Infrastructure costs and lead times for multifamily projects have increased due to rising building material prices. Steel, concrete, and gypsum products are growing at a record rate, and supply chain delays are lengthening project deadlines. Commodity prices for copper and timber reached 10-year highs in May 2021 and are still hovering in record ranges. Although we are continually monitoring and assessing expenses in our underwriting during this unstable moment, we remain optimistic about the profits that multifamily real estate investment delivers and feel there are compelling reasons for investors to not remain on the sidelines.
Higher Development Profit Margins Than Ever Before
High development margins may appear surprising given how much attention is paid to building expenses. But the reality is that despite price volatility, multifamily housing fundamentals are still solid and continue producing a high projected return on investment.
Investors should consider three factors that are vital to the success of each development agreement to comprehend the impact of rising commodity costs and the long-term expectations for multifamily real estate:
- Increase in rent Net operating income (NOI), or the earnings an investor may generate from a property, closely correlates with actual and anticipated rent increases. In December of 2021, the average rent increased by 13.5% to a new high of $1,594. Demand for rental accommodation has increased throughout the epidemic. The need for rental accommodation has grown significantly during the epidemic.
- Cap rates. As a proportion of the acquisition price, capitalization rates—first-year net operating income, or NOI—are decreasing. Cap rates at a constant NOI fall as property prices rise. As real estate prices increase, cap rates decrease at a constant NOI.
- Building expenses. Although commodity prices have an adverse effect, some signs indicate stabilization. Lumber futures, for example, are exhibiting a continuous fall, reflecting that perception in the market.
How Multifamily Rent, Price Growth, and Construction Costs are Moderated
The truth is that even while growing building prices appear to be a financial barrier, rent and cap rates easily make up the loss. For starters, rising prices indicate that demand for multifamily housing is strong.
The second point is that cap rates are significantly reduced than they had been in 2020. The epidemic has caused uncertainty in hotels, offices, and other rental properties, which has caused the financial markets to move toward industrial and multifamily housing developments. The affordability of borrowing is driving up prices for these sorts of properties. As prices grow, cap rates decrease with a constant NOI. 10% cap rate is applied to a $1 million property with a $100,000 NOI; at $2 million, the cap rate is 5%.
Low cap rates and steady rent increases work well together since they are both advantageous. The future worth of the property ought to increase if the rent roll is anticipated to increase, as it already does. The capitalization rate acts as an earnings multiple.
Making Two Elements of the Equation Work in Profit-Maximizing Solving
Currently, multifamily investing may be successful without investors succeeding in all aspects of the equation. It is feasible to construct multifamily housing if two out of three factors are good. A private investor in real estate may wait for building costs to decrease. However, given that multifamily construction margins are now at record highs of 35%—it will be challenging to find superior risk-adjusted returns in the near term. For example, the difference between cap rates and return on expenses in Phoenix increased from 30% to 55% during Q4 2020 and Q4 2021.
The other inputs could alter once costs do start to decline. Rent growth might be slowed by decreased demand. As a result of the uncertainty, cap rates may rise, further limiting profit possibility.
The ideal option would have been to develop during the epidemic since it would have had the lowest input costs, future rent increases, and lowest cap rates. If other factors make up the gap, higher commodity prices won’t have an impact on returns.
The greater admission of baby boomers into the 75+ age group, when rental costs generally climb, will occur during the next 20 years, boosting the growth of older tenants.
The Implications of Volatile Inputs on Pricing
Projections are challenging when commodity prices are unstable. The danger can be reduced, though, in several ways. The approach is to employ a cautious pricing strategy that budgets more money for such situations while taking future steel and lumber prices into account. To test whether the agreement can withstand the volatility, we will assume $1 million for growing construction expenses in addition to a 5% contingency for building (i.e., $2.5 million). A deal is worthwhile if it generates a 35% profit after accounting for contingencies of $3.5 million and pays the cost of capital.
A big margin for error might result in one of three outcomes:
- The cost is greater, using the whole contingency, while the profit margin remains at 35%.
- Costs may be reduced, and the project benefits from initial underwriting reductions, which boosts profits.
- The contingency reserve isn’t touched; expenses are paid exactly as predicted. The entire $3.5 million is deducted from revenue.
There are several perspectives on this price modeling. One example is a property that costs $200,000 to construct and sold for $270,000, resulting in a 35% profit. One more is the intended return on expenses, or the profit made assuming no increase in rent. The percentage difference between 4% and 5.5% is a 37.5% margin if the intended yield is 5.5% and the capitalization rate is 4%.
Inflation fears have been raised by price volatility as expected. Conservative underwriting anticipates rising input costs without a corresponding increase in output prices. Inflation drives up costs overall, including rent. The increased top line is a significant adjustment.
Why it’s so important to value relationships and experience now
Given the abundance of cash provided by private real estate, there is fierce rivalry for suitable development sites and reliable partners. In-demand real estate deals are sought after by pensions, trusts, family offices, and real estate funds. Several competitors are looking to put together financing and submit an offer when a desirable home becomes available. Finding excellent offers at the moment might be challenging, so act quickly when you do.
Our connections and track record are crucial in such a setting. We are seasoned growth market investors that regularly watch market indicators and leverage our local market networks to gain access to off-market opportunities. We have a variety of methods to make a deal happen, even in a situation when expenses are on the rise, and we can provide private real estate investors with investment alternatives that will help them achieve their income and growth goals.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.