Truly insane appreciation expectations

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Oh man, the brokers are at it again.

Got a set-up a few days ago on a smaller, rent controlled apartment deal where the broker is pricing in 8% annual appreciation in order to estimate the profit a buyer can expect on the deal.

To understand why this is so ridiculous, you need to understand a few things about real estate, in general, and real estate in LA, in particular:

  1. Prices for income-producing real estate rise and fall in opposition to interest rates (eg as interest rates rise, prices fall), assuming stable net operating income (eg, as long as rents and expenses stay constant)
  2. Interest rates are incredibly low right now, meaning that prices are very high
  3. Interest rates are universally expected to rise over the next few years, though no one can say exactly when or by how much
  4. Rent-controlled rents generally rise by 3% / year and no more

What does the above mean?

First, prices are already very high by historical standards. People are routinely buying 3-4% CAP deals, meaning they invest $1MM and get back $30-40k / year (not counting negative leverage, in the event they use amortizing debt). For them to go much higher, you have to believe investors are willing to buy buildings with zero cashflow.

Second, assuming stable interest rates and buyer demand, then we would expect the value of a building, as expressed by a multiple of the rents (GRM) to rise only as fast as the rents rise. But rents in the building we’re discussing are rent controlled, meaning they can only go up by 3% / year.

Third, interest rates are not expected to stay constant. They’re expected to RISE, which ought to reduce prices for buildings. If you assume CAP rates are 5% and interest rates are 4% and there is a stable relationship between the two (such that a rise in interest rates of .25% to 4.25% increases cap rates to 5.25%), then an interest rate rise of .25% means a building producing $100k in NOI goes from $2MM to $1.9MM.

Since rent increases will only get you 3% annual value increases and you’re investing into an interest-rate headwind, to get to the advertised 8% / year annual appreciation forecast by our friend, you have to believe that buyer demand is going to go crazy… but they’re already buying 3% caps. So you really need to expect buyers to be willing to buy buildings with essentially no cashflow.

Sorry, but that ain’t going to happen. And 8% annual appreciation is totally, utterly insane.

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