#26: Neal Bawa, CEO of Grocapitus & Multifamily University - The future of multifamily investing, investors vs speculators, and being a data-driven investor

I mean, actually listen to what Warren Buffett says. Don't just repeat the stuff that he says about, you know, be greedy when others are fearful, be fearful when others are greedy. Why don't you actually see what the guy is trying to say and listen to him. This is not cocktail party stuff. He's actually talking about the philosophy of finances, which makes a heck of a lot of sense. In 2009, nobody would give us money to buy real estate. But the people who did, the small number of people who did, made shit tons of cash. Just remember that.

On today's episode we have the founder and CEO of growcapitis and Multifamily University, Neil Bawa. Steve, Neil is known in our world and you know this, he's known as the mad scientist of multifamily. And he lived up to this on this episode. He, he dropped so much data and metrics and information about real estate investing. He really lived up to his, his title in our world.

You know, Neil didn't disappoint on this episode. And what I love about Neil as a fellow engineer, that Neil's data driven process to make decisions in real estate, they fall just in line with what we do here at Skyline Point Capital. And he takes the emotion out of real estate and turns it into a quantitative process. And I just love that. It was, it was a fabulous episode.

Yeah, it was fast pace, a lot of information. If, if there's ever an episode where you need to listen twice, this is it. I may listen to it three times on slow, but Neil brings it and he brings so much wisdom and so much information. On this episode we had to cut it off at 60 minutes despite wanting to go for two or three more hours. But again, this is one that you guys are going to listen to so lets just head west. Stay tuned as we discuss the future of multifamily investing investors versus speculators and being a data driven investor with our guest and the mad scientist of multifamily, Neil Bawa. This episode is brought to you by Skyline Point Capital. If you're anything like me, you're always considering where to invest your money. Stocks, bonds, crypto, a rental home. The list is literally endless. As we've all seen over the past year. The stock market is unstable, the housing market is just weird and inflation is on the rise. In times like these, the clear place to invest my money is in multifamily real estate, AKA apartment complexes. Here's why. Returns on real estate investments have little to no correlation with the stock market. There's lower Volatility, stable income streams and the tax benefits are insane. And let's not forget that the apartments will typically appreciate in value over time, which means you can walk away with a pretty nice return when the complex is sold in three to five years. Best of all, multifamily investing is passive so you get all the benefits without the hassle and headache of your typical rental home investment. Getting started has never been easier. Head to skylinepointcapital.com to learn how you can start investing today. Well, Neil, we're super excited that you're joining us today. I really wanted to start with.

How.

The year has been. I mean as we record this, it's August, it's been one of the craziest years at least I've experienced not only in the market, but in real estate. Flashing back to the market, it's been, it's been down, it's, it's coming back. The Fed has decided it wants to, to, to constantly making increases. I would love to hear your take on not only how has the market, what's your take on the market one, but what are you seeing with investor sentiment right now? How are you, what are you talking to your investors about? How are you keeping them from the edge of the ledge of, you know, going to all cash and pulling all investments? Like what has your communication been like to them?

