Altus Insight - July, 2014
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: July 31, 2014
FR: Forrest Jinks
RE: Where do we go to make a dollar?
Before jumping into the content of this month’s article it is worth mentioning that our raise for the commercial building in Rohnert Park is going well although we do still have a few units available. If you have not yet received information regarding this opportunity but would like to, please contact our office and we can supply you with the details.
Also, Altus is in the news again, this time with our Head of Operations, Kristy Brooks being interviewed on radio station WVVY in the greater Boston area regarding single family investing, an area of which Altus has built a substantial database of knowledge over the years.
This month’s article focuses on real world situations that Altus is experiencing right now and will illuminate why we are becoming more conservative in our approach, more thorough in our due diligence, exercising more patience, and devoting more time to developing our off market relationships. Hopefully the lessons learned from our feet on the street can be a help in your investment decisions.
Yields, yields…Wherefore hast thou gone? With the introduction of quantitative easing, and in conjunction with the shrinking of the economy in 2008, bond yields plummeted, even reaching the point briefly where investors were paying to own certain sovereign bonds. The Fed has indicated this was their goal as lower yields (and thus higher prices since yields and prices move in opposition for income producing assets) would result in investors searching for other areas of the economy where they could invest their money and improve their returns. Cynics and critics agreed with the effect of the increased liquidity but bemoaned its use since they believed it would create a misallocation of resources and lead quickly to another bubble, an idea minimalized by the Fed and the Fed policy supporters.
Following the crash of bond yields the stock market soon started its rise as many investors fled bonds into stocks with the hope of higher returns. However, for several years, there was little carryover effect into other investment classes or business creation, at least for the average investor and entrepreneur. Investment real estate, another large sector of yield producing investments, was hardly affected and may have even initially lost ground. In 2012 and into last year that seemed to slowly start to turn around to the point where the real estate markets are now awash in a sea of liquidity and it now seems that a frenzy has possessed certain markets, with other markets, including normally staid and stable Midwest markets, seeing price increases previously unheard of.
Because most real estate data trails the market we often use our experiences, observations, and the observations of others within the industry as a real time proxy as to the direction and speed of particular markets. With time and measurement against the trailing statistics when they do arrive we are able to determine the accuracy of our experience. Generally speaking, and with an admitted bias towards conservatism, we are pretty accurate in our synopsis. What we are seeing now is frankly astounding, as the following real life examples shows:
- Altus purchased an 18,000 sq ft office building late December of 2013. The building’s tenant had an expiring lease so we were able to negotiate a fantastic purchase price with a back end estimated market valuation with the lease situation resolved at a 7.5 – 8% cap rate (cap rate is the ratio of the operating income divided by the price…the measurement of yield if the investment is non-levered), with the 7.5% cap rate putting us at the top of the market. Within 3 months of our purchase we had an unsolicited offer at a price that calculated to below a 7% cap, with additional inquiries and non-solicited offers submitted. For those following the math at home, the difference between an 8% cap rate and a 7% cap rate is an over 14% increase in price. And remember, this change occurred in 3 months.
- In March our Multi Tenant Income Fund had a multi unit property in contract in Calistoga, CA that was older and needed some updating and was advertised by the listing agent as being a 7% cap rate based on the advertised purchase price and the actual performance of the property. In our due diligence we discovered that the true property performance numbers differed greatly from what the agent was advertising resulting in the real income based on the listed purchase price being closer to a 4% cap rate, or a reduction in income of 43%. Since we had no desire to own this quality of property at such a reduced income stream we cancelled our contract. The listing agent, despite now having corrected and verified numbers provided by the seller showing his listing was wrong, never changed his listing information and a few days later had an all cash buyer come along and buy the property without verifying the numbers only a few days later.
- In June we had a similar situation happen on a multifamily property we had in contract in Brentwood, CA except that in this situation we felt the agent knew the numbers were incorrect. After discovering error after error in the reported numbers we had a conference call with the seller’s agent to discuss the discrepancies. While thorough in our due diligence, the questions we ask and the items we verify in each purchase are pretty standard for most experienced investors, and yet, at one point on that call the seller’s agent angrily stated that, “I have 10 properties in escrow to sell right now and no one does this sort of due diligence, NO ONE!”
