103: 4 Apartment Investing Trends That Died in 2022
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If you’ve been listening to us for a while, you know we like to be trending. So guess what? Today we are going to tell you about some apartment investing trends that died in 2022 so that you can be the sassy, trendy investor that we know you are.
2022 has been a mixed bag for investors, we saw a lot of money lost in the Wall Street casino 🎰🎲♠️, we saw cash pouring into 🏢 multifamily apartments, and we saw many people rethinking how they approach their wealth creation.
And like most people, maybe you couldn’t help but ask yourself these two important questions 👉 how bad is it going to get and what can you do about it?
The reality is that inflation is still at a 40-year high, and interest rates are trending in a certain direction, which obviously affects the affordability of real estate across the board.
The cold, hard truth that we will always share with you is that inflation has actually been helping rich people by creating a divide – a wealth separator, those with hard assets have experienced appreciation and have seen their portfolios grow. 😔😔
If you are here, tuning in to us, then we can safely assume you love real estate, but TBH, real estate will never be the same again.
Now as we close out this topsy-turvy year, let’s bust out the obituary for 4 apartment investing trends that died in 2022.
Let’s get into it! 👇
Bridge Loans: New Kids on the Block
The first trend that died in 2022 is bridge loans. ☝️
Let’s take a step back and talk about what those are and where they came from. Bridge loans really entered the scene in a big way in early 2020. At the start of the COVID-19 pandemic, Freddie Mac and Fannie Mae, two quasi-government agencies that were the largest lenders to apartment investing, sort of had a PTSD moment.
Essentially, they froze up and stopped lending based on their previously prescribed underwriting criteria.
Having dropped off the face of the planet, loan-wise, a lot of private equity firms stepped in to fill the void. This ushered in the age of bridge loans.
Let’s first take a look at what a bridge loan is and why we say that it died in 2022. Essentially, commercial bridge loans provide short-term financing for those who wouldn’t otherwise qualify for additional loans for property rehabilitation. They are different from your standard financing because they are based on loan to cost ratio rather than loan to value ratio. 🤓🤓
You can read more about it in the article that we link in the show notes.
The funky thing is that bridge loans are typically structured as a three-year loan with the option to extend the loan an additional year twice, in other words, a 3-1-1 structure. Experienced general partners love bridge loans because bridge loans provide tremendous flexibility upon exit since they don’t have any yield maintenance or prepayment penalty tied to the early exit of the loan upon a property sale.
Yeah, and lenders who are on these loans also can be a little more flexible in their underwriting and typically rely on the stabilized income to size up the loan vs agency lenders focus more on going in income. This translates to higher loan proceeds and lower going-in interest rates.
But 🤚 keep in mind that with this flexibility also comes some volatility as bridge loans do not have a fixed interest rate; it’s a floating rate that is tied typically to an index like the SOFR 30 days average.
At the beginning of the pandemic, for example, a borrower will probably be paying around 3.10 to 3.50% in interest on interest-only payments which makes the cash flow position on apartment investments juiced up.
The problem lies in the volatility of the underlying index.
As inflation has risen, the Fed finally woke up to the fact that it’s not transitory, and their fund rate hikes have also caused the index rate to skyrocket. For some loans, this amount has literally jumped from 3.50 to 4, 5, or 6% depending on their rate cap, which is too detailed for us to go into right now.
For real, if someone today is crazy enough to get a bridge loan, they will see quotes with interest rates as high as 7.50% or more. This also comes attached with a requirement to purchase rate cap insurance which has 10 times the cost. If a rate cap cost $200,000 per year 12 months ago, today it will cost at least $2 million dollars and that will tank the cash flow of most deals. 👀
So this is why the bridge loan trend has died in 2022. So now you may be wondering well if bridge loans have died, what’s in? 🤔🤔
You don’t have to take a trip to Paris to know that fixed-rate loans are now en vogue again, specifically, the sub-set of it called loan assumptions. Loan assumptions simply allow the buyer to access the same low fixed rate that the buyer was able to lock in place before the shizz hit the fan in 2022 and interest rates soared.
It’s kind of like 🧙♂️ Dumbledore’s Time Turner which allows him to jump back in time. In the case of loans, jump back to the time pre-2022 when interest rates were at their all-time lows.
In volatile times, the most ideal scenario is for a buyer to be able to assume the seller’s fixed debt because this de-risks the investment. The major risk in real estate is short-term floating debt with no rate cap, which as it increases can severely impact the cash position of the property, potentially requiring a capital call to stay afloat. 🧐🧐
Sooooooo low interest fix debt de-risks the investment by eliminating the risk of increased mortgage payments. This means that as long as the asset is 💰 income-producing, there’s virtually zero risk of default. And we all know that real estate is a hard asset that in the right markets will always increase in value in the long run.
Buying a starter home may be more affordable than renting in some markets
Honestly tho, one trend that we never would have predicted would die in 2022 is starter home ownership. While we knew that the U.Ss was turning into a renter nation, we also all witnessed homes being snatched up in record time for the past several years.
This bums us out, but it died in 2022 because simply put the interest rate hike has essentially made it unaffordable for people to buy a starter home. This situation is more dire in gateway cities such as New York, Chicago, San Francisco, and Los Angeles where a “starter” home price starts around $1 million+ in reasonably desirable neighborhoods. 😌😌
As new household formation takes place, instead of purchasing their starter homes, these young people will have no choice but to rent and maybe even become life-long renters.