Sure, let's break that into two pieces. So firstly, I don't think I can find absolutely anything wrong with 2023. My litany of problems is tied back to 2022 and I'll explain why. Number one, the stock market was down more than 20% for 2022 this year. It has recovered fully and is now running near all time highs. So if you look at 2022 decline, the stock market, it was huge. 2023, I mean, come on, we're out of the bear market. We've recovered all of the losses in 2022. So firstly, the stock market is tied to investor psychology. At the end of 2022, almost everyone put a higher than 50% chance that there would be a recession in 2023. Some people started at the end of Q1, some people started at the end of Q2. Most of those people have now either completely gotten rid of that recession call or have reduced their chances of the recession call. So Goldman Sachs, for example, bank of America have basically said hey, there may not be a recession. If there is, then the chances are going to be 10 or 20%. So that's another good thing that's happened today. The third thing that happened in 2022 was that that's when the interest rate hikes were demonically high, right? They were ridiculously high. There was this one five month period where the Fed raised interest rates by 75, 75, 75 and 75 basis points, which was 300 basis point or 3% for those that don't understand what the Fed does, But basically a 3% change to the mortgage rate in five months, well, that is by far the fastest rate in history for a five month or six month timeframe. The Fed has never done that in history ever before. Right. So, but you know, look at 2023 and pretty much all of the 2023 stuff is quarter points. And they're also skipping meetings now. So they're, you know, they'll do a quarter point, then they'll skip a meeting and quarter point and skip a meeting. And so they're clearly approaching a plateau or have hit a plateau. So from my perspective, 2023, all of the bad stuff that is happening in the multifamily market is tied back to 2022. If investors are feeling bad, it's because of what happened in 2022, either to the stock market, so that lowered their confidence, or to the interest rates, which is continuing to lower their confidence in 2023. Actually, 2023 has gone well so far. So kudos to the US economy for being so resilient. Keep in mind that we are seven months into this year and we have not had a month with at least 175,000 jobs being created. Every job, every month has been over 175 and most months have been over 300,000. Normally those are incredibly good numbers. So what we are suffering from. And I'll move over from your 2022, 2023 question to the second part of your question where you said, how are your investors feeling? What are they thinking? Right. How do we stop them from going all in on just cash? The answer is many of our investors are feeling terrible. And the reason for that is because I don't consider the vast majority of my investors to be investors. I think that I predominantly work with speculators that like to believe they're investors, want to believe that they're investors, and it's important to them that they think of themselves as investors. And that gets me in trouble because every time I say that every single speculator I have thinks that, I am blaming him and thinking of them as a speculator. Yes, I am thinking of you because simply because every investor has this fantasy, every real estate investor has this fantasy. I'M sure Steve and Jake have it too, that somehow we go back in a time machine to late 2008 and we know exactly what we're going to do when we get out of, you know, out of that, you know, that, that. What was the famous car in Back to the future? DeLorean. Basically, yeah. We get out of the DeLorean and we know exactly what we're going to buy, how many homes we're going to, we're going to buy them in Phoenix, blah, blah, blah. We have this, everyone has this 50 page plan on how they're going to make billions of dollars. Right. If you go back to 2009, my question is, in today's environment, home price. But in 2009, home prices dropped 29% nationwide. Some markets dropped 40%. Right. Very few market actually dropped 50% in those markets. I probably wouldn't have touched anyway. But 30% was pretty common, 40% was pretty common back then. Multifamily properties today have already dropped by 22 to 26%. 22% to 26%. And we don't have anywhere near the problems that we had in 2008. In 2008, the world was staring at a financial crisis that could cause a 20 year Great Depression. $8,000 billion or $8 trillion of assets, Jake, were insolvent. The banks had 5 million homes that no one was paying a mortgage on. If you total up just the cost of those 5 million homes, we're looking at, I don't know, two, $2.5 trillion right now. Let's compare that to multifamily today. Well, yeah, the discount's not 30 or 40%. It's 22% or 26% depending upon the market. There may even be some markets where the discount's still under 20%. But we're early in the game. We know that there's further discounts coming in the next six months. But I can't get one investor to articulate today as an opportunity because they're speculators because of what happened in the last 24 months. So what happened in the last 24 months? Every investor in the United States that invested in multifamily thought that they were hot shit. They thought that they were bulletproof. They thought, I'm Batman and Superman combined. Anything I touch turns into gold, therefore I must be truly awesome. Right? So here we are at the end of 2021, investing into a property that basically is at 3 cap or three and a half cap. And that property has a two year rate cap, which back Then might seem appropriate, now it doesn't. And I'm making this investment thinking that even though this property is at all time highs in terms of pricing, right? And using examples of leverage which are ridiculous, like basically things will stay at 4%. And they were okay with that. All of the investors were okay with that. All of them were investing every month, you know, 1000-001000-00100,001, 100,000. And today, in August of 2023, they're aware that many of these properties, A, haven't distributed and B, are likely to have a cash call, and C, some of them actually are going to go back to the bank and wipe out 100% of their money. All of that is in the past. Those were all things that happened in late 2021, mid-2021 or early to mid-2022. None of those things have happened today because indicators don't do the sort of things that they were doing before as a group, right? So rationality is everywhere today where irrationality was everywhere 18 to 24 months ago. So today a syndicator that's assuming a lower rent growth, a higher exit cap rate and is getting a 22 to 26% discount can't finance their property because investors are thinking about what happened 24 months ago. And those are not investors. I say to you, Jake, that those are speculators and they're making the classic mistake of I bought something in the stock market and it went down, therefore I can't buy anything else again even though the stock market is down. Would you do that? I mean, it's like the stock market crashed 30% and the income of a stock went up. Let's call it Netflix. Right? Netflix is the only streaming company that actually makes money. They make profit every quarter, right? So if Netflix stock was down 30% and their income went up 10% or 20%, would you not buy Netflix? Would you not consider it to be a bargain? Right. Give you all more, Right. You'd buy more because you're like, I mean, this is dollar cost averaging. Maybe I made a mistake of buying Netflix when it was high. Well, it's now 30% cheaper. But their income is up, right? They're making more money. Well, if you describe multifamily properties in the United States as a group, the same thing applies. They are 18 to 26% cheaper on average. Their net operating income has gone up a few percent, maybe 3, 4%. Not by huge numbers, by the way, because rent growth's been weakening, right? So as a group, it's probably up 4 or 5%, especially because, you know, expenses went up, insurance went up. So noi growth has been single digits over the last 18 months. We'll use 5% as an example. It's close enough. So now we make 5% more, we're 22% cheaper, and nobody wants to buy these properties. And that's basically a definition of a million syndication investors in the U.S.

I love that answer. Let's wrap it up right now.

So true, Neil, you were talking about people in 2021 and 2022 and the deals that are going on right now. Major syndicators have their debt service coverage ratio less than 1%. And they're saying that they're doing just fine, they're going to get through it at that time frame. We see a lot of syndicators in the sense of trying to buy deals now that are still thinking of this three and a half cap or four cap and still spending money on deals that don't pencil out in today's environment. Can you comment on that? What are we missing?

The first thing I'd say is that is not what you just said. I will actually give you an exact example of that, Steve, but it's not very common. So if the syndication community is composed of 5,000 or 10,000 syndicators, those are both numbers that I've heard, by the way, and probably some of them are like not in multifamily, maybe self storage, hotels, et cetera, as a community. I think that rationality is pervasive today compared to where it was 18 months ago. However, there's a syndicator, I won't name them, that is currently buying a property in Dallas. And this is a property that they're purchasing for 4.4 cap. It's not a small property, it's a large property. And what they're doing is basically they're buying what is known as an in the money rate cap. This is actually a very interesting concept where you lower your rate. So you take the market rate for a fixed debt or a bridge debt. In this case, it's bridge. And then you use your rate cap to essentially force the rate down by buying a bigger rate cap. Right? And that rate cap basically pays you each month. Because if the rate today is five and you set a cap for four, well, then the rate cap has to pay you every single month. These are called in the money rate capsule. It's a disgusting tool, by the way, but it's in use and it's allowing them to purchase a property for 4.4 cap because it looks like their interest rate is low even though it's high. Right. So their interest rates probably in the 7 or 8% range. And they're using a rate cap and in the money rate cap to show a 4.4 cap percent rate. Right. Hilarious. But that's allowing them to buy a property for 4.4 cap where normally they couldn't make the numbers work even at 5 cap. So to go back to what you were saying, Steve, some of these shenanigans are still happening, but the extent of these shenanigans is very small compared to what was happening 18 to 24 months ago. To address the other thing that you said, some of these syndicators, they're having problems and they're saying we will be fine. My feedback is that many of those people that bought three year rate caps and their property and their banks are friendly. There's a lot of friendly banks right now that really don't want you to foreclose. So as long as you find some way of kicking the can down the road, essentially paying out of your acquisition fee or borrowing money from your investors or doing a cash call or whatever, some way to just keep kicking the can down the road, lots and lots and lots of lenders don't want your property back because they know what happened in 2009 when the lenders basically got handed a million homes back. Right. It took him five years to sell those homes. So as a result, I think these people can claim a bunch of things. My only feedback on that is let's see what happens when your 3 year rate cap finishes. Right. Simply kicking the can down the road doesn't mean that you're okay. It means that your tryst with destiny is still a year away. Yeah.

