Real Estate
Buy Rental Properties With Uncle Sam's Cash
By Christopher Grey
I don't make
jokes. I just watch the government and report the facts. -- Will Rogers
Our government
is unleashing an ocean of cheap financing in the hope of stimulating the
economy and preventing further deflation of assets, especially real estate.
Although most of this government largesse is going to directly benefit large
financial institutions, private-equity shops and hedge funds, there are
a couple of ways that smaller investors can directly benefit from it and
get their fair share.
Fannie Mae (FNM)
, Freddie Mac (FRE) and the U.S. Department of Housing and Urban Development
are offering generous financing terms for the purchase of apartment buildings
priced at or above $1.5 million.
In addition,
the agencies will now buy the mortgage paper of investor-owned individual
rental properties such as condos or single-family homes being used as rental
properties, up to 10 properties per individual owner.
The irony of
all of this cheap and easy financing for investors in rental properties
is that the government is basically trying to replicate exactly the cheap
and easy financing that caused the real estate bubble of a few years ago
and the current crash.
What is different
today is that the spread between the rate of financing and multiple of earnings
on rental properties (or capitalization rate) has never been more favorable
to investors. (A cap rate for an apartment property is calculated by dividing
the current net operating income of the property by the purchase price.)
This is probably
a once-in-a-lifetime opportunity for investors to generate current cash
flow of 15% to 25% per year by locking in extremely favorable financing
from the government to buy rental properties at a time when there are not
enough investors willing to step up and buy these properties because of
concerns about the economy and falling real estate values.
To understand
why rental properties are such a good buy today, let's start by looking
at how they traded historically. In supply-constrained markets such as Los
Angeles, apartments have generally sold at cap rates -- the inverse of a
price-to-earnings multiple -- of between 3% and 8% of the purchase price
in good neighborhoods during the past several decades.
A couple of
years ago, cap rates were mostly around 3% to 4% of the purchase price,
which is the equivalent of a 25 to 33 multiple of earnings, even though
interest rates were higher than today. People were very optimistic about
rents and real estate values a couple of years ago.
Today, people
are very pessimistic about both rents and values. Cap rates are generally
closer to 8% today in good neighborhoods, which is the equivalent of a 12.5
multiple of earnings. These numbers not only include operating expenses
but also capital replacement reserves for these properties.
Also, because
Los Angeles has some form of rent control in most areas, the current rents
at these rental properties are substantially below market rents on average.
Many properties have average in-place rents that are 30% to 40% below current
market rents. What this means is that even if market rents decline somewhat
because of a weak economy, average rents at these properties and income
should continue to rise because the spread between current and market is
larger than the potential decline in market rents.
At today's interest
rates, an investor who is an experienced real estate operator meeting certain
net worth and liquidity tests can borrow about 75% of the purchase price
of these apartments from Fannie or Freddie or HUD at around 5% fixed for
seven years.
Ten years is
typically the maximum loan term, but the seven-year loan is better because
of the current slope of the yield curve and programs offered by Fannie.
If you're not an experienced real estate operator or don't have sufficient
net worth or liquidity to meet the requirements, you can still take advantage
of this attractive financing by investing as a limited partner with an experienced
real estate operator.
Experienced
real estate operators can be identified in your local market or other markets
in which you want to invest through licensed real estate brokers at any
of the major national firms such as CB Richard Ellis (FNM) , Cushman or
Grubb and Ellis.
At those loan
terms, the initial cash flow to the investor would be 17%, and for the reasons
explained above, that cash flow is very likely to increase over time. Further,
the loans from Fannie, Freddie and HUD are typically non-recourse, meaning
that the investor is not personally liable to repay the loans. The lender
will look only to the property as collateral for repayment unless there
are so called "bad acts" such as fraud or a bankruptcy filing
by the owner.
It gets even
better. As a direct owner of rental properties, the cash flow you receive
is partially sheltered from income taxes by depreciation. Depending on your
personal tax bracket, the 17% pre-tax cash flow yield from the example above
could be substantially higher on an after-tax basis.
Lastly, these
properties can often be purchased at a large discount to replacement cost,
which is the cost to build new apartments or other multifamily housing such
as condos. This discount to replacement cost further increases the chance
of an increase in the value of the property in the future.