This sucks for them, but as apartment investors, this represents a major boom, because we know with 100% certainty that the product that we produce (apartment units) will continue to be in high demand for the foreseeable future. ✨
Even crazier than that, according to research done by the Urban Institute, household growth will weaken over the next couple of decades, falling for almost every age group, essentially creating a nation of renters. While this isn’t great news for the housing market, it means that apartment investing will continue to grow. Which we love, am I right?
Yeah, and if that’s not enough, according to the National Multifamily Housing Council, over the next 10-15 years or so, the U.S. will need to build an additional 4.3 million apartments in order to keep up with rising demand. In simple economics terms, these two colliding forces will continue to push rent higher and higher.
TKS continues to see strong rental rate growth in all the properties within our portfolio. For example, Reserve@2070, which is a property we’ve owned since November 8, 2021, has seen a 22% increase in rent and renewals.
It’s Still a Sellers’ Market
We swear we don’t hate trends – maybe just bell bottoms coming back. 😆😆
But the next trend that died in 2022 is the seller’s market. For the past 5 or 6 years, we kept hearing that it’s so hard to break into apartment investing and that property prices are through the roof. And it’s been true, apartment values have never been higher.
With that, the sellers were emboldened and definitely too advantageous and set very aggressive terms to their benefit, because they have a line of people looking to buy their apartments. Some of the terms were things such as a non-refundable earnest deposit within 3 days of the purchase and sales agreement signing, contracts with zero contingency, etc. 😧😧
So obviously you don’t need a degree from MIT to know that these terms are of course very favorable for the sellers, but they also transfer all the transactional risks to the buyers. If the buyer can’t close on the property even if it wasn’t their fault (i.e., the seller’s “cooked the books” and basically made up their financial reports), the buyers have zero recourse to try to recoup their EMD. And for deals that the Kitti Sisters buy, we are talking about 7 figures or so.
By the way, this doesn’t even include the legal, due diligence, and loan application costs which totals in the 6-figures range that also can’t be recouped.
Keep in mind that with the seller’s market also comes the expectation that offers submitted to sellers must be at or above the whisper price.
Most apartments that are listed in hot and highly desirable markets typically do not get listed with a price. Instead, the brokers will typically provide a “whisper price”, which is typically the lowest price a seller will be willing to offload their asset for.
This might have worked when it was the seller’s market and sellers were seeing people making offers way over their whisper price. But that’s not the case anymore. There are a few constraints that those buyers need to consider now. One is the availability of capital. 😨😨
Let’s face it, a lot of lenders expect a slowdown in the economy, they have either shut down completely or have become more conservative with their underwriting on what type of assets and at which leverage (or loan to cost) they are willing to lend. Offering pie-in-the-sky pricing and then hoping a lender will buy in probably won’t work today.
The other constraint is realistic passive investors’ returns.
Because general partners can no longer rely on the hot market to boost their passive investors’ returns, they need to be more conservative with their underwriting and make sure that they don’t overpay for the asset.
But all good things must come to an end, so as we say goodbye to the seller’s market, we also usher in a new buyer’s market reality. This reality consists of refundable earnest deposits, with contingencies built into the offer, such as loan contingency, etc.
We also see an opportunity to purchase properties at a discount where the seller may need to exit due to their short floating rate loan term coming due. In our recent experience, we are seeing even an 8-figure discount. At that point, they will be more willing to take a haircut on the profit in order to ensure that they are able to exit before they lose their investor’s principal. 😉😉
Flat or Negative Exit Rate Cap is a Go
The last trend that we are saying sayonara to in 2022 is break even or negative exit cap rate.
Before we dive deeper into this trend, let’s start from the beginning. As we all know, an apartment’s value is derived from the income it produces.
The simple formula used is value equals net operating income divided by cap rate. The lower the cap rate the higher the value.
For example, 👉 if a property’s NOI is $100,000 and the cap rate is 5% the property’s value is $2,000,000. If you drop the cap rate to 4% the property’s value is now $2,500,000. In the value formula, the hardest thing to predict is the cap rate on the exit. This is because it’s a forward prediction that no one can really foresee.
Think back to 2019, did you see a pandemic coming and then supply chain constraints, and then inflation and interest rate hikes? No, right? And that’s why conservative general partners tend to use an exit cap rate that is higher than their entry cap rate, at least 50 to 100 basis points higher. 😲😲
This is done so that the projected returns account for a potential slowdown in the economy, which is something we absolutely do to stay conservative.
For example, we may have an entry cap rate of 3.5% and an exit cap rate of 4.5%.
No surprise, not everyone follows this example, in fact, we know of many big-shot, well-known general partnership teams that used either flat exit caps or even negative exit caps in order to make their returns enticing to our passive investors. Well, this trend certainly met its makers in 2022 – if you see any deals with flat or negative exit caps then know that zombies are right behind and run away as far as you can.
So there you go, these are the 4 apartment investing trends that died in 2022. 😣😣
While it’s too early to tell with certainty, we don’t expect these trends to be back any time soon.
If you believe real estate will continue to grow with inflation and real estate value will rise over time, the more wealth you build, the less tax you pay, then investing in real estate is still the way to go. All you need to know is how to identify new trends that could create huge market opportunities that most likely make you wealthy over the next few years. 🤩🤩
So that’s it, thanks for tuning in today! Make sure to join the Kitti Freedom Club for even more investing tidbits, and check out our brand new YouTube channel 〰️ 📺 The Kitti Sisters TV as well as our social media channels for even more investing fun. Until next time, Cashflow Multipliers! 🙌🙏
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