So with that in mind and kicking it down the road, and as you look out to where you think interest rates in 2, 3, 4 and 5 years are going to stabilize, they aren't going to go down to the 1 1/2 points anymore. Where do you think it's going to be stabilized? What's the new normal, Neil, that people can think about on interest rates and mortgage rates that we'll see in the future?

All right. Everything I'm about to say is speculation, but I spend a lot of time thinking about it. So I'll just simply say that's what I love, my speculation. Right. So I'm going to speculate. You're asking me to talk about the future, the last normal year that the commercial real estate industry had and that the basically the larger financial industry had was 2019. So let's look at 2019 and analyze how 2026 could look like 2019. Right. So to me, normalization takes another two years. So it's early 20, late, late 2025. Early 2026 is when we normalize. So my premise is that, that 2026 is going to look like 2019, the last normal year. Obviously 2020 was Covid, then 2021, 2022 were zero interest rate. And then late 2022 and 2023 was extremely high interest rates. And that's going to take a long time to come down. So 2019 was when the Fed had basically finished another hiking cycle. So most people don't know this, but the Federal Reserve didn't start raising rates from zero until 2015 or early, well, late 2015. If I were to ask this question from a room of 100 people and ask them to write down their answer, most people would think, well, the Fed must have started hiking, dropped the rates in 2008, 9, 10, hiking in 11, 12, 13, 14. Nobody would get to 15. But the federal Reserve has a lot of room on the downside as well. Right now what we are seeing is the upside with inflation being very high. But on the downside, the Fed normally is very patient. They keep rates down. So in 2015 they start raising rates, Steve, and then it takes them almost three years into 2019 just to get the rate from zero to two and a quarter percent. Two and a quarter percent. From zero to two and a quarter. Where are we right now? Five and a quarter. Right. It's a range actually. So five and a quarter to five and a half. But just to go from the zero to two and a quarter, they had nine quarter point increases spread across three years. That is how hard it is to raise rates when the economy is not doing well. Something that everyone has conveniently forgotten, by the way. It's very, very hard for the Fed to even raise rates once a quarter, let alone once a month when the economy is doing poorly. By 2019, the Fed had managed to raise rates to what they call their equilibrium rate. The Fed Funds equilibrium rate, which the Fed talks about often is about 2 to 2.5% for the Fed funds rate. In case you're wondering, that means a 30 year mortgage of around 4.5%. Also means a 30 year multifamily Freddie Fannie loan of around 4 to 4.5%. So 4%, 4.5%. Those numbers tend to move throughout the year. And just so you know, what is it based on? Well, it's based on the fed funds rate, that aforementioned two and a quarter percent. Right. And then on top of that, the Fannie and Freddie basically put in what they call their spread. And their spread is, in bad times, like right now, 150 basis points. In good times, they might raise that spread to 200, 250, because there's room. Right. Rates are cheap. So you total those up together and you're looking at 4.5% for fixed rates. Now in bridge rates, probably a little bit higher than that. Right. But not much. Not like today where bridge rates are completely insanely out of control. Right. That time was the right time for us to say, can we go back there in 2026? And what would cap rates look like if we went back there? So today, cap rates in the multifamily market, I'm not going to comment on other commercial real estate is five to five and a half percent. That's a range if the fives are very common, if you have a loan assumption because there's no exposure to today's interest rates. And five and a half is pretty common if you have a large building that's 300 units or 250 units, where if it's 200 units or 150 units, probably somewhere in the middle. Five, five and a half is very common. And there's markets that are a little bit lower than 5 and there's markets that are a little bit higher than five and a half. But five to five and a half is where a lot of the industry is living right now. Where were we in 2019 in a normalized environment? Well, we certainly weren't at three and a half cap because that madness only happened once in late 2021, early 20. And we'll never come back unless we have to basically do something just as crazy as Covid. Never say never. But assuming that Covid or something like it doesn't happen, we're very unlikely to go from five to 5.5 cap down to three and a half to four cap. That delta is 150 basis points or 1.5%. Well, as it happens, in 2019, cap rates were halfway there. Halfway 75 basis points back. Right. Or 75 basis points down. Which means when cap rates go down, prices go up. So in a normalized environment, we're not where we were in 2021. We're not where we are today with 5.5% fed funds rate. We were halfway in the middle. And to me, 2026 represents a really, really good chance of getting back to that point. And there's a lot of people that have recently started believing because they unfortunately spend very, very little time reading actual Economist data. Mostly they get their stuff on Facebook or they read either the far left or far right articles which are designed to obviously grind an axe. And there's people who are saying, oh no, we don't think inflation is going to come down for years and years and years. It's not going to come down. My feedback to those is, and I'll stop here, Steve, but my feedback to those is today, am I spending even one millionth of a second worrying about inflation in August 2023? No. But am I worried about disinflation? Absolutely. I am really worried about the lack of inflation that I see in the economy today. I know what happens in the next six months because it's a very, very clear trend. I'm worried about disinflation. I'm worried about too little inflation. I am not worried about inflation at this point. The Fed has done an outstanding job of bringing inflation down to where it is today. So I'll just stop there and say I don't see any reason why by 2026 we could not have a normalized federal policy with 30 year fixed rates for single family and multifamily being in the fours. Somewhere in the fours.

So, so with that in mind, Neil, you're looking out to 2026 and we're at seven months into eight months into 2023 and you have all these real estate investors and syndicators and they're looking out and they're trying to buy properties. Owners who own the property still think they're in 2021 year and the prices are still high. And, and the buyers, the, the bid to ask is so.

