History doesn’t repeat itself… but it rhymes. This goes for the good and the bad in history.
For example, the real estate bubble of the 2000s was caused by euphoria. At the time of the euphoria, everything seemed fine; no one had any doubts about the real estate market. But in the months and years that followed the “pop” of this bubble, so many people said that the euphoria “was obvious.” That obviously, the real estate market was way overvalued.
Why was it obvious?
Well, in hindsight, we saw that people received loans from banks with no income verification, essentially allowing people to lie about their income; people were even lying about their income to be accepted as renters at apartment buildings!
Often, lies account for bubbles. And usually, they start out as white lies. Maybe instead of an average 15% return being pitched on a deal, investors are lured by 16% predicted returns. Only a 1% difference! But then someone else says, maybe we can pitch 17%. And so on and so forth.
This not being repeated today … well, not exactly.
For quite some time, we have been unable to buy much real estate because valuations had been so crazy. We had a lot of our own cash to deploy, as well as international and domestic investors wanting in on our deals. But we couldn’t hit the marks that we wanted, so we did not deploy any capital (and still really haven’t at the time of the writing of this article). So, we decided to ramp up our efforts, but what we found was that valuations were out of control.
We couldn’t justify the valuations based on the returns that we needed to see. But then I thought that perhaps we were being a bit too tight in what we expected in terms of returns because we had bought much of our portfolio between 2009-2011. For those that don’t know, 2009-2011 was a time when real estate could be bought for pennies on the dollar, and we could make 30%+ returns with our eyes closed.
So, I took a step back and said, “Paul, 15% returns are still good. Not everything has to be 30%, especially when the current market simply makes it non-feasible.”
I went to my team and said, “Let’s find some deals!”
We went out and found a lot of deals. We looked at them, and for the first time in ten years I shook my head and said, “Here are the lies again. Is this 2006 all over again?”
When I took a deeper look into the numbers, I saw that buyers and sellers were making the same types of mistakes that were being made in the runup to the Great Recession. I don’t believe that history is precisely repeating itself, but something certainly feels off… let me explain.
When we find a property that we like, we will contact the broker and ask for the operating history and an idea of what the broker thinks the property will sell for.
After we run our numbers, we have a very good idea of what the property is worth to us both now and in the future after we have completed a rehab of the property.
So, we decided to be aggressive on our required returns, aiming for 15% rather than 20%-25%. What we started to find was that we were still not coming in high enough on price. In many instances, we were 30% lower than the expected or eventual sale price.
When we delved further, we saw what was truly concerning about this market.
There are many investment groups out there now that are essentially real estate private equity organizations. They raise money to go put into real estate deals. These investment groups are, for the most part, paid to do deals. They make money on the purchase of properties, on the deployment of capital, on the management of properties, on the exits, etc. If they aren’t getting deals done, they aren’t making management and deal fees, so they aren’t making money.
People who invest with these investment groups are usually novices who trust their “expertise” on what it takes to own and operate the property (notice, I said “usually” and not always). Fast forward a few years, and if the investment group can’t operate a property for what they initially told the investors, do they take the blame? Of course not! They will have a crafty way of explaining it away. But will they still get paid? Of course.
If you think this is cynical, you’re naïve. This happens in every form of investing, not just real estate.
So how do we know this is happening? When purchasing apartment units, a common metric we look at is the cost-per-unit to operate the property. This will include all the operating expenses divided amongst the number of units.
As an example, if you own a 20-unit property that costs $100,000 per year to operate, the cost per unit is $5,000 per unit. We own properties that cost between $3,700 and $5,500 per-unit-per-year to operate. The large range is the result of differing property tax rates as well as who pays the utilities, the landlord or tenant. Obviously in higher tax-rate areas, and at properties where the landlord pays the utilities, the expenses will be higher than lower tax-rate areas or where the tenant pays utilities.
This isn’t rocket science.
In addition, many of the other expenses are uniform across the country. Paint and labor for maintenance are basically the same wherever you go, subject to some labor cost differences depending on minimum wage requirements. Home Depot and other national supply houses sell their supplies at largely the same cost no matter where you are. So, operating costs are going to be very similar across markets for unit maintenance, repair, renovation, etc.
It is how these numbers are being portrayed that started to show how deals were becoming scary and, well, fraudulent.
We started seeing underwriting of expenses at levels 20% lower than the levels we were seeing in underwriting just a few years ago. This meant that a property that we would have underwritten at $4,000 per unit two years ago was now being marketed by the broker with expenses at around $3,200 per unit!
Why? No clue. There is literally zero reason why expenses today to operate a property would be 20% lower than two years ago. No changes were made to the property to allow for more efficiencies or anything like that. The only reason that we have been able to come up with was this: brokers are lying to get deals done.
Is it lying? Yes. Is it misleading? Yes. Is it an honest mistake? Not for someone who has been in the business and has expertise, as many brokers would tell you as they pitch their services. And the investment groups that buy into these sham expenses are just as guilty’ they don’t get to pass the blame onto brokers.
