(Save the date: RealShare Apartments comes to the Westin Bonaventure, Los Angeles, October 24.)

LOS ANGELES-With the multifamily market being touted as both white-hot and a safe bet, a new trend is emerging in this industry sector: Small groups of investors who are inexperienced in owning and operating multifamily properties are outbidding savvier investors for these assets and driving up prices in the market. While this is good news for sellers—and who could blame them for shaking hands with the highest bidder?—CRE experts say it may not ultimately bode well for these investors and the market five years down the road, when rents haven’t risen appreciably enough to cover operating costs and mortgage payments, and these owners are forced to sell at a loss.

GlobeSt.com has discovered that, while this trend is evident all over the country, it is mostly manifesting itself in the under-$20-million category, where institutional investors tend not to play and independent private investors can get a toehold. “We’re not necessarily experiencing that directly because it’s not the size space we are aggressively playing in,” Jay Koster, president of the capital markets group at Jones Lang LaSalle, tells GlobeSt.com. “But it’s not surprising; multifamily continues to be viewed as a great current yield real estate investment opportunity matched with strong overall housing and demographic trends, coupled with the fact that it might get the best inflation protection going forward. Some of these drivers are finding themselves factors in the private-capital world.”

Stuart Saft, partner and co-chair of Holland & Knight’s real estate group in New York, says he’s not seeing this trend to a large degree in New York, but in many other locations in the country, particularly in the South and Southwest—Arizona, New Mexico, Texas, Northern Florida, Georgia, Mississippi, Ohio, Pennsylvania, Michigan and Indiana. “These investor groups are all over the place and investing all over the place. So many properties are going up for sale on the Internet, or they’re learning about them on the Internet, that it has in a sense become a ‘get rich quick’ scheme. It’s problematic because you really need to know what you’re doing in operating multifamily housing.”

Saft adds that newspaper reports that rental rates on multifamily housing are going up are helping to spur on this trend. “I imagine that these small investor groups are saying this is the time to cash in.” He cites an example of a client that is a large, L.A.-based hedge fund negotiating to purchase 32 multifamily complexes as a package throughout the Southwest. Many local, small investor groups were attempting to buy pieces of the package, creating a problem in the bidding because the numbers they were offering made no sense in terms of the overall valuations of the properties. This created a lot of complexity. “Looking at their numbers, I came to realize that they had no idea how expensive it is to operate multifamily housing,” says Saft. “The maintenance and repair costs of multifamily housing are far greater than any other commercial or industrial property. In order to make the bids they were making, they had to have been coming up with arbitrarily low numbers in maintaining and operating these properties.”

Multifamily tenants tend to be particularly hard on these properties, particularly in low- and middle-income areas, and deterioration is greater than average among these properties, Saft adds. “The existing owner of the package of properties in this case was selling them because they had greatly underestimated the cost involved in operating the properties. I’ve seen this now in the South and Southwest, and I’m also seeing it in the Midwest and in portions of the Northeast. The expectation is that the rents are going to go up significantly, but the operating expenses are going up more.”

What defines this new category of multifamily investor is inexperience in real estate, although they may have had experience and success in other sectors of investing.

“They don’t seem like they’re pros, and they’re not extremely real estate-savvy,” Reuben Robin, founder and CEO of the Robin Group in Los Angeles, tells GlobeSt.com. “It’s a great thing on the brokerage front because people are buying, but it’s people who don’t really understand the business, and they were not here in 2008. Pricewise, things are starting to get insane again. People have forgotten what happened in 2008, and they’re starting to hit the C market today.”

Robin says where cap rates at one time were north of 7.5%, he’s now seeing cap rates in the L.A. area in the mid-6% for all classes of multifamily—A, B and C. For the last 3-6 months, these numbers have been seen in the C markets in areas of East Hollywood, Westlake and downtown. “These people are buying on spec, not on fundamentals, which could create issues in the marketplace. I’ve seen this happen before. The factors are low interest rates, not getting any money in the bank, but not buying on the true fundamentals of real estate. We’re capitalizing on it, but it scares me at the same time.”

Robin adds that these investors are not amassing a portfolio, but they are grabbing these properties away from experienced multifamily investors. “We’re closing with small groups that are reading how hot multifamily is and jumping in.”

Neema Ahadian, VP of investments at Marcus & Millichap in Los Angeles, tells GlobeSt.com that he is currently involved in three different transactions in L.A. County where he is seeing this phenomenon. “I’m representing the sellers, and if we’re able to close with the numbers we’re anticipating, we definitely will be setting records for the price matrix in multifamily in this market.”

Ahadian says the phenomenon is less location-driven than product-driven and the investors are first-time multifamily buyers using proceeds from a non-real estate-related business. “These are savvy investors who are running multi-million-dollar corporations and are not used to investing in multifamily. What’s concerning to me is they set the market at values that typical investors have a hard time understanding. We’re not getting the same type of returns that we used to, so it’s challenging for a multifamily investor who’s been in the business for 15 years to compete on these levels. I also see a concern in that in five years, when that investor’s five-year fixed-rate debt comes due and rents haven’t grown a significant amount, their cash flow will be hit when they go to refi because the interest rates aren’t going to be at 3.5% as they are now.”

David Gaines, AVP investments and associate director of the national multi housing group for Marcus & Millichap in Chicago, tells GlobeSt.com that the cap rates for Midwestern multifamily properties built in the 1960s and 1970s is nearly the same as for product built in 2000 and later. “That shouldn’t be because the cost is higher on repairs and maintenance. But the buyers are paying that, so the sellers are taking it. These investors are spending their own capital, so they’re free to make their own decisions.”

Gaines tells GlobeSt.com that the investors he’s talking about tend to be diversifying out of other real estate product types into multifamily, rather than having no real estate experience whatsoever. “There’s a lot of apartment capital partnering up with those who have experience in the area, and they have to buy whatever’s in the market, so if they need to buy it at a 7.5% cap instead of a 7.75%, they’ll make it work.”

Saft says what will ultimately end up happening is that these owners will default on their bank loans, and the banks will take over the properties. But Noah Hochman, VP acquisitions and dispositions for Triumph Management Co. in Beverly Hills, CA, sums it up simply: “It feels a lot like 2007. It makes it harder to do things.”

Gaines adds that his firm recently released a survey that indicates apartment buyers outnumber sellers 4:1, creating significant increased demand in the multifamily space without the supply to meet it. This demand is greater in multifamily than in any other product category. Other M&M research indicates that consumer confidence is at an all-time high, another factor fueling the investment frenzy in a strong category like multifamily real estate.

**graph courtesy of Marcus & Millichap