So what do.

You as a syndicator or a real estate investor going to buy multifamily, looking out, seeing where it's going, what's your advice to them? What guidance can you give them? Because right now I'm seeing more deals not closing than closing and they get close almost to the one yard line and it falls apart. Something happens and it goes from there. And I've talked to some peers that they're up to bat, they're swinging the bat and they're not getting very many hits. What's it look like for the next couple years for the syndicators?

Well, slice and dice, what you just said. Right. So on the one side there's a high cancellation rate, which I agree with. On the other side you're saying that the bid and the ask is still too wide. Right. Those two things generally don't go together because if you continue to have a high drop rate and the drop rate's getting worse every quarter. You know that, Steve, are the percentage of deals that we take a swing at that actually closes is continuing to drop quarter after quarter. Well, that means that the bid ask gap must get narrower because as more and more deals drop, the sellers become educated on what price is really necessary for deals to close. So I am going to say this. Even though it gets me in trouble all the time.

It doesn't sound like you care about that.

I do not. But that doesn't mean I don't get in trouble over it. Sure. For high grade, high quality assets that have a lot of demand or persistent long term demand, like multifamily. Right. Again, I am not talking about any other commercial real estate class except for multifamily. For that kind of class, the bid ask is always unreasonable. So 2014, unreasonable. 15, 16, 17, 18, 19. These are all pre Covid years. In every one of those years when Steve and Jake were basically doing podcasts, if they were heading west back then, they were saying the bid ask is ridiculous. Sellers are asking for too much. That hasn't changed. At no point during those years did you say the market is in equilibrium. You didn't, Right?

It's fair.

You didn't. No one did. No one ever said that. Everyone said that the sellers are asking for too much. So that part of it is actually ever present, regardless of what the cap rates are, regardless of what interest rates are. And I would argue, Steve, that today the bid ask is actually narrower than it was in 2021. People ask me, well, how many properties did you buy in that madness? And the answer is I could have bought two dozen. I ended up buying one and a half. One of them was my own property. I just exited my partner, so I had to raise some equity. But I knew that property and it's, you know, it was a five cap property, so I was fine. The other property that I bought was in Killeen, Texas, which basically I had to live with the military base and its challenges and, you know, people leaving for the Ukraine and those kinds of things. So that's it. There's a risk that you take when you buy into a military city. But on the good side, I paid 5 plus cap for that property. Right. So that's what I did in terms of purchasing properties in the madness time frame. And I can tell you, in the madness time frame, I was consistently losing offers by Millions of dollars. I was 2 million out, 3 million out. Months would go by before I got into a best and final. Today I'm losing offers by 2003-004005-00000. So the bid ask is actually more reasonable even though I am on average paying 20 to 22% less on the property than I would have bid in 2021. So unreasonable. Sure. Less unreasonable, definitely. Right. So as a syndicator, if you are going to wait for some magical time when the bid ask will be in equilibrium. Well, I want to remind you that it didn't even get there in 2010. Even in 2010 and 2011 when I mean there were a million single family homes that you could buy. Even then every buyer thought that the sellers were selling for too much. It never changes. Right. So there is no reason to wait to buy properties because you think that the gap between sellers and buyers is, you know, should not be there. If you think that the gap is, that is not going to be there, you will never buy another property. Enjoy retirement.

Neil, the reason for saying that, because you hear some of the sellers sentiment. That's why I was asking about interest rates. They're saying, oh, the interest rates are going to come back down, the value of my property is going to go back up. So if I don't get what I want, I'm just going to hold onto it and do it again. And then you see it come out nine months later or a year later from that timeframe.

And so they're learning. That's what you're saying, Steve. Because the fact of the matter is that cap rates have increased from about three and a half cap for certain kinds of properties, value add properties to five. Okay. Some people might say no, it was not really, it was four and now it's five and a half. Well that's still one and a half percent. So whatever your two numbers are, one and a half percent seems to be appropriate. Now for those people that not fully educated on how cap rates work, basically that's a 25% discount. So we have managed as a group of buyers, you, me, Jake, have managed to drag these sellers kicking and screaming to a 20 or 25% discount in the last 18 months. I call that progress because their net operating income has not dropped during that time. So we are still buying the same or greater net operating income at a 20 or 25% discount. Should the discount be 5% more? Sure, but show me the last time, even in the middle of the 2008 recession when the bid ask was zero, hasn't happened.

Yeah, that's fair. I mean, the more I think about it, if brokers rarely undervalue a property, so if that spread is not there, that probably means you're over valuing what you're intending to buy.

There has to be complete capitulation. Right. And even during complete capitulation, let's say cap rates go to seven. Steve and Jake are going to be saying seven's too little, I should get seven and a half. Yep.

Fair, Fair, fair. All right, Neil, I want to come back to something. You'd made a comment on the recession. I want to come back to the recession. It sounds like from what we're hearing in on the news and from, from people who are prognosticators, if you will, that they're thinking that there's not gonna be recession if there is gonna be minor. I mean, you kind of touched on that. Do you think there's no, you know, there isn't gonna be a recession? And let's just assume that there is. Let's say that that one's gonna come the end of 23. How's that going to affect rent growth? What do you think? Is there going to be, is there going to be a negative rent growth for a short time or what are you thinking will be the outcome?

