For several years we’ve enjoyed significant investment gains in multifamily real estate, driven in large part by a fundamental shift away from home ownership in the US, a trend likely to continue. It’s easy to get caught up in the excitement of the current market but don’t let the inevitable downturn catch you unprepared.
The U.S. economy closed 2018 with solid GDP and historically low unemployment. In 2019, the general consensus points to much of the same, albeit at a slightly slower pace. Meanwhile, stock volatility has shaken our confidence, and global economies are showing signs of cooling off. Clearly, the economic upswing is in its later stages. For the prudent investor, now is a good time to double down on proper risk mitigation strategies. Here are four ways to protect your lead in a late inning cycle.
1. Move Up In Asset Class
Class C apartments (generally pre-1980s) have enjoyed the highest rent growth in recent years. But more families are spending over half their income on rent, pushing the limits of affordability for blue-collar America. Unfortunately, this demographic will feel the most negative effects from an economic downturn, creating greater risk exposure in the Class C space.
Class B product (between 1980 and 2000) represents a better risk-adjusted investment alternative. It caters to a grey-collar demographic, slightly less affordability constrained and better able to withstand shocks to the economy. Lower end Class B stock has the added advantage of being priced several hundred dollars below Class A, providing a natural crossover barrier on the high end in case discounted Class A inventory floods the market in a downturn.
With compressed CAP rate spreads between Class A and Class B stock, some value-add investors are now buying Class A product for only a slightly higher premium over Class B. There is some logic to this approach, especially for long term holds. However, there is also elevated short term risk exposure due to the record supply of new Class A product delivered or under construction. In the event of a downturn, lower end Class A product will compete directly with newer, better amenitized supply as the pricing delta fades.
2. Choose Quality Locations
Major economic hubs in top-tier metros provide insulation from economic downturns. Look for strong population and job growth, with a diverse set of employers across multiple industries. Also focus on metros with slightly lower rents compared to the US national average, to provide a hedge against affordability constraints.
Secondary and tertiary markets, often promoted as attractively priced alternatives, are less able to absorb economic change. As the economy weakens, it will be harder to keep properties in these markets at profitable occupancy levels, and it will be an even greater challenge to refinance or sell them.
Micro-market location also becomes more important as the economy turns downward and renters gain market power. Given the choice between similar properties separated by only a few streets, the less desirably located apartments will suffer greater vacancies.
3. Secure Long Term Debt with Low Leverage
As a buyer of multifamily real estate since before the Great Recession, I’ve witnessed the pitfalls of a market downturn. When the Great Recession hit, lending dried up almost overnight and property values declined. As vacancy spiked and profits dipped, investors with highly leveraged properties and short term balloon loans were squeezed into negative cash flow situations. Worse yet, forced refinancing at lower leverage required recapitalization on the equity side to make up the difference. Sadly, even some cash flow positive projects were lost to foreclosure simply because they could not raise the additional investor capital to refinance.
At this point in the cycle you should look at secure fixed rate, long term debt to avoid the risks outlined above. The good news is that most lenders are strictly adhering to Debt Service Coverage Ratio (DSCR) limits, which have reduced Loan To Value (LTV) ratios. However, it remains a competitive lending market, with both established and new entrants willing to aggressively lend short term bridge money at higher leverage. This approach represents increased risk in today’s market.
4. Tighten Your Operations
In a market upswing, properties with bad customer service and poor operations can still realize growth by leaps and bounds. Without the market to inflate property values and drive rental rates up, profits have to come from a great customer experience and operational efficiencies.
As a vertically integrated company with in-house operations, we like to focus on the three P’s: people, product, and process. Finding and retaining great people is our most important mission, especially our onsite staff. Product quality means focusing on the fundamentals like secure and well maintained grounds, clean and functional units, and fast and competent maintenance service. Process means putting a defined structure in place to produce reliable results that can be repeated across multiple thousands of units.
Whether you are an owner-operator or use third-party management, running a tight ship during a downturn will be the difference between making money and taking a loss.
A smart investment isn’t a gamble, it’s a formula. Find out how the MPG strategy can work for you.