- We looked at a property in the small farming town of Hamilton City, CA, population 1,759. It is a decently run property with a decent set of financials, although there was no inclusion of property management expense in their income statement since they did the property management themselves. The property was listed at what I thought to be an absurdly high price resulting in a reported cap rate of 7.25%. We told the agent that we weren’t interested because we thought the price was far to high for a decent property in a tiny town, to small to even have a local bank, and no other source of tenants. The agent made sure to call me back three weeks later when the property officially closed at the asking price, all cash (closed!, not in contract, closed!).
My list can go on and on…cap rates in Omaha, Nebraska around 6% on B level multi family, when in the last run up they barely got below 8%. Cap rates in Oklahoma City and Tulsa in the 8. 5% range when they were close to 10% only 6 months ago. Four…Five…Six Million dollar apartment complexes in Sacramento going out around 6% cap rate (7 – 7.5% six months ago) with multiple offers being made with 14 day inspections, 30 – 45 day closes and no loan contingencies. I can see making such an offer on a severely mispriced asset, but to be willing to research a $6 mil asset of hundreds of units and hundreds of thousand square feet, leases, contracts, etc. and then pledge a couple hundred thousand dollars on the hope that the financing will come through for a purchase to be completed two weeks later, all for a (hopefully) market rate purchase? To me this reeks of a desperation that I never want to have when I am making any sort of decision, let alone one involving millions of dollars of investment.
The juxtaposition of the situation is that from a historical basis the yield spreads between the market cap rates and the corollary interest rates in most markets are not out of line. A 6.5% cap rate on a purchase that can be financed with debt at 4% interest results in compensation for the borrower of 2.5% on the money borrowed, not at all unreasonable for most California markets (although not a spread I would be happy with in Hamilton City). Many markets outside of California have higher cost debt but also have greater overall spreads. Additionally, the general lack of construction over the past several years has created a situation of increased demand for space. This is especially true regarding multi-family properties because demographic and economic trends point to an increased demand for such units in the years ahead even while construction of such units in many markets is trailing even the current growth rates.
I like apartments and industrial, and in many cases retail and office, and I think people that actually buy properties at the cap rates they are being told they are buying will most likely do fine. But what about the person who thinks they are buying a 7% income stream on money borrowed at 5% when they really purchased a 5% income stream on money borrowed at 5%? So long as the debt is being covered, and maybe even a little distance into the red, those buyers will continue to pay the debt payments and skimp on property repairs and improvements. It is better to limp along than admit to the world a serious mistake was made on an investment.
The elephant in the room is the possibility of interest rate increases. Rate locks longer than 5 years have become harder and harder to obtain with many people opting into even cheaper 3 year or 1 year money. If interest rates rise (and at some point in the future they will, we just don’t know when), those properties will then be solidly in the red.
I can see a divergence happening in the market place where well purchased and maintained properties continue to be priced and traded at competitive historical yield spreads but there is a sizable increase in distressed apartment sales and apartment foreclosures. Without the silly money to overpay for these properties there will be great opportunity for redevelopers to take on these projects and earn fair economic profits for their labors.
Because at the true market cap rate these purchases still make sense, there is no reason to expect that the direction or rate that yields are moving will change any time soon. At Altus this means we become more conservative in our approach and more thorough in our due diligence. It means that we double down on our off market relationships and focus on being patient while we wait for that network to produce us with solid opportunities (we are scheduled to close on over $5 mil in non listed property purchases in August). It also means we continue to look for niches missed or not understood by the general investing public that can provide better risk adjusted returns than the more in vogue investments. We are currently working on the purchase with NNN leaseback of a large ag. property (although raising money for this opportunity has been challenging) and actively researching certain types of oil drilling (shallow well) that has far less risk of loss but still can produce attractive returns. We will share more information on our findings as they become available.
Altus Equity Group, LP