Sure. The United States has had negative rent growth for the last year, even though all of the numbers published are in the 1% range. And I'll explain why. There are two rent growth numbers in the US that everyone should look at. The net and the gross. Right. So the, the gross number is positive. So according to RealPage and I go to the Globe street website every day, sort of click on four or five articles. The RealPage publishes a lot of stuff there. And according to RealPage last week, rent growth in the United States is slightly under 1%. Right. And people are like, oh, but so rent growth is positive. The answer is hell no, it's negative. That's because rent growth has to be adjust inflation adjusted. So the net number of inflation is really the one that you, a friend. Growth is really the one that you as a professional have to have in your head. Now let's go back the last 50 years and look at inflation. So sometimes inflation's high, like 74, 1974 to 1984, somewhere in the 7, 8, 9, 10% range. And then the rest of the time inflation in the United States has been pretty darn low, with a small exception in 2006 and 7. But the rest of the time it's been very slow. Very low. So the Fed routinely struggles to get inflation up to 2%. They try, they do all kinds of shenanigans to try and get inflation up to 2%. But if you look at the 10 year average, even with the last year, we're still under 2%. Right. Even with the madness of the last year, we're still under 2% average for the last 10 years. And what's rent growth? Well, rent growth for the last 10 years has been about 3.5%. Right. So it is very normal for rent growth to be about 1 1/2% above inflation. Because inflation basically sets the prices and because we're not building enough single family and multifamily in the United States, you've got to be above that base price. Base price is equilibrium, that's inflation. So anything that has even a small shortage is always going to be above. So on a 10 year basis, rent growth usually tends to be about 1.5% above inflation. Now, today, inflation in the last 12 months, the numbers that I hear for headline CPR are around 4%. Doesn't that mean that rent growth should be at 5.5%? Yeah, but it's not, it's at 1. Well, what's this 4.5% gap? Well, this 4.5% gap is basically caused by two things equally powerful. Number one, when you've just had a 15% rent growth in a single year, the following year at 1%, if you average it out, you're still at 8.

Oh, good.

Take two years, average it out. Now you're at 8%. Inflation's at 5. During that time, those two years, average inflation was at 5 and a half percent. So you're 2 and a half percent higher. Good job. Rent growth. Right. So we're adjusting because we just had a ridiculously high number. 16% makes no sense when inflation was only around 5%. Right. So why was rent growth at 16? The answer is people had money. We took helicopters all over the country and rained roughly $1.2 trillion on Americans differently from what we do in 2009, because that was basically quantitative easing where the money went into the banking system. Here, money went into people's pockets. So people overpaid for rent because they could. Right. It was just everyone had a shit ton of money and that money is now gone. Now people are basically back to their salaries. And so now you're seeing an adjustment of that process. So the first thing is rent growth's low because it was too high. If you average it out, it's awesome. 8% rent growth. I will take it. I will do the naked dance on the street with the Champagne bottle for 8% average rent growth. That's what we've had for the last two years, right? Here's the second reason. We have one of the biggest supply or inventory overhangs that we've had since the 1980s. There are currently a million units in construction. In 2023, we will have about 425,000 multifamily units of different stripes and colors that will come to market. The market currently can absorb about 300,000, 325,000, so that there's 100,000 units that are spare. And those 100,000 units are pushing down on rent growth because of something known as concessions. When new construction comes into a marketplace where rents are not growing right now, they're flat developers like me use one month off or two months off to lease up their units and keep the rents high. They don't want to drop the rents because that affects their takeout loan. They want to get rid of that construction loan. So they keep the rents high and they offer one or two months concession. Many markets in the United States are currently at two months concession. Well, that means that it's very, very high for the value add properties around this new construction property to raise their rents. That overhang really doesn't go away for another 12 or 13 months. Well, I just say end of next year, in 2025, there is no overhang because once interest rates started going up in 2022, that started to affect new construction projects. And many of the projects that were going to be greenlit didn't get green lit. They got pushed back, they got frozen. They got slowed down. Their numbers of units were reduced from 300 to 200. They were phased. Whatever the reason might be, in 2025, there isn't a lot of inventory coming in. So our next chance to have strong rent growth in the United states is in 2025. But I'm betting it'll still take time for inventory to clear up. I think our next great rent year is 2026.

So what do you. Neal, again, we're talking about 2026, the next year, waiting for 2025. You've got a lot of these syndicators here thinking they bought in the 21:22. It was a wild, wild west. You buy anything, it comes up C class, A class, whatever, looking out for the next two years. And there was a lot of supply coming on, like you said, driving prices down with concessions, it appears to me. And that if you're going to buy something, you've got to make sure it's got a good value add component to it so you can increase the rents after they have rather adding the value add to it as compare just buying a nice apartment complex and make it a financial decision. If you really want to get the upside, you got to have something and value add. Is there some Class ABC that you would say stay away from for the next two years or is there something you would say just as the numbers work out and you can make it work, go for it?

No. My advice for people is this. You're a syndicator. Your job today is to turn all of your speculators, and you all have lots of speculators back into investors. That's your job today. There is nothing fundamentally wrong with the market or with pricing. You can buy A's, you can buy Bs, you can buy Cs. It's hard to make the numbers work because if you put a fixed loan on it, right, your cash flow is going to be low and you're not going to be able to refinance. You're basically stuck for five to seven years. Correct. If you put a bridge loan on it, again, your numbers don't work because of bridge loans being very expensive and the leverage being low. My feedback to you is this. Do whatever you can. Even if you go out and buy a fixed loan today, if you convince your investors you're still better off than you were 12 or 18 months ago. If you compare today's high fixed rate loans to where you were 18 months ago and just go back and look at your portfolio from 18 months ago, you'll find that that fixed rate is significantly better on a risk reward basis that you buy today than anything that you bought 18 months ago. And I'm sure everyone's regretting the stuff that they bought 18 months ago. So bottom line is you're better off if you're better off than then. And back then you were buying this stuff like it was $5 widgets from Amazon. Why wouldn't you buy today? Right? A, B and C all makes sense now. I'll give you something better though, Steve, I expect, and I'm predicting that six months from today, the bridge market will become solvent. A lot of people don't fully understand or take the time to understand. This is our craft. We are professionals. Our job is to understand monetary policy and how it affects our properties. And I find that people do that at a very surface level. And that's a real problem. Right? And by the way most of our industry is immature anyway because, you know, the Jobs act passed in 2014, so syndication came in in 2014. Everyone's immature. So here's two things that people don't fully understand. Number one, people are like, rate caps are really expensive because interest rates are expensive. Interest rates have nothing to do with rate caps. Interest rates have nothing to do with rate caps. People are like, really? How could that be? Rate caps are millions of dollars today. No, the only thing that impacts rate rate caps is the direction of rates. So I could have 10% fed funds rate and still have the cheapest rate caps of all time. If the Federal Reserve simply said, we are convinced we're done, we're not going to plateau, we're going to take rates down by 5% in the next year. Rate caps would be practically $0, $0. Right. Even with interest rates at 10%. So they have nothing to do with rates. And I don't think syndicators actually none of them understand this concept. So I am telling you, we're in August the first time the Federal Reserve cuts rates, and I'm guessing that'll happen in February or March. Who knows, sometime early next year the Federal Reserve will cut rates once. But the moment they cut rates the first time, the direction of rates now is downwards, down.

