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How to Win Deals in Today’s Market
August 9, 2021
For a while now, prices have been very high, and the market very competitive. Good deals both on and off market do exist but they are very rare and require a ton of work to find. However, just because there is a tiny percentage of good deals out there, does not mean you should expect to be able to walk into a marketed deal process and a best and final process and buy the property at a discount. “Discounts” are nearly nonexistent and certainly won’t be found in a competitive bidding process. In fact, we are seeing most deals that go through a full marketing process sell above the whisper price, or pricing guidance.
Unfortunately, virtually all valuations are full to overpriced, leaving investors with the difficult decision of where to invest their capital. To pile on to this difficult situation, prices are high and deals are competitive across A, B, and C class assets as well as primary, secondary, and tertiary markets. Furthermore, while there is a slight return premium to be had for going out on the risk spectrum either from a class, market, or business plan perspective, the marginal return is slim and usually not worth it. To find great deals in secondary and tertiary markets, one has to diligently hunt just as they have to in a primary market – so that is not an easy solution.
Additionally, the perceived discount or cap rate premium that exists in smaller or weaker markets is discounted by the fact that the growth prospects are usually lower than more expensive markets. Lastly, optimally managing properties becomes a more challenging task in a small market if your operations are not set up for it, which can erode the return premium originally underwritten. This means that most investors are better off focusing on taking less risk and focusing on quality assets in growing markets. However, this answer may be frustrating since the prospective returns for stable and growing market deals are near all-time lows, around 10% net IRR to investor, which may be unacceptable to quite a few investors.
This brings up the conversation of relative versus absolute returns. Relative returns are the returns you can achieve relative to other options in today’s market. For example, you may be investing in a class A multifamily deal for a 10% IRR or you could invest in unlevered hard money loans at 8%. Additionally, you could compare these return options to stocks and bonds. You could make the argument that a 10% return today is attractive on a relative basis considering that global interest rates are largely 0% or negative. However, at the end of the day, most of us are not just relative investors, seeking the best return option today, we are also absolute investors, which means we have certain return targets irrespective of what the market is offering.
For example, some investors only want to invest in alternative real estate investments if they can achieve a 15% IRR. They are less concerned about the quality of the deal, business plan, location, or the way the deal is financed, and more concerned with the numbers projecting out to meet his or her minimum return target. This is a fair approach since we invest to meet our certain goals of passive income. But this sort of mindset can lead to risk taking since more risk must be taken to earn the same returns as before when interest rates and prospective returns lower across the board.
The paradigm shift is to accept the high prices today and find great properties worth paying up for in this competitive market. Instead of trying to find a discounted deal which may cause you to search in the “undesirable bin” (you will find high prices here still), investors are likely better off accepting lower prospective returns in exchange for greater certainty of those returns.
Great opportunities today are those which exhibit true value-add potential. The reality is that 90% of deals brought to market today are advertised as having a value-add component, with the goal of selling for a higher price due to the potential upside. Unfortunately, this means that many investors are overpaying for deals that don’t really have a compelling value-add component. Even if the value-add story is real, the price likely fully reflects this upside and leaves you back at square one.
The key then is to find properties priced fairly, with true value-add potential, and are located in strong growth areas that have previously experienced robust population growth, job growth, and little new supply. This last part is really the trick. Most people focus on demand and will praise a location for its wonderful growth statistics, but will rarely analyze the supply pipeline in comparison to the demand.
The difficulty of most markets is that developers only build in high quality locations where growth is occurring, therefore mitigating the upside potential associated with such growth. Meanwhile, neighborhoods which are of little interest to developers may have no new supply but they also likely lack desirable growth, otherwise developers would be there. I think the workforce housing sweet spot is identifying areas which are growing quickly and have strong affordability (rents in relation to median household income is roughly 20%) yet are still too cheap to attract developers.