Posted - 05/22/2009 : 10:19:51
| Reposition Your Multifamily Portfolio for Inflation:
While some economists are concerned over the possibility of deflation, inflation appears unavoidable in the near future. The Federal Reserve is printing money at an unprecedented rate. This can benefit the well prepared apartment owner and it’s a good time to analyze and reposition your apartment portfolio in anticipation of inflation. There are four areas where an apartment owner should give serious consideration.
Inflation is a “rise in the general level of prices of goods and services in an economy over a period of time”. Some inflation is good for the economy where high levels of inflation can be devastating.
According to the Nobel Prize winning economist, James Tobin, to avoid inflation “investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects”, such as multifamily real estate.
While inflation generally hurts people on fixed incomes or those holding large amounts of cash, the well positioned apartment owner could benefit in several specific ways. Below are some areas where attention should be given now to best prepare for the inevitable period of inflation.
Financing: The Federal Reserve will begin raising interest rates once the economy turns the corner - they will have no choice. Now is the time to restructure your long term debt. If you are like the majority of apartment owners, you could have a variable rate loan, or a loan that has recently gone from fixed to variable or a short term remaining on your fixed rate loan. Those variable rates are at historical lows right now; however, they will most likely be going up in the near future as there is no where else for them to go.
It is tempting for an owner to keep their current LIBOR based adjustable rate loan with, for example, a 3.5% interest rate. However, that rate will not hold and we recommend getting a fixed rate loan for a longer term. A new fixed rate loan might be at a going rate of 6.5% for 7 years. If inflation increases to 3% (a mild level) your net cost of funds is actually back down to 3.5%. While the variable rate loan rates will be increasing during that inflationary period, your net interest rate on that fixed rate loan will actually, technically, be declining. If the inflation rate increases beyond 6.5%, your actual money cost will be negative. The net cost of that currently attractive variable rate will soon become higher than that of a long term fixed rate.
Rent Control vs. Non-Rent Control: Rents right now are declining off their peaks. We anticipate that they will continue to do so for the near future as unemployment is increasing and residents are downsizing and doubling up. In the long term, however, rents in Southern California will, for certain, be going up. Population will increase and new construction will be limited. Rents could skyrocket depending upon the severity of the inflation. Owners of rent controlled buildings will not be able to keep up with inflation as allowable increases will likely be below real inflation levels. In fact, it is believed by many economists that the CPI can actually be as much as 7% below actual inflation rates (the CPI is used in determining maximum allowable rent increases on rent controlled apartments). Owners of non-rent controlled apartments will be best positioned to take advantage of an inflationary economy as they will have the flexibility to raise rents in concert with the overheating market.
Acquisition: Holding cash at low returns is safe for the time being but not so in the long run. As inflation increases, the purchasing power of that cash diminishes and the safest, most productive place for that cash will be in real property. Generally speaking, the best place to hold assets during a period of inflation is in gold or real estate. But, keep in mind, gold does not produce a cash flow, tax shelter or dividend. It just sits and the owner hopes for appreciation. In our opinion, real estate, specifically apartments, is the best place to be to benefit from inflation.
Exchange: Move your equity into larger projects. Simply put, the more units you have, the more you can benefit from the four returns of real estate, Cash Flow, Equity Build Up, Tax Shelter and (very important with regards to inflation as noted above) Appreciation. For example, if you have $500,000 equity in a $1,000,000 property and the market appreciates 10%, you have made $100,000, a 20% return. If you move that $500,000 equity into a $2,000,000 property and the market appreciates 10%, you have made $200,000, a 40% return. Potentially, you could double your return with the same equity by repositioning into a larger property.
Conclusion: There are generally four ways to position yourself to take the greatest advantage of an inflationary economy, 1) Restructure your long term debt obligations, 2) Exchange out of rent controlled apartments into non-rent controlled, 3) Use available cash to acquire additional real estate and, 4) Exchange from small apartment buildings into larger ones.
While, in the near term, we anticipate continued weakness in occupancy and downward pressure on rents, in the long term there will be a tremendous need for apartments in Southern California and over the next 5 to 10 years demand will outpace supply. We have a fragmented economy and unemployment should rebound increasing the need for apartments. Occupancy will improve and rents will increase. Think with an eye towards the future and position your multifamily portfolio for long term wealth building.