Absolutely.

How do you have expensive rate caps when the Fed is A, showing the dot plot moving the interest rates down and B, actually cutting rates following through with what they're saying? Right. So my assertion is that next year rate caps are going to get cheaper or a lot cheaper. And that's what might save some of those people that have rate caps until 2024, because they may be able to again kick the can down the road with the help of the lenders. So Q2 next year, Q3 next year, you should see some cheap rate caps. Now, what's the corollary to that? When rate caps are cheap, bridge loans tend to also get cheaper, because bridge loans are also a bet on future direction of rates. So once again, you can have high rates, but if there's an expectation of rates to go downwards, then all of a sudden the bridge market starts to open up. So it's possible that somewhere in Q1 or Q2 next year you start getting bridge loans. I mean, they're available today, but they're outrageous, right? So that outrageous nature of bridge loans, the LTVs, the LTCs, the interest rates should all be in a significantly better position in six to nine months because once again, rate caps and bridge loans are more tied to direction of interest rates than to interest rates themselves. See what I mean?

Right on. Absolutely.

So. So to me, syndicators are thinking, I have to wait until 2025 or 2026. The answer is nonsense. You don't even have to wait for six months. You're going to see better numbers in 2026. Now, does that mean that I think cap rates are going to compress in early 2024? Hell no. Cap rates are actually going to decompress. If we are five to five and a half percent right now, I think we're going to be five and a half to six percent and that may be the bottom. And we might hit that bottom in Q2 or Q3 next year. Why? Well, firstly, Steve mentioned that a bunch of properties are below the SCR of 1. Correct. Well, more than 90% of those properties have not been sold yet. Correct. Because many of their rate caps are expiring this quarter, next quarter. Next quarter, next quarter. So there's these rate caps expiring at different times. So that inventory, Steve, still has to come to market. Majority of it comes to market sometime in 2024. And given such a large number of properties will come to market and are technically distressed, you're likely likely to see at that point of time a slight bump in cap rates as a lot of that inventory comes up. Second, a year ago, rent growth was still in the 4% range. Today rent growth is at 1%. Right. Even though expenses are high, insurance cost is high, payroll cost is high. So NOI is not growing at is actually beginning to dip because there's always a 12 month lagging effect on net operating income. So you might actually see a small decline in NOI in the overall market market over the next six months. And that small decline in NOI can also have a put pressure on cap rates and keep them higher. So I am not projecting that cap rates are going to rise in Q1 and Q2 next year. They may not rise in Q3. Oh, sorry, go down. Sorry. I'm not projecting that cap rates are going to go down. Go back down in Q1 or Q2, possibly not even Q3. Q3 is my personal bet on when cap rates are going to be highest. But here's the cool thing. If I turn out to be right and by Q2 the bridge market comes back and rate caps are cheap, but Q3 is when cap rates are going to be highest, doesn't that mean that Q2 and Q3 are going to be an insane opportunity to buy everything in sight?

Mm, absolutely. Absolutely. And it's, everybody is talking about all these, all these different scenarios from that timeframe. And 2024 ought to be a real interesting time for us, for the syndicators. And what we're doing is at Skyline we've got our dry powder just sitting here waiting to see what things are happening, be ready to pounce on some things that come up. And Neil, what do you talk about? What about the syndicators now that have their rate caps expiring in the next six months, maybe the next four months?

There are very few options. I think that if they're expiring the next four months, they need to be selling now because I mean they could get to the point where they're in full default. Some banks are friendly, some banks are not. Unless you know your bank is friendly, you'd be very careful about going into default and then trying to sell your property. There are all kinds of bad things, covenants in your docs that you sign, never thinking once that these covenants meant anything. If the bank's not friendly. All of those trigger if you're in default. In certain cases, banks can even turn recourse loans, non recourse loans into recourse. Read the frickin language man. So bottom line is if your rate caps expiring the next four months and you haven't managed to raise enough money to pay for a rate cap, new rate cap, or to kick the can down, or you don't have an agreement with your bank to kick the can down the road, I don't think you have options. You need to put your property on the market. You know, don't gamble with investor money. And I know that in most cases you're not going to get most of their money back, but some money back is better than none. But if you were four to eight months out, there's some light at the end of that tunnel and that light seems to be headed your way. Just make sure it's not an oncoming.

Train, as they say, going through the tunnel. The train's not coming at you. Absolutely.

Before I have two other things I want to chat with you Neil, before we wrap up because we're coming up on 45 minutes, but Bill Durant is what we'll end on. But before we go there, I want to, I want to end on a high note with Bill Durant. But let's go, let's go the other direction first. It's no secret. Office space from an asset class is struggling, has been struggling. If you walk through any office spaces today, it Looks like an apocalypse has happened. There's nobody there, very few people. If you own office space, you've got your own difficulties to deal with. But I'd love to hear your input on. Do you see the upcoming office space, let's call it apocalypse, as I use that word. Do you see that affecting the other asset classes? You start to hear, I've heard, I won't name names, but I've heard other people in the industry talk about, well, you know, you might not own office space, but because the problem is so big, it actually might affect these other asset classes. What do you, what are your thoughts on that?

