Multifamily Investing in a Slowing Market

If I could go back in time 5 years, and wave a magic wand, I’d buy as many large multifamily assets as possible.

Why?

With my 20/20 hindsight in hand, I would know:

- There would be a surge in interest from private investors in the multifamily space.

- Cap rates would compress 2-3% in many markets, significantly driving the value of multifamily higher (the lower the cap rate, the higher the value of a building)..

- Rents would increase at double digit rates once the initial shock of Covid settled.

Put that all together, multifamily owners across the country have looked like geniuses, earning their investors in many cases over 100% returns over a relatively short hold period.

How long will that last?

How long can that last?

What can you, as a prospective investor, do to protect yourself from a potential downturn in this market sector and still benefit from a passive investment in multifamily?

Here are some key factors to look for when considering any investment opportunity.

Cap Rate Assumptions

Is the exit cap rate, or cap rate for refinance if part of the deal, higher, or lower, than the going in cap rate, or cap rate upon purchase?

Assuming a higher cap rate upon refinance or sale is the conservative approach you want to see. Make sure the deal sponsor is assuming the market will soften. If you see an exit cap lower than the going in cap rate, tread carefully. The lower cap rate inflates the assumed valuation of the building, and may setup an overpromise, under-deliver scenario.

Interest Rate Assumption

If a refinance is projected, make sure the projected interest rate is much higher than the current interest rate. This has a significant impact on your debt service, or mortgage payment, which dictates the cash flow that can be distributed.

Refinance Assumption

If the deal you are considering is relying heavily on an assumed refinance, carefully inspect the assumptions used for that refinance. No one knows for certain where rates will be tomorrow, let alone 2 years from now, so make certain a very conservative approach is being taken. Ask the deal sponsor to project returns assuming the refinance does not occur. If this drives returns well below your threshold, move on to the next opportunity.

Rent & Expense Growth Assumptions

The days of 10%+ rent growth may soon come to an end. Does the deal you are considering project otherwise? Historically, rent growth between 1-3% has been common. Expense growth of 1-3% has also been common. Make sure the deal pro forma is not falling too far outside of those goalposts.

Sponsorship Team

While most any sponsor did well over the past 5 years, some of the success may have been buoyed by the compressed cap rates. Make sure the sponsorship team has experience taking deals full cycle. Do they have experience working through a depressed economy? Is the deal sponsor full time in real estate? Is the sponsorship group investing their own capital? Make sure you know not only what you’re investing in, but also who you’re investing with.

Return Assumptions

IRR: The Internal Rate of Return accounts for the time value of money. Receiving returns sooner than later drive the IRR higher. Receiving a single lump some year 5 drives the IRR lower.

AAR: The Average Annual Return is a simplistic, and potentially misleading, return metric that takes the total returns divided by the initial investment. No matter if the returns were received equally over a 5-yr hold, or in 1 lump some year 5, the AAR would be exactly the same.

Similar to the points above, scrutinizing the assumptions on cap rates, interest rates, closing costs, loan prepayment penalties etc is vital as they all have a direct impact on the ROI.

What’s Next?

We at Timber Run Capital are believers that wealth is built over the long run in real estate. We do not anticipate the enhanced returns experienced in this asset class to continue over the next 5 years. That does not mean we won’t be buyers of multifamily real estate. It does mean we will only buy when our conservative assumptions for a declining market generate the level of return our investors expect.

This may lead to stretches of time with no deals in the pipeline, as we are at peace with that. We are confident that by putting our investors’ needs first, and by pursuing opportunity in the marketplace with unmatched persistence, we will secure a viable investment that will survive, and ultimately thrive, through headwinds in the market that may be on the horizon.

To learn more, and be notified of future investment opportunities, click the CONTACT tab at the top of the page or JOIN THE INVESTORS CLUB at the bottom of this page.