Most of us understand inflation as the dictionary definition: “a general increase in prices and fall in the purchasing value of money.”
It’s when you start to investigate what causes inflation, what type of inflation we are facing (runaway, stag, etc.) and how quickly we will see its impact, most people get glossed over. It’s been a long time since most of us took a formal economics class, making it harder to grasp inflation’s nuances.
What we cannot ignore is how inflation is playing a role in our multi-housing business today. U.S. inflation accelerated last month and remained at its highest rate in over a decade, with price increases from pandemic-related labor and materials shortages rippling through the economy. This will weigh on policy decisions at the Federal Reserve and will continue to have a greater impact on the overall cost of living, wages and social benefits programs.
With unusually high demand driving higher inflation, we could be seeing greater effects quickly, after years of this topic being a talking point vs. today’s reality. Higher spending, rising energy prices, rising housing prices, low inventory across multiple inputs, higher wages needed to keep and fill employee shortages, shipping delays and many other factors are issues we face today. With living costs being a key category, as it makes up nearly one-third of the CPI index and tends to influence inflations’ future path, all of us can certainly appreciate that inflation is something we can’t just talk about as a future “potential” anymore.
It’s no secret that there is ample capital available. That’s why multi-housing investors are struggling to win new acquisitions. It’s not, however, the only reason. Those who see inflation as a major issue ahead will purchase deals at very tight cap rates, as they see and believe that higher prices are inevitable.
A money manager recently reached out about investing a significant amount of capital into multi-housing in Florida strictly as an inflationary hedge. The investor in this case isn’t taking into consideration the acquisition’s internal rate of return or multiples. They do not care about the cash flow or how property performance may yield higher returns.
They simply want to place their money in an appreciating asset class in a market where they see further demand providing tailwinds when other factors may force headwinds. Would-be buyers that are accustomed to approaching deals with disciplined investment strategies based upon property analytics may face unexpected challenges when consummating a deal as the competition has changed. As such, it is imperative for all investor types to be fully aware of the current transaction market dynamics across the multi-housing space in order to compete today.
Lack of Alternatives
Multi-housing has proved to be one of the most resilient real estate sectors during COVID-19. Despite all the noise in the market, fundamentals continue to observe significant growth, with effective rent growth reaching 11.2 percent nationally in Q3 2021. As expensive as we may think apartment deals are today, what is the alternative investment for investors who want to diversify their holdings out of the stock market, commodities and other alternative investment classes? Commercial real estate, which is an appreciating asset during times of inflation.
When it comes to multi-housing, we have witnessed that 4 percent cap rate become a 3 percent cap rate, and now often moving toward a 2 percent cap rate, causing investors to continue to have to stretch to win deals. Freddie Mac and Fannie Mae just had their cap raised an additional $8 billion each for 2022. So as we continue to see additional debt capital fuel the fire, remember that the lack of an alternative investment that is producing this type of yield, and it might inspire you to press on. Private equity funds are also helping drive the flurry of activity in the multi-housing space. As evidence, a major real estate firm announced that it raised a record-breaking $10 billion. I have a strong hunch as to where this real estate giant will be placing its capital.
With the highest rate of inflation last seen in the 1970s, it’s no wonder that those who have logged a few more years than us do not look at today’s values as inflated. They do not worry about the lower returns our cash flow models display on each new deal sizing. They have the experience and appreciation of what we are starting to experience, and it’s why we have buyers more excited to buy than sellers are to sell at these “peak” prices.
Again, nothing lasts forever, but are you willing to sit on the sidelines while the game is far from over? When people asked me a few years ago what inning we are in, I replied “who cares?” We are going extra innings. Now, I think maybe we are about to start a doubleheader.
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