The answer is yes and no. So I believe that properties, multifamily properties that are dependent on downtown type high density environments where there's a large number of offices that are going to be vacant are going to be affected. The impact actually is going to be two step. So let's assume San Francisco is the best example. Right. A building just sold in San Francisco for 20% of its 2019 appraised value. It was the Wells Fargo building. Just Google Wells Fargo San Francisco building and you'll see it's an 80% discount. And then across the street from them, the Union bank building sold for a 75% discount from its 2019 value. So the unlike multifamily office peaked in 2019 where multifamily peaked in late 2021. So we have to use that as the peak value. So San Francisco, worst market in the United States for this kind of stuff. So what's happening right now in San Francisco? Well, the occupancy is now basically in the 70s and it looks like it's heading towards low 70s, break even point is somewhere around 86, 87%. So basically everyone's bleeding or highly bleeding or ridiculously bleeding. And so what happens to condo prices? So what happens first is in a downtown, it's the condo prices. All these multimillion dollar buildings, they start getting affected first because those condo prices are propped up by the office prices and then that eventually waterfalls into multifamily properties in that area. Right. So it's central business districts, also called CBDs and downtowns. Multifamily in those areas is going to be affected. The good news is only about 10% of the multifamily in the United States is in those areas. Those 10% are likely to see pretty drastic declines in value. Could be as much as 40%. Right. It's not going to be 50. So office is going to drop for sure to 60% plus from 2019 value overall, I think the office market is going to drop. Large Office might drop 60%. Small office might drop 40. Why only 40 for multifamily? The answer is it only has to get cheap enough for people that live outside of the downtown core to come live in the downtown core because they're getting a bigger discount than the suburbs. Normally the suburbs are a bigger discount. Well, but suburban properties are only down 25%. What if downtown core properties were down 45%? Well, now whoever's buying this property can actually drop the rents and actually pull people from the suburbs, which isn't the most difficult thing in the world to do. So there's going to be a, you know, a level under there. But when I look at the overall industry, keep in mind we have 19.7 million apartment units that are tracked by, you know, costar and Yardi matrix. Of those, I'm assuming that less than a million are in downtown cores and CBDs. So it's a small portion of the industry.

Yeah.

Good.

Okay, well, let's add on a good note, the high note. Neil, you know, we've listened, we listened to a lot of content of yours and we know Bill Durant is a topic you discuss oftentimes and I'd love to talk about it one, because it's not a terminology that maybe many investors know about. Syndicators do know about it, people in the industry, but investors might not know about it. What about build Durant intrigues you, especially now in what we're going through in 2023.

Very simply this. Before COVID home prices were expensive, but people who were in the 75-85k range in terms of income, annual income, were able to still afford a single family home that they were able to buy, let's call it a two bedroom or one bedroom shack built in the 40s or 50s. You could still afford that one or two bedroom sh shack and start your process of being a homeowner and moving upwards for the next 20 or 30 years. Because that's what people did. They basically buy that shack and then shack would go up in value and their income would go up after five years or 10 years and then they'd basically buy something a little bit better and then they'd repeat that process every 10 years for 30 years building equity and that the vast majority of middle class America's equity is in their homes. Sure. Right. So prior to Covid, that was hard to do, but possible for people in that 75, 85k annual income range, family income Range that was completely destroyed by Covid. It was just completely crushed by Covid today in the United States. And this is an accurate number. You need to have earned 88% more in the last three years to buy that same shack. That same shack, Right? Well, how many people in the United States got 88% raises in the last three years? And many markets like Tampa, it's 122%. So what we've done after Covid is completely destroyed the American dream of homeownership, it's gone. And if home prices today fall by 20%, they're not falling. Right. In case anybody's wondering, well, interest rates are high. Home price should be falling. Please go and check. Home prices from their peak in June 2022, they peaked late, have dropped by 1%. Wow. One amazing percent. Right? And why? Because everyone's got rates locked in at under 4% for 30 year fixed. So everyone's just sitting on their homes. And because there's so little transaction volume, why would prices drop? There is 5% inflation in the economy. So a 1% drop is technically a 6% drop, right? Because 5% up 1%, down to 6%. Point is today, when you buy a mortgage, that mortgage is $1,000 more than a year ago, even though home prices were 1% more expensive because you're, instead of a 3% mortgage, you now have a 7.1% mortgage today in August. Well, that's more than a doubling of your interest rate. So what has happened is a home, that shack that you could afford, it's gone. Right? And let's assume for a moment, let's assume that rates go back down to 4%. Three is kind of hard to do. That was Covid, but let's assume it goes down to 3,4%. Okay, well, now you still need about a 45,000 increase in salary in the last three years. Again destroyed for most people. So Covid basically has now massively accelerated a new class called build to rent, where the only choice for people who don't want to live in apartments because they have three kids and two dogs is something known as built to rent. Because obviously you could rent a single family home. But have you seen how ridiculously expensive the prices of home single family rentals are? The only solution is that we now have this intermediate class of people that their families are too big or they make too much money to want to go live in apartments. And that class, which I sometimes hear 8 million families, sometimes I hear 18 million families, they want to live in a home they can't I can't even afford to build a build to rent single family home for them. I tried, it didn't work for me. So now I build townhomes and there are at this point over a hundred thousand built to rent units, majority of which are townhomes that are the replacement for that lost dream. And that's why built to rent is an amazing asset class. Because these people, they have a lot more money than the average tenant. The average tenant in the United States makes less than $45,000 a year. These people make 75, 80,000, 85,000. They want to live in a home and if they can't afford to live in one that is their own, they still want to live in a home. That's what build to rent is. It's a new asset class.

Yeah.

Neil, with the build to rent, how do you keep the expenses to build a townhome down? I know you've got some unique things that you're doing to keep the townhome cost down so you can, they can rent it at a reasonable rate. I think it was, I saw $20,000 a year trying to keep the rent under $20,000 a year. What are you having to do when you construct and design these built to rent?

