The other day I wrote a case study of my 106-unit property that is currently for sale. The most common question I received was, “what will you buy next?”
All I can tell you at this point is that I’m taking a long, hard look at upgrading my portfolio and increasing my exposure to Class A multifamily.
Here’s how I’m thinking about it.
How to Profit from Inflation
Let’s take as a given that we are experiencing, and will continue experiencing inflation. You can look at the commodities markets (e.g. oil, natural gas, lumber, steel, uranium, etc), a basket of consumer goods, rent, or even just the shrinkflation you see at the grocery store. It’s happening.
The question to ask is: how best can we profit from inflation?
The framework is simple:
We want our major expense to be inflated away to zero. This means borrowing lots of cheap debt at low interest rates.
We want our income to grow faster than the nominal rate
It turns out that real estate can fit this framework, but I believe Class A will benefit more strongly than Class B & C from inflation.
Why?
Every landlord qualifies tenants based on income. The industry standard is that a tenant’s monthly income must be at least 3x the rent.
So someone making $3,000 per month can lease an apartment for $1,000 per month.
Status Quo
The problem is this: many Class B & C tenants are already living on the edge of this threshold. They barely make three times their monthly rent. That’s before inflation.
If this is your tenant base, you’re in a tough place. You could raise rents, but that would require you to lower your standards. Maybe now you’re only requiring them to earn 2.5x their rent. But this makes financially imperils the tenants.
But now consider a nicer, higher-income area. Someone earning $6,250/month living in a $1,500/month apartment is earning 4x the rent.
If the market supported higher rents, this person could absorb a rent increase while remaining within your criteria.
Wage Growth
When inflation increases the cost of labor, whose wages grow faster? The top earners. If you want the biggest increase in revenue, you want those to be your customers.
Where do they live? In Class A apartments.
Cashflow
Class B & C
Many investors buy Class B & C in search of higher cashflow. Traditionally, the idea is that Class B & C have more operational risks, and so these projects are priced lower, which means higher cashflow.
What tends to happen, though, is that deferred maintenance eats into the distributable cash. Why? As buildings age, major systems need to be replaced. The older the property, the more costly the replacements.
It’s very easy to look at a 1983 building that is having its best quarter ever and assume that it will continue just like that. But it may be right around the corner from an expensive retrofit project. It’s kind of like a game of hot potato.
And if it’s not a major building system, it’s a litany of minor issues like broken HVAC units, leaks from old pipes, subfloor or foundation issues from settling, appliances that need to be replaced, etc.
Class A
In contrast, Class A newer construction doesn’t have to deal with deferred maintenance because everything is brand new and possibly under warranty.
The going-in yields may be lower, but when honestly adjusting for deferred maintenance, cashflow is more similar than it at first appears.
Pricing
Class A always sells at a premium to Class B & C. This can be expressed as a lower cap rate, which is equivalent to a higher EBIDTA multiple. The “Class A Premium” is currently at the lows for this cycle, meaning Class B & C are as relatively expensive as they have ever been. In other words, it doesn't cost that much more to buy A right now.
To put this in perspective, a few years ago in Dallas, pricing looked like this:
Class A: $150k/unit
Class B: $85k/unit
Class C: $60k/unit
Now it looks like this:
Class A: $220k/unit
Class B: $160k/unit
Class C: $120k/unit
Class B & C have roughly doubled, while Class A is only up 50%.
Mean Reversion
The other big elephant in the room is mean reversion: at some point, the “Class A Premium” will revert to its long-term historical average. For this to happen means that Class A will appreciate faster than Class B & C.
Conclusion
The market is very hot right now. This might not be the best time to invest in real estate, either for you specifically, or in general.
But, if you are planning to invest in multifamily real estate in the near future, it seems to me that increasing your exposure to Class A multifamily is a good idea because:
The tenants have higher incomes with more room to raise rent currently
The tenants will have higher wage growth, which allows you to increase rent
Deferred maintenance will be lower
Mean reversion predicts that Class A will appreciate faster than Class B & C at some point in the near future
Would love to hear what you all think! Let me know in the comments or on Twitter.