For investors
with a higher risk tolerance, there are even better cash flow opportunities
in rental properties located in markets like Phoenix. Historically, cap
rates in Phoenix have ranged from about 5% to 10%. Cap rates are higher,
which means that income multiples are lower, in Phoenix vs. someplace like
Los Angeles because the supply of housing is not as constrained, and there
is no rent control, so rents are always close to market. At the peak of
the real estate market a couple of years ago, cap rates in Phoenix were
mostly in the 5%-6% range because of investor optimism.
Today, cap rates
are sometimes 11% for similar rental properties. Although there is still
some potential that the income at these properties could decline because
of economic weakness, a significant amount of that decline has already happened
during the past two years.
If you buy at
an 11% cap rate, borrow 70% of the purchase price from Fannie, Freddie or
HUD at 5.25%, which is available for Phoenix properties, your initial cash
flow to the equity is nearly 25%. Even if the cash flow declined by 10%
after you buy the property, your cash flow to the equity would still be
21%.
As previously
mentioned, these pre-tax cash flow yields will be even higher after adjusting
for the tax benefits of direct real estate ownership, and there is also
likely to be future appreciation because of lower cap rates in the future
and the large discount to replacement cost at which these properties can
be purchased today.
If you compare
these two opportunities for direct ownership of a multifamily property to
owning a public apartment REIT such as Equity Residential (EQR) , owning
the REIT shares doesn't look very attractive.
Even at these
depressed share prices, EQR's common stock pre-tax yield is only about 10%
vs the 17% to 25% yields in these examples. Also, the investor does not
receive any additional tax benefit from sheltering income by owning REIT
shares.
As a public
company, EQR's stock is also subject to many other issues for an investor
such as Sarbanes-Oxley, more expensive overhead and management costs, short-sellers
driving down the shares via various trading strategies, negative impact
from inclusion in the REIT index, and potential misalignment of interests
between the managers and the shareholders.
EQR also has
a much more complicated and risky capital structure as far as its corporate
debt and preferred stock vs. an individual apartment building.
Many investors
will not be able to understand all of these risks, as recently happened
with General Growth Properties (GGP) , which has seen its share price collapse
nearly to zero primarily because of issues relating to its capital structure
and unrelated to its properties.
Further, this
more complicated capital structure means that the investor is not getting
a similar direct benefit from government financing that you can get from
buying apartments directly. Yet another risk with REITs that will be difficult
for investors to evaluate is the quality of earnings and the assets in the
portfolio of a public company. The additional liquidity that you get from
having a public security does not compensate you for the much lower yield
and other costs and risks involved.
There are obviously
other risks of direct ownership, including asset selection, market selection,
due diligence and other property-specific issues such as evictions of tenants
and bad debts. Finding good-quality apartments buildings for sale and evaluating
those investments can be challenging for individuals with no real estate
experience.
However, this
process is actually easier than trying to understand the balance sheet and
portfolio of a national REIT. Investors who want to pursue these investments
should start by contacting apartment sales brokers and mortgage finance
brokers in their local area.
Alternatively,
all of the issues relating to asset selection, underwriting and due diligence
can be handled by professional real estate operating and management companies
that will typically invest their own capital alongside the limited partner
investors so that there is no potential for a misalignment of interests.
If investors
want to own rental properties for cash flow and appreciation, this is potentially
a great time to do it through direct ownership that takes advantage of attractive
government financing.
The spread between
apartment cap rates and fixed-rate financing to buy them has never been
wider. It is very likely that this spread will narrow either because of
higher interest rates or lower cap rates in the future. In either case,
this should be a relatively good time to buy if investors want to achieve
solid current cash flow returns and upside potential.
Christopher Grey is a managing partner and co-founder of Third Wave Partners,
a leading restructuring adviser, distressed situations expert and turnaround
operating company focused on the real estate industry. Previously, Grey
was a managing director in the California office of Emigrant Realty Finance,
the real estate group of Emigrant Bank, a New York-based financial institution
with $17 billion of assets. Founded in September 2005, the California office
of Emigrant Realty Finance completed and managed on balance sheet $2.5 billion
of debt investments.
Grey is a
founding member of the Capital Markets Forum II of the National Association
of Office and Industrial Properties and the Stanford Real Estate Network.
He is a graduate of Stanford University with a degree in economics and holds
a California real estate broker's license.
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