I have a terrible answer, Steve. Really horrible, horrible answer. So I've had to leave 96% of the United States alone because I can't get to a rent of 20, $20,000 a year. I just can't make it work. I've had to walk away from every high property tax market in the United States, even markets as powerful as Florida and Texas. Because what happens is for me to keep rents under 20,000, right, the net operating income of the property is going to be really affected if property taxes are high. And that'll force my rents up way above 20,000, closer to 30, right? So basically I'm heading to high growth, unknown states, smaller markets, half a million people like Rogers, Arkansas, which are five times 10 times faster growing than the rest of the U.S. and have the lowest property taxes in the U.S. because one thing that is not well known even to syndicators is property taxes are an 800 pound gorilla when it comes to net operating income. Nothing comes close. People are like, my labor costs. I don't give a. It's your property taxes, right? They don't understand how huge a portion of, of operating expenses property taxes are.

Yeah, and that gorilla keeps on growing.

It is, I mean, it's ridiculous, right? I mean property taxes in the United States are up. God knows I mean 15% a year. This is ridiculous. Right. We can't raise rents 15%, but property taxes are up 10, 15% a year every, every place. So I'd much rather go to Rogers, Arkansas, where property taxes are 0.35% than go to places in Florida that are 1.6%. Well, that's four times the property taxes per square foot in parts of Florida compared to Rogers, Arkansas. I'm not saying it's the best market in the United States, but it's the market where the math works the best.

So that the tertiary markets out there, half a million employment area and growth, but minimal property taxes and et cetera, the people that.

Yeah, cap rates. Right. So I have to deal with like in Rogers, like in, in, you know, parts of Florida, parts of Texas. I could basically put in four and a half cap exit and people wouldn't really bat an eyelid. Well, Rogers, I have to put five and a half cap and that makes it very, very hard for my projects to pencil out initially. Initially. But then my net operating income, you know, is much higher because property taxes are lower. And that's what allows me to still exit and make people, you know, make people 18 IRR with a high, you know, cap rate in there. And I feel today, you know, given what's happened, Steve, I actually feel better with a high cap rate, high noi property than a low cap rate, low noi property.

You know, Neil, I had the utmost pleasure of being involved in one of your boot camps. Loved it. I'm a mechanical engineer and I love the numbers. I love how you think in that process. And one of the things that was one of the most interesting was your location magic and how picking cities and etc. How has that your philosophy on location magic and some of the metrics to stay in a, in an environment like for example, when you're doing built to rent and Rogers or other smaller areas, how has that changed over the years and what you're seeing right now in 2023?

So location magic is a set of five metrics I'm adding to. The sixth metric is property taxes and the seventh metric is insurance. I think 32 make a lot of sense. So just for people who don't know this, insurance in the United States is rising between 15 and 30% a year. Right. And there's evidence that we're not at the end of that race. I can clearly say that we are at the end of double digits or high inflation. I think inflation in the United States, if you don't annualize it if you just look at the last two months, we're at 2.4%. I'm not worried about 2.4% inflation. Could I say that next year insurance in the United States is not going to rise up by 10%? I can't. And the reason for that is simply this. Construction costs have gone up 34% in the last three years. And what is insurance for to replace properties that are destroyed? Well, if insurance construction costs up 34% in three years, that's more than 10% a year. Why would that mean that insurance costs won't go up by more than 10% next year? It clearly can. It clearly will. Right. And so I have to deal with that. So location magic is being modified to add two new 800 pound gorillas.

So. True. We've been underwriting and trying to get insurance costs on properties and it's like it's a moving target all the time. You can't get a really good number and everybody wants to hedge their bets. And so you plug something in and cross your fingers and see what happens. But I'm glad you're adding those two metrics. Yeah.

And I think one of the ways that I'm adjusting is I'm just going to places where, you know, when I'm building townhomes. By the way, the insurance underwriters strongly prefer new construction. Very, very strongly. Because they don't know what's wrong with these older properties. If the property takes a hit and there's something wrong in it that the insurer doesn't know about, basically you have to demolish it and then you have to pay the whole thing out. Whereas with new construction, you don't have that issue. You know, anything that could be an issue is something that's visible to you. So I'm finding that even in high insurance markets, with the exception of Texas and Florida, those two markets, actually, my insurance cost is pretty low on new construction townhomes and very high on value add.

Well, Neil, we're coming up on an hour. We've talked about a lot. But is there anything that you want to leave the audience with? Is there anything that we didn't talk about that you'd love to end the conversation with?

Yeah, yeah. I mean, actually listen to what Warren Buffett says. Don't just repeat the stuff that he says about, you know, be greedy when others are fearful, be fearful when others are greedy. Why don't you actually see what the guy is trying to say? And listen to him. This is not cocktail party stuff. He's actually talking about the philosophy of finances, which makes a heck of a lot of sense. In 2009, nobody would give us money to buy real estate, but the people who did, the small number of people who did, made shit tons of cash. Just remember that.

Yeah, apparently it's worked for Warren. Well, Neil, super appreciate you joining us today on the podcast, where can people find you if they want to get in contact with you, if they want to follow you, where can they look?

Luckily, I'm the only Neil Bauer on the World Wide Web, so type in my first name and last name and you'll find me. For those that like to follow our data and statistics, we publish 12 interesting, fun webinars a year on multifamilyu.com. that's multifamily followed by the letter u dot com. Roughly 20,000 people a year sign up for our webinars. 25,000 people. They're all slightly geeky like me, but we try and entertain them as much as we can. So you can join us@multifamilyu.com once you're there. Every once in a while you notice us talking about an upcoming project and you can get involved if you wish.

Yeah, and we'll link everything in the show notes, but we could not. Steve and I could not recommend Neil and his team and the content they put out anymore. So please check it out. But until next time, we appreciate you guys tuning in to Heading West. And Neil, thanks again for joining us.

Thanks for having me.