When I first started investing in single-family real estate, there were two rules of thumb that I used to determine whether a deal was worth further evaluation. The first is the 2% Rule: For a rental property to cash flow well, the monthly gross rents should equal 2% of the purchase price.
So, if you bought an investment property for $100,000, it should rent for $2,000/month. The second rule of thumb is the 50% rule: 50% of your rent will go to expenses: vacancy, management, repairs, taxes, insurance, evictions, utilities, etc.
Within two years of building my single-family rental portfolio, the 50% rule became almost impossible to achieve in Orlando (where I was living and investing at the time). Sales prices rose significantly, but rents did not keep pace, although they grew and continue to grow year after year. In various conversations I had with other investors, many felt that the 2% rule was gospel and that when the fundamentals no longer supported that evaluation metric, it was an indicator of frothiness in the market or irrational exuberance. Their response was to sit on the sidelines and wait for it to correct.
As you know or can reasonably deduce, that has not happened. In a failure to acknowledge a fundamental shift in the marketplace, a permanent or semi-permanent shift in the supply/demand equation, and the institutional and individual appetite for assets that would likely deliver lower returns in the short run, this sitting on the sidelines proved to be quite costly. A similar shift has occurred in the multifamily space in a more dramatic fashion over the last four to six months, but steadily over the last several years. Investor and tenant demand has continued to increase, and supply has not kept up. Interest rates have increased dramatically relative to the last ten-plus years, which is increasing the cost of capital and thus driving down cash on cash returns.
Now, as investors, we have a binary choice in any given market: invest… or don’t invest. Groundbreaking stuff, I know. You may choose in this market cycle to look at the compressed cash flows and more conservative return projections and elect to hold off for a while and see what happens. You may believe that the multifamily equivalent of the 2% rule will come back around and that this is cyclical. That is, of course, your prerogative. However, we believe that would be an error on your part for the same reason it was an error for those investors I mentioned to pull back from investing in 2016.
I wrote an article in a previous newsletter about how our strategy is validated by the biggest investors in the world. Here’s an excerpt from a recent interview with their CEO and co-founder Stephen Schwarzman and their president and COO Jonathan Gray:
With the additional money, Blackstone’s total real estate assets under management increased 54% to $320 billion, outpacing its private equity, hedge fund, and other businesses. “These results are stunning versus losses most investors are experiencing,” Schwarzman said. “We had anticipated higher interest rates and more pervasive inflation for some time and positioned our portfolio to reflect that. We are seeing a clear benefit of that foresight today. Looking forward, market conditions will remain challenging.”
Jonathan Gray, Blackstone’s president and chief operating officer, said its bets on “hard assets with short-term duration with pricing power” will continue to pay off and help the firm navigate market uncertainty. These include its residential rental real estate and logistics property investments, which make up the majority of its real estate portfolio. He said increased online shopping is providing a boost to the logistics space, while supply chain concerns and companies moving away from “just in time” inventory management—or making goods when orders come in versus stocking them—translate to additional demand for warehouses.
For both residential and industrial property types, “the backdrop is extremely constructive” with “record low vacancies,” he said.
While Gray expects the high residential rental rate growth “at some point will come down,” he said the decline in new construction and home starts, coupled with increased mortgage rates and construction costs, bodes well for the rental market.
“People still need to live somewhere,” he said. “There’s less new supply. We have a big infrastructure shortage. That pushes people to the rental market.”
Blackstone has and continues to place large bets on residential real estate. They have thousands of employees analyzing the markets at an incredibly sophisticated level, and they’ve reached the same conclusion we have. Not investing is not an option, especially in an inflationary environment & rental real estate continues to be a very good bet.