Obviously depending on the submarket, there is now too much capital chasing too few deals even in secondary markets. As an investor who tries to seek out value add or development transactions, it has become very much harder to find deals that pencil well enough to justify the prices we see others willing to pay. Lately, what are supposedly off market situations to start, sometimes morph into auctions with either unsophisticated investors jumping in, or Asians just interested to move flight money and not really caring about maximizing returns, or others who do TIC or other syndicated or semi public REIT deals where they are satisfied with 6% or similar returns. Continued underpriced debt, has stoked offers that in the long run will not withstand the pressure of rising rates. I have had numerous investors tell me that they can borrow at a 4 handle or less and so why not go for it. They correctly believe they can lever up to generate a 11%-12% cash on cash return and do not care if there is a capital gain in the end.

For an investor like my Asia clients who want to actually make a proper risk adjusted return, and who intend to be invested for 4-7 years, the calculus is different. When we underwrite, we have to assume the ten year will be materially higher and exit caps will also rise accordingly. We assume that there will be over building during the next 2-3 years, and rents for multifamily in many markets will not continue to rise anywhere near what has been the case lately. It is simple economics. When rents rise a lot and debt is historically cheap at 65%-70% leverage, it is hard not to develop if you are in the development business. So now instead of building to a 7% cap developers build to a 5.5% cap and hope top sell at 4.5%. At some point rates will rise more than they have been doing, and during construction, those ratios may flip. Chances are the ten year over the next 4-5 years could go back to its historic levels of 5% to 6%. It is not possible to predict, but over time rates do revert to the mean, and it has been almost 7 years of historic low rates. At some point that will shift.

When we underwrite these days we do not assume the good news trends of rents and interest rates will continue during the investment period. Nor should you. Multi is headed to over built. Office is headed to less space used per employee as open spaces and operations like Work Space make it a materially changing demand situation. Retail is moving faster and faster to shop online and less demand for big retail spaces. They need big high tech warehouses now. Hotels like to think they are in a sweet spot, but reality is Airbnb has added possibly 400,000 -500,000 rooms top the inventory but the hotel industry continues to make believe they do not exist. That number will grow and likely others will offer similar services. In addition, it is finally possible to get construction debt to build hotels, and since hotel operators falsely believe they are in some Nirvana period, there will be rapidly growing hotel development over the next several years at the same time Airbnb is adding large numbers of rooms at no cost. In addition, the brands have already pretty much covered the landscape with their original brands, so now there is a new proliferation of brands which will get around the issue of protected area.

In some sub markets we may be reaching the point where just buying an asset is no longer a good investment. Development may be getting to the edge. In some markets, construction costs have risen anywhere from 10% to 40%, and land costs are rising so fast that the combination of much higher land cost and much higher construction costs, then later hit with much higher interest costs, may sink the economic viability of the project over the hold period. In some markets, there are developers and operators who are starting to think maybe we are reaching the pause button. Even in the Hamptons, which should be pretty impervious to cost, prices and costs to build have reached the point that sales and prices are in reverse. Manhattan will reach this same stage soon. The Russians are pretty much gone. The Chinese are hesitating now due to the effective anti corruption campaign of the government and the extradition of some corrupt Chinese investors investing in places like Canada. The French moved their money awhile ago and there are not that many wealthy Greeks to matter. To assume the flood of foreign capital will continue is possibly over optimistic. Maybe the Chinese will continue to flood the US market with capital but recently they have become much more hesitant.

All in all, we may be reaching the peak soon, and the signs are certainly flashing yellow for those who want to look carefully. If you are a 3-7 year investor, now is a good time to underwrite much more carefully. It is a historic certainty, that investors and lenders are very careful at the start of a upturn when they really should be very loose, and they are very loose near the end of the upturn when they need to be much more disciplined. I have watched this over and over for 50 years. It never changes. It will be no different this cycle. Then the pain will happen again. It is inevitable. I just suggest you take off the rose colored glasses, put down the glass of Kool Aid, and take a long term look at the underwriting for your next deal. The world is as uncertain as anytime I have been in business, and it is not a time to gamble that good times will roll on for a lot longer.

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