Falling Knife or Golden Opportunity in Multifamily Investment?

TAKE A TACTICAL PAUSE

Jocko Wilink, Navy Seal and the author of the books Extreme Ownership and Discipline Equals Freedom talks about how effective leaders will take, “tactical pauses” to step back and assess the entire field in front of them and try to gain a new perspective to avoid focusing only on the small, but very real problems that are right in front of them. It is hard to see the whole picture when one is only looking down the sights of their weapon.

Similarly, in his book Principles, Ray Dalio says that, “an accurate understanding of reality, is the essential foundation for any good outcome… Don’t get hung up on your views about how things should be because then you’ll miss out on learning how they are.”

So, let’s attempt to take a step back and look at the field in front of us and assess the primary obstacles and opportunities in the multifamily investment space.

WHAT ARE THE PRIMARY OBSTACLES FACING MULTIFAMILY

INTEREST RATES

The Federal Reserve recently announced that they were going to raise rates another seventy-five basis points in their effort to combat inflation. The sentiment in the market is that rates are going to continue to increase through the rest of the year and potentially into Q1 of 2023. According to visualcapitalist.com, the Fed is raising rates at the fastest pace in U.S. History.

TOUGHER LENDING TERMS

As interest rates continue to increase, the amount of debt that banks are willing to lend on an individual property decreases because of adjusted leverage requirements, DSCR hurdles, and/or increased debt yield requirements. Less debt means that buyers need to bring more equity to the table which in turn will typically reduce overall expected returns from an investment.

FEAR IS DRIVING SOME INVESTORS AND LENDERS OUT OF THE MARKET

Uncertainty about the future is causing private and institutional investors alike to pause investing until clear stability returns to the marketplace.

INCREASED RENOVATION COSTS

Building materials, labor, and reduced access to materials due to supply chain delays have caused significant increases in renovation costs over the last couple of years. This is forcing investors to increase their capital improvement budgets and contingencies to plan for unforeseen increases in the future.

RISING OPERATIONAL EXPENSES

Property operations budgets are starting to roll in for 2023 and across the board, we are starting to see the effects of inflation. Payroll, property taxes, repairs, and maintenance, utilities, and unit turn costs are all growing at a rapid pace. Not to mention the multifamily market is bracing itself for increased insurance rates after Florida was hit by hurricane Ian in September.

DOWNWARD PRESSURE ON REAL ESTATE MARKETS

Much of what has been mentioned has contributed to downward pressure on real estate values, and we anticipate that most of these obstacles will continue to exert downward pressure on pricing well into 2023.

In the last couple of years, it was common to hear of properties selling for more than the broker’s whisper prices and to see significant participation in the bidding process. This is no longer as common.

Rising cap rates represents downward pressure on property valuations.

According to CBRE research, “Going-in cap rates rose 33 basis points (bps) to 4.09% in Q3 2022, a slightly more modest increase than the 39-bps rise in Q2. Investors have reacted to heightened market volatility and higher borrowing costs by pushing cap rates up 72 bps over six months. However, cap rates have risen from record-low levels in Q1 2022 and are still slightly below the pre-pandemic (Q4 2019) level of 4.16%.”

As multifamily real estate investors, when the world is changing, we should ask ourselves two questions:

1. Do we believe in a positive future for the United States?

2. Do we believe that there will continue to be a housing need here in the United States?

If the answer is yes to the first two questions, the third question we would need to ask ourselves is, how do we turn the obstacles into opportunities?

WHAT ARE THE MAIN OPPORTUNITIES FOR INVESTORS?

INVESTORS AND BANKS ARE SITTING ON THE SIDELINES (LESS COMPETITION)

Over the past couple of months, our team has had conversations with brokers, investors, bankers, management companies, and other professionals in our space, and often we have heard that groups are taking a “wait and see” approach.

According to Realfin, “[…] scrutiny and caution have spiked, significantly slowing down transaction decision making and financial closes. The total number of commercial real estate transactions involving a private fund or institutional investor declined sharply by 52.6% year-on-year to 1,358 in Q3 2022, while also declining by 29.0% on the previous quarter […]”

THERE IS STILL A NEED FOR QUALITY, SAFE AND AFFORDABLE HOUSING

Developers need to build an estimated 4.3 million new apartments between now and 2035 to keep up with the demand. This represents a need of more than 330,000 new apartments built every year for the next 13 years. The United States remains one of the most attractive countries to both immigrants and refugees and we believe this will continue to drive demand for quality homes and apartments.

LOAN ASSUMPTIONS

Over the last two years, the United States saw new records set with transactions and new loans being placed on multifamily properties around the country. This is due in part to the fact that we also saw historically low-interest rates.

Loan assumptions will continue to be a great opportunity for lower-cost debt. Often this debt will also mean lower leverage, so investors will need to weigh the cost of their equity against the savings found with this lower-cost debt.

MOTIVATED SELLERS

Tough times often mean that sellers will find themselves in a position of being motivated to sell properties either at a discount or with creative options or risk foreclosure/deed in lieu situations.

CREATIVE FINANCING OPPORTUNITIES

With fewer investors/buyers in the marketplace and debt being harder to place, this opens the market to new creative solutions for closing deals. Seller financing, loan assumptions, seller equity contributions, and seller joint venture options are some ways that buyers will be able to complete deals while also helping sellers achieve necessary returns to their investors.

FORECLOSURES

We are starting to see a tick up in foreclosures and we are of the opinion that we will see the trend continue as we enter 2023. This likely will provide opportunities for buyers to purchase properties at a reduced price.

GREEN INITIATIVES & TAX INCENTIVES

With programs like H.R. 3684 the Infrastructure Investment and Jobs Act and H.R. 5376 Inflation Reduction Act of 2022, there are several government programs aimed at providing incentives to property owners to pursue green initiatives in their properties. These incentives can make multifamily deals much more attractive.

WHAT IS WILKINSON CORPORATION DOING ABOUT IT?

PRESS INTO RELATIONSHIPS

We believe that relationships are one of the most important factors in finding success in multifamily real estate. The brokers, lenders, property managers, tax consultants, and construction professionals that we work with are critical to finding deals and making them successful.

CAUTION, CREATIVITY, & TENACITY

We continue to be excited about the future of the multifamily space in the United States. The fundamentals of the business have not changed even if the rest of the world is changing. We do expect to see value reductions in the short term, but also believe that there is going to continue to be significant demand for apartments both from tenants who cannot afford payments on homes as well as from institutional investors looking for long-term stable assets.

The best way to move forward is to be cautious and very selective about the deals that we buy, underwrite conservatively, buy in great locations, and find creative ways to get the best possible outcomes for our investors, and tenaciously drive our business plans forward. It’s vital to take a long-term view of our investments in order to weather any short-term uncertainty and to drive cash flow and property performance. With this approach, we believe that any market can be a golden opportunity.