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Multifamily Investments on the Rise for 2014

By February 12, 2014No Comments

Multifamily has been the darling of investors for a little while now – but will this winning streak continue, or is another asset type poised to take its place? WREB talked to some of the West’s top multifamily experts to find out.

Is there still a lot of potential for investors to buy value-add multifamily properties?

Goodman: This is an interesting question, specifically because the value-add qualifier has been defined in many different ways over the past five to seven years.

The fact is, a true value-add deal is one in which an investor applies significant capital expenditures to a property in order to raise rents substantially. These true value-add opportunities tend to be more successful when the economy is on fire and rents are increasing dramatically. In today’s market, however, job growth is not yet strong enough to support major rent increases. The rental demand remains somewhat inelastic, with many residents still concerned about job security.

The dirty little secret regarding value added ventures is that most of the profit on these renovations is made when the market is frothy and there is cap rate compression. For example, investors are purchasing at a 6 cap and selling at a 5 cap. This was the case before the Great Recession. However now, with cap rates at historic lows and the expectation of higher interest rates in the future, the value-added proposition becomes much riskier.

The key in today’s market is to work with someone who understands where the opportunities are with regard to cap rates and future rent growth expectations, as opposed to relying on the blanket value-add scenario.

How is the multifamily industry faring in the primary markets near you? How about in the secondary/tertiary markets?

Goodman: Contrary to popular belief, there currently is more risk for investors in primary markets than in secondary/tertiary markets.

It remains easier to attract financing for multifamily development in primary markets. As a result, there is some concern of overbuilding in these markets, which would affect market fundamentals and ultimately lower yields, resulting in increased risk for investors.

Many investors are already finding more attractive yields in secondary or tertiary markets than in primary areas as a result of lower pricing.

Are you seeing more activity in multifamily development or redevelopment nowadays? Why?

Goodman: Yes, we are seeing an increasing interest in multifamily development. Developers believe that rental demand will accelerate with an improving economy and, because there was so little new construction from 2008 to 2012, there will be a growing supply/demand imbalance, at least in the near term.

Right after the Great Recession, most of the available entitled land was quickly acquired by developers. Developers call this the “low hanging fruit.” In the last two years, it’s become evident that what remains are sites that are unentitled, and consequently will take longer to develop.

In addition, costs including labor and material have gone up significantly, making it difficult for developments to pencil. This fact, coupled with recourse financing and significant equity requirements for new development, continue to make it very difficult to being new multifamily.

On the redevelopment side, activity is tepid at best. There is some redevelopment happening where investors see an opportunity to add value and raise rents, but these opportunities are few and far between.

From an investment perspective, redevelopment or value-added ventures focus more on the profit upon sale and often do not produce significant cash flow during the holding period. Passco maintains a long-term strategy of purchasing Class A or newer properties that produce cash flow during the holding period, with less emphasis on the profit upon sale. Our investors prefer known cash flow to speculative profits.

What will the lending environment be like for multifamily investors in 2014?

Goodman: Financing is likely to remain unchanged in 2014, specifically with regard to the acquisition of existing properties.

While there is some pending legislation being reviewed by Congressional committees that might affect Fannie Mae and Freddie Mac, with many other major issues facing Congress, it is not likely that these changes would occur in 2014. In addition, life insurance companies and CMBS lenders are providing more debt to investors, so multifamily investors are continually seeing more options for financing.

What are the biggest challenges you believe multifamily investors face today?

Goodman: Today’s primary challenge is competition from other buyers, due to the ongoing enormous interest in multifamily product. As a result, investors must be able to move extremely quickly through due diligence and financing in order to complete acquisitions.

For example, Passco recently acquired Vue21, a 332-unit, Class A multifamily community in Colorado Springs, Colo., for $54 million. We successfully closed on the acquisition in less than 45 days.

This is an extremely limited time to complete due diligence and finalize all debt, but we understand how essential it is to effectively compete by closing quickly, so we have streamlined our processes to enable us to do so.

Which would you say is more popular nowadays among investors, Class A, or Class B and C properties?

Goodman: With so much demand for multifamily product in today’s market, there are truly investors for each property class. The fact is, for multifamily, one class is not necessarily more popular than another at the moment.

However, based on the fact that there was almost no Class A multifamily development for a number of years during and after the recent recession, it’s likely that investor demand for Class A product will continue to be strong.

Currently, the majority of multifamily product on the market is Class B based simply on age. As the development pipeline improves, we will see an increase in the supply of Class A properties available for purchase.

Which types of investors are interested in Class A properties, and which types are interested in B/C?

Goodman: Class A product appeals to more conservative investors. These investors are focused on capital preservation, and typically include buyers such as pension funds, real estate investment trusts, and other sponsors.

Class B product is riskier, and appeals to investors who often do not want to hold long term, since significant capital improvements will be necessary to maintain the property as it ages. These properties are typically held for only four to five years, during which an owner will rehab the asset and plan for significant rent increases. These investments can be somewhat risky given the unpredictable debt market. If interest rates increase significantly, values will be affected and may not allow investors to exit their ventures with any profit, or worse yet, a return of their original investment.

Finally, Class C product appeals to owners with very strong property management. In fact, there are some investors who invest only in Class C properties. These properties are usually older and more difficult to finance.

What is the one piece of advice you’d give to someone looking to invest in multifamily this year?

Goodman: My advice is to partner with someone who knows what they’re doing. Multifamily investment is not for the novice. Investors must have a strong background in analyzing multifamily properties in order to understand how they will perform over time.

For multifamily acquisitions, solid underwriting assumptions and analysis are key. They require sophisticated due diligence with many variables that must be considered that will affect the long-term profitability of a multifamily asset.

An investor who is investing in multifamily for the first time, or one with limited exposure to how multifamily properties perform, should partner with a firm that has successfully maneuvered multifamily markets over time.

All risks aside, multifamily has emerged as the best of any product type for investment in the current market, and we believe that this demand is likely to continue.

Investors who select the right partners and invest in the right markets are likely to achieve high returns.

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