As we enter 2023, there are fears of a looming recession, layoffs by the big tech companies are piling up and some hot multifamily markets like Las Vegas and Phoenix are posting negative rent growth. At the same time, many Midwest markets showed not just the stability they are known for, but also rent growth that is leading the nation. Of course, this is partly due to hot markets cooling down, but it is also due to fundamental strength in the Midwest that has been growing even stronger due to de-globalization, reshoring and onshoring.
We’ve been investing in the Midwest since 2006, and our primary objectives during that time were capital preservation, cash flow and stability. We achieved each of those objectives, but we also learned that the Midwest can offer significant capital appreciation opportunities as well. One of the reasons for this is that there is less competition in the Midwest, so there are more opportunities to make your money when you buy. There is no more important factor in the success of a real estate investment than the acquisition price. This is because almost any real estate investment can be profitable if you buy it at the right price.
The Dark Side of Strong Sunbelt Demographics
The demographics in the sunbelt markets are undoubtedly stronger than most of their Midwest counterparts. However, the downside is that competition among sunbelt investors often results in fierce competition for assets, including bidding wars. This makes buying these assets at an advantageous price much more difficult. Over the past five years, this competition in the sunbelt drove cap rates down toward the 3% range in markets like Austin, Charlotte, Phoenix and Las Vegas, especially as debt financing became cheaper and cheaper. Meanwhile, developers responded to this growth by building tens of thousands of new units in these very same cities.
Now, renter demand is weakening in these markets at the same time as these new units are coming online. According to Real Page, Phoenix looks “especially vulnerable, with a massive volume of new supply on the way as demand evaporates.” In Florida, there is also a “stout” construction pipeline, as CoStar described it, with a record 28,383 units under construction in Miami alone. This pipeline will expand Miami’s apartment inventory by 15.6%, according to Costar. This is five times the national average of 3%.
The Midwest: Boring is Good
In our experience, well-located Midwestern assets can also offer investors impressive rent growth without the investor demand and supply pressures found in the sunbelt. Over the past five years, cap rates did not compress to anywhere near 3% in any Midwestern market. For example, Costar data indicates that Indianapolis cap rates compressed by less than 200 basis points from Q3 2013 to Q3 2022, from 7.49% to 5.55%.
At the same time, Indianapolis finished 2022 with annual rent growth of 7.4%, which was higher than any of the strongest markets in Florida, including Miami. In addition, Indianapolis has just 5,147 units under construction, which would expand Indianapolis’s inventory by only 3.2%. Cincinnati, which had rent growth roughly equivalent to Miami’s (6.8%), has a multifamily construction pipeline that would expand its inventory by just 4.2%.
What This Means: Two 2023 Cash-Out Refinancings in Ohio
Real estate is a long lived asset. It is illiquid, transaction costs are high, and taxes on sale proceeds can be significant. As a result, we are long term investors. When our mortgages mature, we typically return capital via proceeds from tax-free refinancing proceeds rather than through an outright sale. This allows us to capture the long-term compounding benefits of real estate appreciation without the burden of capital gains taxes and the stress of 1031 exchanges.
In 2023, we will be refinancing two properties in Ohio. The first is a 58-unit property purchased in 2006, and the second was a 150-unit property purchased in 2013. This will be the second cash-out refinancing for the first property, and the first cash-out refinancing for the second property.
The cumulative refinancing proceeds from the first property could produce a net equity multiple approaching 6.5x after the second refinancing closes. Furthermore, because we will still own this property after closing, we can create even more value by continuing to execute our successful interior upgrade programs.
As for the second property, it was deeply distressed, and more of our capital reserves were allocated toward non-accretive upgrades than planned. We replaced concrete, parking lots, roofing, windows, balconies, sewer lines and managed through four serious fires, including one fire that took out an entire building. Still, the interior upgrades we did complete were very successful, and as a result we expect that the refinancing proceeds alone will return 100% of capital and produce a net tax free equity multiple of approximately 1.5x — and we will still own the property and its future upside. This means we won’t pay taxes on either of these gains, and we’ll be able to create even more long-term value on a tax-free basis by continuing our successful interior upgrade program in a much more deliberate manner.
We think these Midwest returns would compare favorably to many of the much more popular sunbelt markets, especially on a risk-adjusted basis.