I'm Sorry, Did I Offend You?
Yes, interest rates affect valuations. No, your property is not worth what it was last year.
Hey. Welcome to the next edition of Small-Scale Sunday from Brick + Mortar where readers get insight into the acquisition, financing, design, construction, and operations of small-scale real estate development projects.
Another great tour of 501 Main last week.
This one organized by the Green Mountain Economic Development Corporation as a part of their Housing Solutions tour with folks from Vermont’s Agency of Commerce & Community Development, Vermont Housing & Conservation Board, Vermont Housing Finance Agency, Downstreet Housing, and Twin Pines Housing.
A big question I get asked often—how do we get more small-scale developers like you in our town?
The simple answer is training and education.
While there is a path to a lucrative and rewarding career for the motivated entrepreneur, that path isn’t well defined (I’m still working through it myself). It’s clear we need more resources for small-scale developers.
But onto the topic du jour.
Justifying an offensive offer
I probably have offended a few owners recently. But they should get used to it.
Someone smarter than me (probably on RETwit) made the point that real estate is just a game of interest rates.
And I can’t stop thinking about it.
Deals that made sense a year ago no longer do—the average 30-year fixed mortgage has gone from 2.96% in 2021 to 6.83% today.
But owners have yet to bake this into their valuations. Home prices have started to come down, but not nearly to the level they should be.
Forget the rumors of Credit Suisse’s insolvency, let’s just focus on what facts we have right now:
Wild.
Granted, home prices are driven more by emotion than fundamentals. But still—this has to be an indicator of an upcoming reset.
The logic is similar for investment property. And here we’re actually rooted in the financials.
Take the example of a deal I was looking at last year.
A Class B 8-unit apartment building in Tier 3 market. The going cap rate of 7% put the value of the building at $600,000.
Fully turnkey, no immediate value-add opportunity.
Note: I rarely look at turnkey investments but sometimes the numbers just work.
Commercial debt at the time (summer 2021) was at 4.25%.
Last week, I was quoted 7.5%.
So how does this affect the amount I can offer?
Let’s compare the two scenarios assuming the only variable is interest rate. The goal is to achieve the same return (on a percentage basis) and back into the appropriate purchase price.
The math doesn’t lie.
All things equal, a buyer would have to reduce their offer by 20% to allow this deal to deliver the same returns today as it would have last year.
A caveat here that this is a basic model. There are more levers that can be pulled to make this more complex and (I guess) realistic: lower LTV, accounting for principal paydown, IRR/time value of money, value-add, etc. You know the drill.
Either way, the downward pressure is clear.
And the writing is on the wall, too.
Just last week, the one (yes, one) investment property on the market in my area just dropped by 14%.
Sadly, it’s got another 14% to go before it’s a viable investment. Courtesy of the owner not splitting out heat when they had the chance.
Side note: if you’re renovating a multifamily, please always individually meter heat. Else, you will pay dearly on operating expenses and valuation. I’ve made this mistake and fully intend on avoiding it going forward.
There always seems to be a gap between seller and buyer pricing expectations.
That gap just appears to be widening.
Sellers don’t yet have an appreciation for the cost of rising interest rates. Or a good pulse on what that means for property valuations.
So for now we wait.
And, in the meantime, make “offensive” offers until sellers come to terms with reality.
Until next time.
— Jonah 🧱
P.S. Want to connect? Find me on LinkedIn and my projects on Instagram.
Just ran some numbers for the first time in a while to see what buying and moving into a 3 or 4 flat would look like, and oh my, what a sobering experience. Would definitely be insulting some owners if I made offers than even came close to penciling.