Despite its long run of booming sales and leading performance in occupancies and rent growth over the past decade, the multifamily sector is proving that it’s by no means bulletproof to economic headwinds. Although the pandemic has created some near-term hurdles, investors are still eying investment opportunities that may pay off in the future.
A drop in rent collections and expectations of softening fundamentals ahead are putting dents in cash flows and weighing on investment sales. Like the broader commercial real estate investment sales market, multifamily transactions dropped 70 percent year-over-year to $13.9 billion in 2Q2020, according to Real Capital Analytics. Industry participants, however, generally agree that while uncertainty and the logistics of being able to conduct due diligence in person is weighing on transaction activity, investors still have strong appetites for apartments.
One question is whether
COVID has shifted investment
strategies on the type and
location of potential assets.
Two more key questions
include: How long will it take
for capital lined up on the
sidelines to jump back in?
And at what price?
“Investors nationally and internationally are not encouraged by the continued spread of the virus, nor are they encouraged by the national and local political strife,” says Candice Chevaillier, CCIM, principal, Northwest Multifamily Team at Lee & Associates in Seattle. However, many groups have capital they need to deploy in 2020. “So, we expect that once there are clear signs of recovery, investors will come roaring back to the market,” she adds.
“The appetite for multifamily hasn’t decreased, it’s just been put on pause,” says Thomas McConnell, CCIM, a managing partner at Redwood Realty Advisors in Hasbrouck Heights, N.J., which specializes in multifamily sales in New York, Hudson Valley, and New Jersey. “Our firm entered 2020 with a great sales pipeline. Unfortunately, like every firm, our sales are down for the first half of the year,” says McConnell. “I think it will get better in the second half now that everyone is dusting themselves off and getting out of their homes.”
Multifamily had outperformed other property sectors over the past decade with strong occupancies and rent growth. Although some pockets of oversupply have emerged, most U.S. metros had been struggling with a shortage of rental housing prior to COVID-19. There might be some short-term challenges in softening fundamentals and rent collections due to high unemployment and ripple effects caused by college campuses shifting to distance learning, but investors remain confident in long-term demand for the sector. One question is whether COVID has shifted investment strategies on the type and location of potential assets. Two more key questions include: How long will it take for capital lined up on the sidelines to jump back in? And at what price?
“Nobody wants to catch the proverbial falling knife, and people wanted to understand where the market was going to go,” says Bill Shopoff, CCIM, president and CEO of Irvine, Calif.-based Shopoff Realty Investments. “I think we have a somewhat clearer picture. We are definitely underwriting transactions, and other market participants are doing the same and would transact if they can find the right opportunity at a fair price.”
Investors across the board are trying to figure out how prices have shifted, and the answer is not the same in all markets. “In our case, we want a slightly lower entry point to cover for two things — the lower rent growth and the lower current rent collections — to offset our needs for overall return,” says Shopoff. He is hoping to acquire assets at a 5 to 10 percent discount compared to where properties were trading pre-COVID. “We think that is not just us — that it’s universally how people are going to get comfortable with making a buy at this time,” he says.
Investors Adjust Underwriting
The multifamily market was gathering momentum at the start of the year, thanks to stable occupancies and moderate, though slowing, rent growth. According to the Freddie Mac 2020 Midyear Outlook, vacancies were 4.4 percent at the end of 1Q2020 with annual rent growth of 2.9 percent. Unsurprisingly, the report forecasts weaker fundamentals due to the negative economic impact related to the coronavirus. Vacancy rates are expected to rise between 200 and 250 basis points in the second half of 2020, with average rents declining between 1.2 percent and 1.7 percent. However, multifamily fundamentals are likely to vary widely across metros. Many large coastal areas, such as San Jose, Calif., San Francisco, and Miami, are expected to experience bigger declines in gross income growth, while interior metros, such as Chicago, St. Louis, and Knoxville, Tenn., are expected to see only modest declines, according to the report.
Above all, investors are adopting more conservative underwriting. “I don’t believe investors are going to aggressively project upside rent as they have in the past,” says McConnell.
Still, getting a clear picture of how fundamentals have shifted is challenging in the current market. Apartment occupancy levels and rent collections have been somewhat insulated by government stimulus checks and moratoriums on evictions, including a broad mandate requiring moratoriums for Fannie Mae- or Freddie Mac-backed loans receiving forbearance. In addition, results are highly nuanced depending on the region and market, not to mention individual property-level drivers. For example, an apartment that caters more to tech workers has been less impacted versus a property that caters to renters who have lost jobs working in bars, restaurants, retail, and other service industry jobs. “You really have to look at a micro market and the tenant makeup of a building to understand vacancy and collections,” says Chevaillier. In Seattle, for example, concentrations of student housing and hospitality workers have created bigger challenges in areas such as the University District and South End Seattle.
Workforce housing that had been the flavor of the month has taken a hard hit in some metros due to job losses. Value-add is another property type that has been highly sought after in recent years. Yet investors are understandably taking a more cautious approach to new investment.
Lenders also are underwriting deals more cautiously, factoring in higher vacancies, concessions, and rent losses, as well as requests for six to 12 months of debt service reserves to provide added security. “Until we see firm signs of recovery, I think those guardrails will persist,” says Chevaillier.
Additionally, reduced rent collections are challenging for owners. As of Aug. 27, the National Multifamily Housing Council’s Rent Payment Tracker found that 92.1 percent of apartment households made a full or partial rent payment for the month of August based on its survey of 11.4 million units of professionally managed apartment units across the country. Although rent collections have, so far, been higher than expected, they are still problematic as it results in a big hit to cash flow for many owners. Rent collections will come back, but the longer COVID disrupts the economy, the more it jeopardizes tenants’ abilities to pay rent, says Shopoff.
