Multifamily Investing Part 3: Risks and Outlook
In the Multifamily Investing series Part 1 and Part 2 , I discussed the various aspects of the asset class, including demand drivers, risk profile, and profit centers. For the accredited investor, there are many benefits in multifamily investing through a direct syndication. The investment is backed by a hard asset- the building and land. Investors profit through cash flow and value-add forced appreciation. Real estate is tax efficient. I tout the many benefits of multifamily, but I would be remiss if I did not discuss the risks that come with this type of investment.
There are a multitude of risks to investing in multifamily and it is possible to lose your entire investment. So what kind of risks are we talking about?
In the private placement memorandum (PPM), there is a section on risk factors which can total up to thirty pages of legalese. It lists everything that may go wrong with the deal. Most are boilerplate statements but some are deal specific. It is analogous to a written consent prior to a medical procedure or the warning label on the bottle of medication. “Risk factors include nausea, blurry vision, headache, etc etc ….and death.” Ok, you’re not going to die from a real estate investment, but losing your capital can certainly be painful.
Economic Conditions Risk:
The national and local market conditions can change. If the economy dips into a recession, there could be massive job losses and higher rates of unemployment. Tenants may not be able to afford their housing and this can result in increased vacancy. Rents may need to be lowered to fill apartment units. For example class A tenants may become class B tenants and previous class B tenants may become class C tenants. This will change the demand for different asset types. Developers have been building class A luxury buildings at a rapid pace in primary gateway MSAs, but there is only a subset of people who can afford to live in these high-priced luxury units. Currently these type of properties are seeing slowing demand and some experts think some markets have peaked. A negative shift in the economy can really hurt these properties.
Real estate market Risk:
The real estate market is cyclical. There are peaks and troughs like the equities market. There is a risk that a sponsor may buy at the peak and sell at the trough, and not be able to achieve their targeted returns. The real estate market cycle is typically longer than a stock market cycle, but nevertheless, investors need to be aware of the stage in the cycle that they invest in.
There is competition for tenants. Other nearby apartment buildings may be less expensive, newer, or have more amenities. This will affect the vacancy rate. This applies to all commercial assets like hotels, office, retail, industrial, and self-storage. Competition for tenants affects rental rates.
There is competition for labor and materials. In certain markets, there is a shortage of construction labor, which increases the cost of development and renovation. Likewise, an increase in the cost of materials will adversely affect the profit margin.
You never know who is going to sue. In one apartment deal I know, the sponsor raised rents across the board. A few low-income tenants complained to a local non-profit housing agency which then sued the sponsor for discrimination and unfair housing practices. Whether merit existed or not, it was cheaper to settle the case than to take it to trial.
The success of a multifamily deal is largely dependent on the sponsor and the property manager. These may be one and the same. There are many moving parts to managing a property and handling tenants. Any property maintenance issues must be promptly and adequately addressed. Any deferred maintenance may be more costly down the line. Tenants must be screened properly. Rents must be collected and evictions must be handled. A problem tenant can damage a property, resulting in enormous repair costs. Bad elements such as gang members and drug dealers can bring down the attractiveness and value of a property. A property must be marketed to keep occupancy levels high. In all, a poorly managed asset can result in significant loss of profit.
A sponsor’s proforma is an estimate of revenue, expenses, and CAP rate, and is based on various assumptions. The important ones include rent growth, vacancy rate, rental price, and expenses. Aggressive underwriting can lead to underperformance if things don’t work out perfectly. Conservative underwriting allows for various unknown factors and can lead to UPOD (underpromise, overdeliver). It is important to invest with a sponsor who factors in a cushion for unexpected contingencies.
Properties are usually purchased with debt. The loan-to-value ratio (LTV) is a metric to evaluate how much leverage is undertaken in a deal. A highly leveraged property has a high LTV. There is a risk that a property’s cash flow may not be sufficient to service the senior debt, in which case, the owner will be in default and the property may fall into foreclosure.
