is quite simple; identify buildings which are better suited as apartments than as condominiums as most buyers prefer fully renovated or brand new units for their personal residence purchase.
Condominium de-conversions allow an investor to purchase all of the units within the building below new construction/replacement cost and cater to the Class B rental market. This submarket continues to see record low vacancy rates which means there is a high demand for the product and rents are able to be increased (unlike Class A which is seeing the opposite happen).
With financing remaining extremely attractive, bridge loans providing investors with the capability to take on such projects, and lenders being much more comfortable providing loans on apartment buildings which aren't setting market records with rents, condominium de-conversions will be the topic of conversation closing out 2016 and heading into 2017.
What Does a Rate Hike Mean for You?
Over the course of the past year, the labor market has vastly improved. Some will argue about the quality of labor gains and stagnant wages, however, we urge everyone to look at the bigger picture. February’s Jobs report came in at yet another robust figure: 295,000 new jobs. Wage growth came in at 0.1% after January’s 0.5% (2% overall since this time last year),
The market as a whole is beginning to get an inkling of when a rate rise will occur; the line is drawn between June or September. So what does this mean for the investment real estate market? To answer that, we have to look at three major factors:
- Oil prices
- U.S. labor market
- Global yields
1. . The Feds want to see inflation tick up to their 2% target before they raise rates, however, because of supply and demand fundamentals, oil prices have put a damper on inflation. January's Consumer Price Index (a measure of inflation) came in at -0.1% (predominantly because of a 18% drop in the gasoline index), and CPI minus food & energy rose 0.2% Additionally, there aren't any big signs of oil prices moving up noticeably; 2015 inventories are almost at 400M barrels. To put this in perspective, storage capacity is becoming a concern and oil producers have to finish current projects meaning there isn't a stop in the short term.
2. The US economy has averaged 288,000 new jobs for each of the past three months
February Job creations per sector came in as follows:
Leisure & Hospitality-59,000 (24,000 over the average for the past year)
Professional & Business Services- 51,000
Transportation & Warehousing- 19,000 (5,000 over the average for the past year)
Petroleum & Coal- (-6,000)
The U.S. economy is moving in the right direction; wage growth is still low, around 2%, but with large firms like Walmart and Gap beginning to raise wages, the need for skilled workers increasing, and organizations beginning to understand the benefits of paying employees more vs. cost of retraining, wages will start to slowly perk up. Economics professor, at Dartmouth University, David Blanchflower a sheds some light on the movement, “It's hard to see, on a general basis, that this is from a lack of people. But let's say it costs you two days to train people and they stay for six weeks. If they stay for 12 weeks, you’ve halved the cost of training.”
The chart below from the New York Times gives a snapshot of the overall labor market.
3. Concerns over global growth and deflation have led many investors to be wary of the big picture in the near term. China, which cut its growth rate to 7% for 2015, has used rate cuts to stimulate their economy. There are rumors of further rate cuts in the future & potentially QE. Additionally, January saw a net outflow of capital. This reflects a decline in confidence about the growth prospects of investments in China. This outflow of capital from Chinese investors has and will continue to flow into the US and other parts of the world.
In Europe and Japan, yields are still hanging around 0.35% or lower, and will most likely continue to do so for quite some time. The picture in Europe is showing signs of getting better, but it's too soon to tell.
Lastly, institutions continue to pile into bond ETFs; from January 1st through the end of February, Bloomberg LP stated Bond ETFs took in $32B globally, the strongest start since 2002. As rates around the world remain low, investors are struggling to find yield; hence, we have inflows into bond ETFs that defy history. Combine this with an aging global population who seek steady returns, and you have a ideal formula for yields staying low based on supply & demand.
If we put together these pieces, yes, U.S. yields will rise in 2015 as the Fed raises rates by 25-50 basis points, but there should be a ceiling on the upward trajectory based on supply/demand fundamentals, positive U.S growth, and deflationary pressures from abroad. This means that cap rates in Chicago will continue to hover near their current levels; some markets will push slightly lower based on changing demographics and neighborhood fundamentals. Lastly, we continue to see properly priced assets going under contract within a week of being brought out to the market. We believe this trend will continue into 2015 as we hit the spring market.
There you have it, a rate rise is coming, but rates will still remain historically low, and no, the world of investment real estate won't come to an end because of it. Cap rates will stay at or near current levels because buyers will continue to provide demand to the new supply which enters the marketplace.
Reality Check for Real Estate investors
Once a week we have had the following conversation with potential investors:
Client - "I want a 7 cap and a 10-12% cash-on-cash return."
Us - "That's fair; I know of a few that we've personally visited already in area X, Y, Z."
(upon hearing the words Albany Park, Uptown, Rogers Park, Bronzeville..etc)
Client - "Oh I have to be in Lakeview, Bucktown, Lincoln Park, or Wicker Park."
100% of the time, we'll spend 15 minutes explaining to them the dynamics of the market, how the interest rates are playing a role, how the global economy is playing a role and where Chicago is shifting towards. Only to have them say that they had a buddy who bought a 6-unit a couple years ago for X and its generating him or her 15% annually. We try not to laugh and simply respond "ok we can take a look & let you know if something comes up."
What we really wanted to say is, "You didn't buy when everything was cheap because of fear, and now that smart money has bought, you want to play in the sandbox. Unfortunately, the sandbox is crowded, we have to find you a new one."
Chicago investors are not seeing the larger picture; foreign investment. In the past 3 years we have seen a dramatic shift in foreign purchases of US real estate. This shift has migrated to Chicago as the more attractive deals in New York, LA, and Miami look less attractive on a 5 year hold. Foreign investments generally make up about 1/6 of prime NYC condo purchases. These days that number is closer to 35%. Additionally, the chart below says a hell of a lot about foreign money.
Without going into a whole rant about global central bank stimulus, the world economy, and how that is playing a role in Chicago's real estate market, we will simply say this: Foreign investors will continue to invest in quality investment real estate in premier locations (city & suburban).
If you continue to search for higher yields, you'll have to explore markets outside of Chicago's hot spots (West Loop, River North, Bucktown, etc): see where populations are growing, study up on schools, watch the retail district, look at public transportation, watch road construction, watch the bond market, the ECB, PBOC, and the BOJ. (Or you call us).
There's still value to be found & great deals to be found, however, it's going to require work.
Buy the equivalent of a Class A building in neighborhoods outside of the it-girls "River North, West Loop, Lincoln Park & Lakeview."
Investing is about diversity; if you want to be ultra conservative, that's okay as everyone's level of comfort is different. However, in this market, you simply cannot complain about your returns if you don't extend your comfort level.
As we tell every client when we first meet, "No matter if you're black, white, rich, poor, gay, straight, married, or single, everyone needs a place to live. How can we help you?"
There you have it, our year in review. Thank you for reading, sharing and interacting with us. We look forward to working with you in the new year.
Kevin Rocio & Chikoo Patel