Multi Family and Economic Outlook,

A few months ago we passed the three year anniversary of a global pandemic which temporarily shut down the world. And the last 3+ years have been a fascinating ride in the entire financial sector, as well of course the real estate investment market. It’s been both challenging to navigate and also fascinating to watch a multitude of competing factors playing out.

It’s very deceiving to people outside finance who see trusted news sources like CNBC with headlines saying things like “inflation is caused by such and such”, as if the complex interplay of the financial market has only one source; it is incredibly oversimplified and frankly inaccurate. As Michael Saylor correctly points out, inflation is the sum total of every good, product and service the world over. It has a near infinite number of inputs.

At the risk of dumbing down a simple formula for the price of real estate can be dumbed down to a simple formula:

Price = Supply x Demand.

Things like inflation, and forward expectations of economic outlook, will impact both the supply and the demand, hence impacting the price.

This formula is so important because it can explain so much of what we have seen in the multifamily space the last few years.

When the lockdowns happened no one know what was going on, just how serious the virus was, and we were all in shock. Weddings were cancelled, we couldn’t attend our parents’ funerals and suddenly states had draconian powers like stopping me running on the Chicago lakefront alone at midnight “for my safety.  With real estate, the market was deemed “essential”, by bureaucrats playing God).  While my own business slowed, I still had sales a few sales I was going through. I’ll never forget driving to inspections and final walkthroughs with completely empty streets in the 3rtd biggest city of America. It was like a dystopian movie. 

As an observer I was very curious to see if we would see some “fire sales”, sales with massive price discounts. Were $800,000 multi units going to suddenly be selling for $550,000? Interestingly, in Chicago, I didn’t see one single fire sale, and certainly not of a stabilized or turnkey building. 

I remember listing a rehabbed 4-unit for $800,000.  The developer in question was finish a project, months behind schedule and getting buried by hard money loans right as the lockdowns started. He had very little room to wait, so was forced to accept the first decent offer he got.  It ended up selling for $752,000.  Pre-Covid it would likely have been presold at asking price before ever hitting the market. So a 6% reduction in price as the world quite literally stopped, seems almost insignificant.

Why was this? Well remember our formula: Price = Supply x Demand.

At the time the demand was tepid at best, down from a very strong market a few weeks prior. Buyers were mostly stuck indoors, and embroiled in the Tiger King series which just came out on Netflix. But the supply was minimal also. Who would want to list properties for sale, and tenants were very reluctant to let potential buyers walk through their units when no one knew just how serious and how contagious the pandemic was. So this lack of supply kept prices fairly stable.

And when we saw the boom in prices the following summer, we can again look to our formula. Sellers felt ready to sell, and there was much less general fear. However, while the supply was consistent, again we had months of pent-up demand from 2020, which exploded. This tipped the scales into a sellers-market and with rates close to historic lows, it was bidding wars left and right. I was preselling multi units at asking price, again and everything seemed good in the world. 

But the good times never last. Housing is one of the largest components of CPI and the Federal Reserve realized that the rising inflation, after months of saying it was, was not, in fact “transitory”. Too late they scrambled to raise rates and did an unprecedented number of rate hikes over the next 12 months. In 2022 alone, the Fed raise rates 4.25% (the previous historic highest was 3.5% in 1978) and this crushed the demand of real estate.

Firstly, higher rates meant buyers had much reduced purchasing power. Typically, lenders give buyers a prequalification for a maximum monthly loan amount.  Now this impacted affordability of many buyers who even if they wanted to buy, couldn’t get qualified on the loan, to get close to the kind of property they wanted. And this wasn’t just with personal residences, but it impacted multi-family too. Firstly, cash on cash returns for buyers plummeted. So that dampened investor demand. And secondly, any type of house hacking buyers just couldn’t pass the banks’ self sufficiency tests, to get approved to their loans. [Banks require 75% of rental income in 3-4 units to cover not just the loan amount, but also the tax and insurance costs]. With rates for investors between high 6s and low 7s, nothing could pass these requirements. Only 2-units might work, which don’t need any self-sufficiency tests. But their return was much lower. 

So you would think that with demand being torpedoed by the Feds’ aggressive rate hikes, prices would plummet. But they remain firm. Why? It’s all about the supply side of our equation: Price = Supply x Demand. Prices are up over 5% in many markets Year to Date. The NASDAQ is up over 30% YTD!

We are seeing a massive decrease in supply. Firstly, many builders seeing the rapid fluctuations and increases in many basic material costs, from lumber to copper to labor, they are simply holding off on new developments until things settle down. One of my builders in the booming Chicago southside, typically builds 8-10 multifamily buildings a year.  His last remaining batch at the end of 2022 was 5. We sold the first 4, but the last one just sat on the market. 

We had showing after showing, but no offers came in, and he refused to drop the price. As rates kept climbing, he eventually decided to keep it as a long-term hold. And secondly, he owns many other lots to build on, but is holding off on breaking ground on any new projects, because of the forementioned escalating material costs, lending costs and price uncertainty. 

He is just one example of a builder pausing developing and keeping a finished project. But I am seeing the same thing again and again, with many of the developers I know. So, again with a balanced equation – with lower supply cancelling out lower demand – prices remain strong. DESPITE higher borrowing costs for buyers.  In fact, YTD prices are slowly rising. Especially picking up in the last six weeks. 

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My Investors bought these four in the booming Southside, during the buyer frenzy of 2021 locking in historically low rates.

Why are people buying now – as opposed to waiting for prices to come down?

  • Many buyers are coming in with all Cash. Their cash is losing purchasing power with realistic inflation (not curated government data inflation) likely in the double digits. So they would rather have their money working for them than sitting in the bank.
  • High earners who want to diversify from their stock portfolios. Remember, for high earners their primary role in buying real estate is the tax write offs and upside appreciation. They don’t care so much about the cash flow being lower with the higher lending costs, because they are earning enough money through their day jobs. And that’s why they are ready to buy now, for the tax write offs through appreciation. 
  • They are savvy investors, buying with a loan and a long-term mindset. Let’s do the math: If a buyer has to take a 7% loan on 25% down for an $800,000 purchase, their payment will be $3,221. So, assuming rates might go down somewhere in the low 5s, you’ll be paying a $771 monthly premium, until you can refinance. Bond process a year out are pricing a significant rate drop of several percent.  Even if it takes 18 months, that’s an additional 18 x $771, so about $13,878.  I would imagine you could easily get a seller to give 2% of seller credits to cover these extra costs, and most of my sellers are willing to do so. You can break even if you refinance anytime before the start of 2025. 
  • Prices might not come down. The longer inflation persists, the more assets will inflate. How did real estate perform during the decade of the 1970s when we last saw persisting high inflation? It massively outperformed the S&P which remained flat when adjusted for inflation, while we saw a doubling in real estate prices. So worst case scenario, loan payments stay high,. Rents will continue to go up as people cannot afford to buy property and their income should continue to increase. 
  • And if rates go down quicker than expected, I would imagine prices will be higher. It’ll be just like in the summer of 2021, with the explosion of demand before the inventory can catch up. 

So that is the scenario we are in.  The formula: Price = Supply x Demand explains the persisting high prices, with inventory shortages balancing out the lukewarm demand. 

The bond market remains the place to watch for the best estimates on where rates will be heading coming into the election year, next year. 

And historically, election years see a decline in rates. We will be closely watching! History tends to repeat itself. 

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One of my recent developers flipping a 2-unit in Pilsen

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