By Brandon Polakoff
It feels like yesterday that COVID-19 struck our nation, sending the real estate markets into a frenzy. What would the next week, six months, year, or even multiple years look like? While very few investors decided to double down, most remained on the sidelines because they were certain more cracks would lead to better opportunities.
Of note, these “better” opportunities never came to fruition. We hit a perceived bottom, and the investment sales market effectively came to a halt. By last summer, effectively a year after the initial onset of COVID-19, we battled back with rallying cries of “Don’t bet against NYC!” ringing across the market (most coming from buyers who sat on their hands for 12 months). As buyer sentiment grew strong, investors started competing in masses, pushing pricing and sales velocity back to normalized levels.
As conveyed in Avison Young’s Fourth Quarter 2021 Property Sales Report, for the first time in two years, the Manhattan investment sales market recorded quarterly sales activity at pre-pandemic levels. More specifically, in the fourth quarter of 2021, Manhattan had 100 transactions for just over $6.2 billion in total dollar volume. This represented increases over the trailing four-quarter average of 117% and 307%, respectively. Furthermore, this was the highest quarterly dollar volume since Q3 2018 and largest for total transaction count since Q4 2018.
Well, here we go again…thanks inflation!
The inflation rate is currently ~8.3%, running around its highest level in more than 40 years. To reduce inflation down to a benchmark target rate of two percent, the Federal Reserve is committed to fighting back with endless “jumbo” Fed rate hikes. While different from the “fed” rate, which is the cost banks charge each other to borrow money, real estate investors are experiencing a trickle-down effect in the way of higher “mortgage” rates. This higher cost of borrowing is diminishing cash flow after debt service as well as predictions about exit cap rates (which I would argue becomes an overly inflated assumption tied to negative sentiment).
And herein lies the opportunity. While Warren Buffet is a brilliant investor, far above any level of sophistication I will achieve in my lifetime, I happen to find his famous quote “be
fearful when others are greedy, and greedy when others are fearful” to be misleading. In fact, Warren Buffet is a longtime advocate of dollar-cost averaging in volatile markets marked by price discovery.
“The concept of dollar-cost averaging is simple: Pick some stocks, figure out how much you can afford to invest, and then commit to buying shares at preset intervals. The idea behind dollar-cost averaging is that while you might overpay for shares some weeks, you’ll also underpay other weeks. All told, things should all work out in your favor so that you’re ultimately paying a lower price per share all in.” (Maurie Backman, USA Today)
I fully recognize that the stock market is different than the real estate market, but I do believe there are basic investment principles that apply to both. It is incredibly difficult to time the bottom of the market. Things can flip almost immediately, and then you’re too late.
The cracks are here, but they won’t necessarily last forever. Just like we saw in the summer of 2021 as we started emerging from COVID-19, things turn as soon as sentiment improves. Rent rolls were still very low (with extensive vacancy) when contracts began to get signed in rapid clips. However, assumptions about the future were optimistic again, pushing pricing levels higher and higher.
Over the next three to six months (at least) I expect sales volume to dip to very low levels. The reason being investors are both greedy and fearful. A good opportunity needs to be great (typically in the form of an expected call back from a seller that never surfaces). This is a flawed strategy. I have seen it time and time again. These investors do not buy anything until the market recovers and it is too late. Why not undercut the greedy and fearful, and smile when they eventually buy a similar asset at a much higher basis due to an improved exit assumption? Sure, your cash flows will be negatively impacted today by higher interest rates and the hold period may be longer. However, when the market turns, which it will, your ultimate profit (via sale) should far exceed the diminished monthly income.
Some examples include a property we sold to a buyer in May of 2020 in Greenwich Village. Prior to Covid-19, we had contracts out in the mid $30M range. In the blink of an eye, buyers smelled blood in the water and began offering $15-20M. There was a single buyer that recognized an opportunity and moved lighting speed to simultaneously sign a contract and close all cash at $22M. While money was spent to renovate the asset, the current value has eclipsed $50M. Buyers who backed off now wish they could go back in time.
The same could be said about a client who purchased an almost entirely vacant portfolio in Hell’s Kitchen for $26M in May 2020. Zero renovations were completed across the portfolio
after the acquisition. After selling one of the four assets for $16.3M after the market quickly improved, their basis in the three remaining assets dropped to ~$10M. The current value for these properties exceeds $20M, in a high interest rate environment. Once again, an investor saw a good opportunity and acted on this intuition. While it is easy to look back on these acquisitions and forget the boldness required, when everything transpired it felt like the world was going to end. Of course, today, buyers tell me why this time is different, and the better opportunities will come. Everyone has very short memories when fear strikes.
That being said, it certainly goes both ways. Over the last five to six months many of my clients have chased the market down. When very strong offers came in, greed took over and we did not issue contracts (…things will get better). Months later we are scratching and clawing to bring those offers back to the table. However, blood is already in the water and the ship has sailed.
Here is my advice. If you are definitely selling, do not ask a price that is far too difficult to achieve. Do not expect to hang around and pick off a unicorn over time. As mentioned above, most buyers are on the sideline waiting for the great opportunity that never surfaces. Be quick to catch the attention of buyers that are smart enough to act
on the very good opportunities, create real competition to maintain leverage, and strike. If you are not committed to selling, now is probably not the best time to list or quietly shop your property. You only have one chance to make a first impression, and word travels quickly. Additionally, it is imperative that investment sales brokers become extremely educated and not promise owners they can achieve pricing that is not achievable. You are hurting the client by delivering a stale product, not to mention elongating the price discovery process across the market.
Another thing for sellers to consider is that they do not need to hit a home run on every sale. The best strategy may be redeploying capital into properties with more long-term upside versus trying to time the market with your current, maxed out investment (whether repositioned or idle without the wherewithal to execute a business plan). If someone is paying you a price that is above market, but not where you penciled your exit, that does not mean you cannot take advantage of an even better 1031 opportunity in a down market. It’s very important to weigh the trade, and not just the sale price.