Opinion: Many Real Estate Investors Bought "Wrong" 2020-2022!
- Wes Purvis
- Feb 6, 2023
- 6 min read
Updated: Jun 1, 2023
Photo by Dave Hoefler on Unsplash
Did your real estate portfolio become a dumpster fire?
There's little doubt that the real estate market of mid-2020 through mid-2022 was one of the strongest for sellers in well over a decade. Properties sold far faster and for higher prices than even during the decade leading up to The Great Recession. This market was largely driven by: historically low interest rates & billions of extra cash combined with historically low levels of available inventory. It was a great time to be a seller. Home buyers, while growing frustrated, could lock in long term low interest rates, and businesses saw the opportunity to expand due to high consumer demand and PPP funds.
But what about real estate investors?
Well, real estate investors went on a spending binge. And not just REITs, pension funds, and family offices. From the experienced investor with thousands of rental units to the small group of friends just starting out, real estate investors spent more, faster than any other time in recent memory.
I've been involved with real estate investors since 2001, and I've never seen anything like this two year period.
The question I have, though, is "did the majority of real estate investors really build profitable portfolios during this time or did they set fire to stacks of money they'll likely never recover?"
For the investors that stuck to their time tested, data backed investment strategy, they most likely added profitable properties to an already stellar portfolio. Don't fall into the frenzy of multiple offer situations and don't deviate from the property analysis that has years, if not decades, of proof of concept.
However, in my opinion, this was not most real estate investors of the last two years. Let's examine just a few of the traps real estate investors willingly walked into during their binge.
And perhaps cost them millions of dollars in the process!
Failure to account for increased real estate taxes
I chose to start with this as it appears to be, to me anyway, one of the most common analysis errors real estate investors made while making purchases during this time. By the way, it isn't just my opinion. During the latter half of 2022, I spoke with over two dozen property managers and asked the following simple question.
Me: "Are your clients factoring in increased real estate taxes when purchasing a new property?"
Every property manager polled: "No!"
Um...excuse me?
Real estate taxes are one of the largest costs associated with investing. Changes to this line item weren't being accounted for. It's also the single largest cost that the real estate investor has little to no control over. Local governments set the tax rates and taxable value. Yes, a real estate investor could challenge the value assigned by the local government. But they don't really have a leg to stand on in the argument since they literally just paid that price for the property in question. Good luck winning that fight.
Insanely, the future change in real estate taxes were being accounted for on Class-A properties but not Class-B or C. Recently constructed Class-A properties may have ten years worth of tax abatements associated with them. In these cases, the potential buyers were factoring in future real estate tax liabilities. The only reason I've come up with that makes since is that, in general, only the most experienced and well capitalized investors were buying Class-A properties. They didn't reach their atmospheric levels by making such basic mistakes.
Class-B & Class-C buyers (almost regardless of asset class) made this mistake over and over and over.....Here's what was missed. During this two year period, many properties were sold that had previously been owned for many years if not decades. Generally speaking, local taxing authorities under value these properties. They base values off of per SF or per Unit appraisals like they would a home. But that's not the real value of an investment property. Without recent sales activity on an investment property, they really have no idea of it's true market value. So, that means there were huge gaps in county valuation and the purchase price.
I saw this daily during my analysis of potential client purchases. Let's take a look at just one example.
County | Purchase | Change |
Value=$1,150,000 | Price=$3,500,000 | +$2,350,000 |
Tax Rate=2.80% | Tax Rate=2.80% | 0 |
Tax Amount=$32,200 | New Tax Amount=$98,000 | +$65,800 |
By the way, this chart doesn't include any new taxes that were voter approved and hadn't yet taken effect.
This is one example of how this basic analysis error will cost the buyer tremendously. In some locales and states, there are ways to mitigate and prolong the time it takes for this to occur. But remember, the tax code is written against your favor. They demand their tax dollars!
Ignore this analytic reality at your own peril.
Failing to have optimal operations
This is a very real, and long discussion. Perhaps this will be another article in the near future.
To be somewhat brief, can we all agree on this. Every real estate investor likely began reading book after book on the topic and maybe even attended a seminar or two when they made the decision to join the fray. These books and events largely speak about strategy, analysis, and how to fund the project. Maybe form an LLC or a small partnership, use the bank's or other people's money (OPM), here's how to analyze, and go buy your first or maybe your biggest property to date. Woohoo you're on your way to becoming a millionaire!
Have you ever noticed these books rarely mention property operations? Operations, in my opinion, goes beyond selecting the cheapest property manager. It should entail capex reserves, what qualities should your property manager possess, what systems need to be in place, and most importantly your involvement in the management of the property. It is your asset, and likely debt, after all.
This is a topic that has come up many times recently with out-of-state real estate investors. They're discovering the challenges with the very topics I just mentioned. It's not as simple or easy as the large corporate investment funds make it look. And sometimes, they mess this part up as well.
Poor property operations will tank an otherwise profitable investment property.
Assuming Rents Increase Linearly Forever!
If I've said it once I know I've said it a thousand times. I am a huge data nerd!
I began my career as a mortgage broker during the early 2000's. Everyone made the same mistake then that real estate investors made from 2020-2022. The belief that real estate values and rents would only every increase, forever. Apparently, we really didn't learn anything after all.
"The proforma rents are 30%+ higher than current rents. I'll spend a few thousand dollars per unit and be able to max out to those rents. After that, I'll keep raising rents every year." Said by many real estate investors during this time. This is, as my college philosophy professor would say, inherently false logic.
Just because something has occurred in the past or is occurring in the present, does not mean it will continue to occur. We only need to look back at 2007-2010 for a reminder.
But let's stick with the present.
Many economists posit that national median rental growth peaked between 15%-22% year-over-year during this two year period for multifamily properties. This accounts for differences in unit size and location. Unfortunately, many multifamily investors believe(d) this would continue essentially uninterrupted. The below chart from Realtor.com published December 2022 shows they couldn't have been more wrong.
It's clear based on the above chart that multifamily rents are not continuing to increase at the same rate as when many real estate investors were purchasing based on proforma. Obviously, the national market is not necessarily representative of each and every single unique real estate market. But it illustrates my point clearly.
"Oh that's just one example. What does Realtor.com really know?"
Fair enough. How many examples would you like?
To quote Marvel's Captain America, "I can do this all day."
The false logic that rents will continue to rise on a linear basis can be damaging to a single property and exceedingly destructive to a real estate investment portfolio.
If you want real portfolio destruction, combine this false logic with the failure to account for increased real estate taxes as noted above.
And many have!
The two year timeframe from mid-2020 through mid-2022 saw one of the strongest real estate markets since WWII. It brought with it record value increases and even shorter days on market. The reasons for this market are varying and likely won't be fully understood for several more years.
However, one thing is very clear. Many, if not most, real estate investors deviated from the basics of building profitable portfolios. They let the fear of missing out on a "good deal" lead them down largely unsustainable paths. Regardless of asset class and location, investors sat aside the notion of negative effects that rising real estate taxes may have on future revenues. Moreover, they didn't have proper operations in place to maintain long term profitability especially when purchasing out-of-state.
What will the long term market effects ultimately be? We may very well find out in the next few years. I have a feeling the answer will come in the next truly great buying opportunity.
Wes Purvis
Director & Founder
Purvis Commercial Group
Purvis Property Advisors
Coldwell Banker Schmidt Realty
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