In the event of a downturn, the investor’s common equity may be significantly reduced if the property loses value. If the drop is large enough, the property risks foreclosure by the senior debt holder. In a situation like this, the common equity holders could be wiped out. Personally, I use a cutoff of no more than 70% LTV when evaluating an investment.
Properties purchased with short term variable interest rate loans may be subject to risk when interest rates rise. A higher interest loan raises the cost of the loan and will affect cash flow. If there is insufficient cash flow to service the loan, the property could default. When short term or bridge loans mature, they need to be paid back either through an exit sale or a refinance. Terms of refinancing are unknown and the option may not even be available, as evidenced during the Great Recession. At loan maturity, if the balloon payment cannot be made, or a refinance cannot be arranged, the investors’ continued ownership of the property could be jeopardized.
Sponsor Misalignment Risk:
The sponsor may not be totally aligned with the LP investor. If a sponsor makes most of their money on fees, they may not be incentivized to optimize property performance. In other words, a sponsor will make a profit regardless if the property performs well or not. On the other hand, if the sponsor makes their money on the promote, they may take excessive, unnecessary risk and jeopardize investor capital. When doing due diligence, I like to see as much alignment as possible. This is as much related to company culture as it is to hard numbers. I do like to see at least 10% sponsor common equity do demonstrate “skin in the game”.
Acts of Nature Risk:
Real estate is subject to natural disasters such as flood, fire, tornado, and earthquake. These may result in uninsured losses and adversely affect cash flow and property value.
There are many other risk factors that are listed in the PPM, but these are some major ones. I haven’t even discussed the risks associated with crowdfunding platforms. Investors should at least be aware of the different risk factors and evaluate how a sponsor seeks to mitigate these risks.
Outlook on Multifamily Real Estate:
The economics of multifamily is hyperlocal, just like any real estate asset. The question is whether the multifamily has peaked and is headed for a correction, or whether the sector still has steam and will continue to grow. Continued strong job growth and demographic trends will drive demand for housing. Consumer confidence index remains at high levels. The new tax laws are especially favorable for commercial real estate. Reducing the corporate tax to 21% from 35% will benefit all major players in the real estate industry from banks to REITs. Tax rates for income earned by pass-through entities such as LLCs will be eligible to deduct 20% of their income. The 1031 exchange tax deferral has been left in place. In addition, real estate investors should continue to enjoy historically low cost of debt through low interest rates.
However, some data show that Class A multifamily is being overbuilt in some primary markets, leading to increased vacancies. According to Marcus and Millichap, nationally, Class A vacancy rates have advanced to 6.3 percent in 2017 and will climb to 6.8 percent in 2018. Class B and C workforce apartment buildings will continue to do well, especially in secondary and tertiary markets.
Rent: National average rent increases were 2.5% in 2017. Breaking it down into metro and submarkets; secondary markets such as Sacramento, Orlando, Las Vegas, Salt Lake City, and Colorado Springs with affordable rents and growing populations should see above-trend increases. Business-friendly cities such as Dallas and Atlanta should see moderate rent increases. Expensive coastal markets such as New York City with excess supply are likely to see little or no gains. Source: Yardi Matrix
Supply: In 2017, roughly 300,000 units were delivered nationally. In 2018 it is expected that 360,000 new units will be delivered. Shortage of construction workers slowed the delivery pipeline in 2017 and lengthened construction periods.
In summary, a multifamily investor should be aware of the risk factors in this asset class. When selecting a sponsor it is better to choose one that has been through one or more market cycles and makes conservative assumptions. The importance of the sponsor cannot be emphasized enough. I choose a high quality sponsor first, then the property. It is also important to keep an eye on the multifamily market and tailor your investment approach according to areas of supply and demand and demographic trends.
This wraps up this series on multifamily investments. Do you invest in multifamily? What trends are you seeing in your market? Please comment below.
Also, I’m looking for real estate investors who are willing to be interviewed or write a guest post. If you have any experiences in single family or commercial real estate that you would like to share, please contact me on the contact page.
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