This is exactly why I am scared. When you lie about expenses to that level, I can see how we lose out on purchasing properties by 30%. And when you pay 30% more than the astute investor, you will have a hard time making money.
We recently came across a deal in which someone was buying with before pictures that were very similar to before pictures of our properties that we had rehabbed. Their after-picture projections were impressive, even better than some of ours.
Then we saw the budgets for those renovations. One word to describe it all: lies. And fraud. Ok, maybe two words.
We spend $15,000 per-unit to do the renovations that these people showed. And that $15,000 includes built-in discounts that we get since we own our own construction supply companies and can realize 40%-50% discounts from what we would pay at stores such as Home Depot.
What do you think their budget was?
$6,100 per unit.
Granite and cabinets alone are $4,500 per unit. And this group said they were also doing bathrooms, new flooring throughout, back splash tile, new light fixtures, and new drywall!
Is it possible that we just overspend? Yes, it is. But when many contractors quote us, they think our $15,000 pricing is unrealistically low… so how is our $15,000 per unit unrealistically low, but someone else can do it for $6,100? Could it be that we are somehow the only people in this industry to have higher prices that contractors complain are still too low?
In the movie “The Big Short” the main character, Michael Burry, explains, accurately, that during bubbles you see a lot more fraud occurring.
Lies = Fraud. Lying about something as “simple” as expenses is nothing short of fraud.
These are dangerous times to be investing in real estate, in my opinion. Does that mean if you invest today, you will lose everything? Of course not. But over a spectrum of decades, the best investments are made during times that are not like today. The best investments are when fear is high, and euphoria is low. We did very well from 2009-2012 because people were afraid of real estate and we could buy properties at absurdly low valuations. Now, the euphoria for real estate is back and we can’t complete in the purchasing market.
In fact, I only see fear from value investors, such as myself, who tend to do very well over long periods of time versus doing well over the short-term through mere speculation.
While this article may seem like gloom and doom, there is a silver lining to it all. If buying a home starts to become harder, rents will go up as more people will stay in rentals longer, thereby increasing demand for rentals. Assuming the supply of apartments doesn’t outpace the increase in demand, this can lead to greater rental appreciation. So, your risky deal can turn out just fine. But success is this scenario has nothing to do with the low expenses that a broker or manager fraudulently told you about.
Again, this euphoria analysis does not only apply to real estate. This is especially prevalent in stocks. “Private wealth managers” and “financial advisors” know even less about the companies they sling than real estate brokers and fund managers know about the real estate that they throw at you.
Remember how easy it is to look back ten years ago at the real estate bubble and think, “Oh, it was obvious. How could you not see it coming?” I have heard that many times over the past five years about the Great Recession. But how obvious did people believe it was in the runup to the Great Recession?
The same was said after the tech crash of 2000-2002. “It was so obvious! These companies didn’t have profits or revenues and were worth tens of billions!” If it was so obvious, why did people buy into them during those euphoric times? Because of euphoria. When things are great for a long period, we don’t remember the bad times and vice versa.
And don’t even get me started on Bitcoin.
We’ve seen a 107-month bull market. We just experienced the first 12-month consecutive rally of the stock market since the Great Depression. And now, a real-estate market that had the worst drop-off in US history is immediately followed by a rally that exceeds previous valuations?
How “obvious” will this euphoria be in the next ten years? In ten years we will be saying, “Come on! Stocks were obviously overpriced. I mean, look at them! We went years without a 10% correction! Every day the market was up just a bit more. We set a record in the first ten days of 2018! It was so obvious.”
Or for real estate: “It was so obvious! My friend’s kids were flipping houses! Everyone owned rentals. People were lying about rent rolls and financials to get deals done.”
This will be what is “obvious” ten years from now.
The same thing happened with stocks in 2000. Tech companies with no revenues and/or no profits were worth billions! After the tech-heavy NASDAQ fell 83%, everyone took a step back and said, “Well, it was obvious! I mean, come on. These companies didn’t even make money! They didn’t have a profit! How could they be worth $50 billion?!?!”
Well, it isn’t much different today. It isn’t an exact repeat, but it’s a rhyme.
In the last four years, I have been accused of thinking that things are always bad.
This is not true.
I make my evaluations of the market based on valuations of the market, both in real estate and in stocks. Have I been “wrong”? Sure. Prices have said that I was wrong. But that is as of today.
Whatever assets you are invested in, always ask yourself what you will say ten years from now about that asset and what you paid for it.
Contrary to popular sayings, it’s never different this time; there is no magic bullet that makes a 200-unit property worth more today than three years ago in the same condition. If you want proof, look at the tech bubble: it could have been argued that 2000 was a different year because a technological revolution was changing the world. But even then, stocks fell fast and hard because valuations were out of whack.
Father time always wins in the end, as do valuations.