Jansen Multifamily Team Blog – Insight and commentary on the Seattle/Puget Sound apartment market

Last month, the Jansen Multifamily Team polled Puget Sound apartment investors about their impressions of the current market.  That poll data, coupled with our own observations form the basis for a three-part series on the “Why’s” of today’s Puget Sound apartment market.  This week’s post, number one of three, discusses why to buy in today’s market.

In last month’s JMT poll, 50% of respondents indicated they are an active buyer in this market.  It seems likely that those active buyers are beginning to see the same things we see: opportunities to achieve positive financial leverage, acquire quality assets in historically strong locations, and hedge against oncoming inflation.  These three reasons are the most compelling rationale for acquiring multifamily properties in the Puget Sound region in today’s market.

Positive Financial Leverage

Financial leverage, in the simplest terms, is the spread between CAP rate and interest rate on debt.  If you buy a property at a 6.0% CAP rate and get a 5.5% interest rate on your loan, you have achieved 50 basis points of positive financial leverage.  Conversely, if your interest rate was 6.5% on the same acquisition, you would have 50 basis points of negative financial leverage.

Why is it important to understand the effects of leverage?  Because the main outcome of leverage when applied to real estate investments is the magnification of returns, whether positive or negative.  From a cashflow standpoint, adding debt with positive financial leverage will provide stronger returns than if the investment was funded entirely by equity.  By the same token, negative financial leverage will provide weaker returns than all-equity.  Generally speaking, acquisitions with negative financial leverage will require more cash down to close, thereby diminishing rates of return in a commensurate fashion.

Interest rates from Fannie Mae and Freddie Mac remain in the high-5% to low-6% range, with CAP rates continuing to trend upward, creating numerous opportunities to achieve positive financial leverage.  Investors willing to make prudent acquisitions in today’s environment will likely be rewarded with exceptional returns over the life of their investment.

The Flight to Quality

The quality of the asset securing an investor’s cashflow is another important consideration.  Contrary to the last market cycle, an investor’s relative buying power today is extremely strong in the Puget Sound region.  The Seattle MSA was ranked #4 in the Urban Land Institute’s national “buy” ranking for 2010, reflecting positive impressions on long-term stability and market fundamentals.  The Puget Sound region continues to be a strong center for jobs and a desirable place to live, especially for young professionals.  Puget Sound apartment investors can take solace in the fact that this market is believed to be one of the strongest in the nation as a long-term bet.

As property values have continued to correct back to their place on the historical trendline, investor buying power has increased drastically.  Many investors could not compete on price with condo converters for properties in core locations during the Anomaly Period.  These same investors, who had been relegated to weaker submarkets in the periphery, now have their pick of quality in-city locations.  Today’s market is one of the greatest opportunities for a “flight to quality” – as apartment investors  reposition their capital into more secure assets in stronger locations.

Guard Against Inflation

In times of rapid inflation, one does not want a majority of their money in cash or other liquid assets, as cash will effectively decrease in value.  In such a scenario, one wants to own illiquid assets that will produce income that increases along with inflation.  Apartment buildings are ideal for this situation; as inflation occurs, rents will increase, thus providing an effective hedge for inflation.  Further, as property values are based on net operating income, inflation will also increase value, provided that rent growth outpaces both expense growth and CAP rates.  To that end, the average annual inflation rate for the Puget Sound region over the last 20 years has been 3.87%, with rent growth outpacing that amount by 1%.  As a long-term bet, apartment buildings are as sound an inflation hedge as one could hope for.

In today’s economic environment, as federal government spending continues to increase and the Federal Reserve increases the money supply to pay for it, inflation seems an inevitable part of the near future.  Investors sharing that viewpoint will find apartment buildings to be an asset tailor-made to protect against inflationary pressures on their money.

There is still much trepidation among real estate investors, but reasons to get back in the game continue to mount.  Low interest rates and rising CAP rates provide opportunities for positive financial leverage, relative buying power for quality assets continues to increase, and inflation on the horizon are all compelling arguments for investors to buy apartment buildings.  Ultimately, one can never truly time the bottom of the market, but one can mitigate the risk of further market deterioration by acquiring quality assets with responsible leverage and long-term financing.

Check back in next week for part two of our three-part series: as we will be discussing why to sell in today’s market.