Federal government stimulus money has helped to support rent collections. However, the additional $600 per week in federal unemployment benefits that the government provided as part of the CARES Act was set to expire on July 31, and Congress failing to agree on terms that would provide an extension of those benefits as of Oct. 12. Those weekly checks were providing additional financial support to an estimated 30 million families. The concern is that without that added financial assistance, rent collections could decline further.
Will COVID Shift Strategy?
Investors are re-evaluating investment strategies, and views are mixed on what the new outlook could be for various locations and different types of apartment assets. Even the concept of what constitutes a good location is being called into question, notes Chevaillier. Some investors are betting on the suburbs, while others remain focused on urban environments. Some think locations on transit are still a smart play, while the opposing view is that those locations will be less desirable given fears about exposure to the virus. Additionally, investors are wondering if the pre-COVID trend toward building more affordable microunits will reverse with renters who may require more space to accommodate work-from-home flexibility.
Workforce housing that had been the flavor of the month with buyers has taken a hard hit in some metros due to job losses. Value-add is another property type that has been highly sought after in recent years. Yet investors are understandably taking a more cautious approach to new investment. For example, investors are moving renovations into year two or three with a more staggered approach, rather than starting right away in year one, notes Gretchen Richards, CCIM, a senior associate at CBRE in Madison, Wis., specializing in multifamily investment. So, there are some changes in business strategy, as well as how they are underwriting deals and adjusting proformas, she adds.
There also is broad industry speculation on how the pandemic may influence geographic strategies. Pre-pandemic, there was a shift underway toward suburban and secondary markets. That shift seems to be accelerating in the near term. Investors that had looked to secondary markets for higher yields, may see an added advantage of putting capital into markets that have been less negatively impacted by outbreaks of the virus compared to major urban centers. In addition, investors may look for more portfolio diversification across regions and different types of primary, secondary, and tertiary markets, as well as urban and suburban.
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For example, Madison, Wis., experienced a drop in its sales volume in second quarter along with the rest of the country. However, much of that decline was likely due to logistical challenges that made it difficult for buyers to travel and visit properties. “Initially, people pumped the breaks on some deals, because they weren’t able to see the units and do the due diligence needed,” says Richards. That being said, investor demand remains strong, and interest and deals are still closing. In fact, Richards has seen an increase in calls from potential buyers both within the region and nationally.
People want to invest in Madison, because they view it as a stable market that has so far proved to be more resilient to COVID as compared to some other larger metros, notes Richards. For example, Madison is still reporting vacancy rates that are less than 3 percent and annual rent growth that has been hovering at about 3 percent, according to CBRE. “We are undersupplied, so you can maintain those rent growth numbers because there is an imbalance in the supply,” she says. Madison also has some good drivers for demand that includes a large student population at the University of Wisconsin-Madison, a base of government jobs as the state capital, and a robust market for young professionals. “Some markets have seen softness in pricing emerge, but we haven’t seen that here,” adds Richards.
One challenge of the
COVID crisis is that local
government has made it
more difficult for operators
in terms of moratoriums
on rent increases and more
stringent eviction laws. That
environment is likely going
to end up pushing some
owners to sell.
There likely will be those renters who do want to exit dense urban living in New York City, which will drive demand for suburban locations in New York and New Jersey that are within commuting distance, notes McConnell. Some of that shift to suburban rentals had already been occurring pre-COVID due to rising costs to live in the city, and that likely will accelerate. In addition, remote working is pushing people to look for quieter spaces to live that also has space for a home office or workspace, he says. However, New York City has long been a global hub for both domestic and international investors. “You’re always going to have demand for property in this market,” says McConnell. One of the challenges on top of the current COVID crisis is that local government has made it more difficult for operators in terms of moratoriums on rent increases and more stringent eviction laws. That environment is likely going to end up pushing some owners to sell, which will create buying opportunities for others who are looking to enter their market or expand portfolios, he adds.
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Capital Pulls Back for Now
Multifamily has been the darling of the commercial real estate investment world for the past decade, and there is still abundant capital targeting the sector. One of the challenges ahead could be a diminished supply of for-sale properties on the market. Although owners sell for a variety of reasons, many may choose to hold onto assets and weather the current storm rather than sell at a discount. “Investors are taking a long-term view and stand ready to deploy capital. However, there are less opportunities, as many potential sellers have postponed plans to divest in the hope capital markets will return to normal later in 2020 or in 2021,” says John Edwards, CCIM, a principal at Carolina Apartment Advisors Inc.
On the positive side, the apartment sector does have an added advantage of good liquidity provided by Fannie Mae and Freddie Mac, which will help to sustain sales activity. If rent collections continue to hold up, the sector also could fare far better than hospitality and retail in terms of levels of distressed asset sales. Although that may be frustrating for capital lined up to pounce on discounted buying opportunities, investors may still find value-add and opportunistic plays in the apartment sector. For example, Shopoff Realty is looking at opportunities to convert select service hotels into apartments. “That industry has been impacted pretty dramatically, and we think we can buy some properties at an attractive basis and do a conversion from hospitality to multifamily relatively easily,” says Shopoff. In early August, Shopoff Realty had two hotels assets in escrow to purchase.
One of the key considerations driving investment decisions these days is the hold strategy. Most investors are looking beyond the short-term impacts of the virus to the longer-term outlook for the rental housing market. There could be a lot of turbulence ahead with the path of the virus and the upcoming election, and real estate is a great long-term investment. Multifamily provides housing in a market where there is still a shortage of housing. “It is so easy to get lost in the day-to-day news cycle and all of these dominoes falling,” says Chevaillier. “But, all in all, our industry is not a six- or 12-month industry, so there is no need to hit the panic button.”