Multifamily Investing: Exposing Vulnerabilities in Everyone’s Favorite Real Estate Asset Class
- Mar 1, 2023
- Joseph Rubin
By Joseph Rubin
For years, multifamily housing, whether high rise or garden-style in urban or suburban markets, has been extremely popular among real estate investors. And with good reason. With tens of millions of Generation Z aging into their prime renting years, and Millennials stuck in rentals due to the high costs of home ownership, demand for rental apartments has been exceptionally strong. Until the last few years, the pace of construction of new units couldn’t begin to keep up with that demand. Rents soared, particularly in Sun Belt markets bolstered by accelerated migration during the pandemic. Multifamily investors were receiving reliable, tax-deferred distributions, and appreciation through value-add management strategies.
Many investors, particularly limited partner (LP) investors in syndicated transactions, thought multifamily was an iron-clad no-lose proposition, a headache free way to deploy capital to hard assets and achieve stable returns. The luster began to tarnish when rent collections suddenly dropped during the pandemic. Distributions to LP investors were often reduced or stopped altogether as property managers worked with tenants to arrange payment plans and apply for government support. As employment rebounded, most tenants started to pay again, and property cash flow recovered. Investors thought they were out of the woods. But then the unthinkable happened. For the first time in a dozen years, interest rates rose.
Today, despite the continued demand drivers, the vulnerability of many multifamily investments to changing economic dynamics has been exposed. Investors need to look more closely at their investments to understand new risks and reforecast property returns. Most importantly, LP investors must inquire about the terms of the property’s financing, including whether the loan is floating rate, and when the loan matures.
Multifamily LP investors should make the following inquiries of the transaction sponsors:
Rent collections: Investors should ask whether rent collections have returned to normal levels and how many tenants remain on payment plans or are in legal proceedings with the owner.
Rent arrearages: When tenants were unable to make rent payments, the rent receivables, or arrearages, added up. Investors should inquire whether the arrearage balance is now declining or continuing to rise, and what portion of past-due rents is collectable or will be written off.
Rent growth: Rent growth is falling across markets. Many markets, particularly in the Sun Belt, were attractive because of a lower cost of living. But huge rent increases over the past few years have made many of those apartments unaffordable. The markets with the highest rent growth are now in the Midwest and other urban areas that some predicted would be abandoned by renters. Investors should inquire whether rents on new leases are continuing to meet the sponsor’s original projections, especially in value-add strategies dependent on revenue growth to achieve advertised returns. Many owners are trying to maintain occupancy through tenant renewals, but renewal rents are often lower than rents to new tenants. In numerous markets tenants are being offered concessions. Accordingly, investors should inquire about both renewal and new lease rent growth, as well as the trend in rent concessions at the property.
Operating Expense Growth and Property Cash Flow: Inflation has driven up property operating costs, particularly wages and supplies. Utility bills have been volatile due to geopolitical dynamics. Increasingly harsh weather has resulted in rising insurance premiums in many markets. The combined impact of lower rent growth and higher costs is beginning to squeeze cash flow in many properties. Investors should be reviewing quarterly property operating statements to monitor expense trends and compare actual to budgeted cash flow.
Mortgage Terms: The sudden increase in interest rates means that the terms of the property’s debt could be a more important determinant of future yields than rent and occupancy. The two key questions for LPs to ask their sponsors are whether the property’s debt will mature in the next year or two, and whether the interest rate is fixed or floating. Because lenders are providing lower loan amounts today to guard against the risk of falling collateral values, in many situations the partnership owning the multifamily property will have to make a capital contribution to refinance the loan. This problem may be mitigated if the value of the property has risen substantially since the loan was originated, or if there are cash reserves available to fund the difference between the balance of the proposed and current loans.
The most immediate issue occurs when the property was financed with a floating rate loan, where the payments have already doubled and likely reduced distributions to the LP investors. Many sponsors have avoided this by hedging the interest rate when the loan was originated. But if that hedge is expiring, the cost to buy a new hedge may be prohibitive in today’s market. If the deal has exposure to floating rates, the sponsor is likely trying to refinance into a fixed rate loan, but that may also require a cash infusion.
Sponsors of value-add deals typically try to refinance the debt once the business strategy has resulted in higher property value. This enables the LP investors to partially cash out of their investment mid-way through the life of the deal and boost their yields. If the partnership didn’t achieve that refinance prior to the rise in rates, such a refinance is now unlikely, and the partnerships return on investment will be below projections.
One other area of concern investors should be monitoring is loan covenant compliance. Multifamily mortgage loans typically include covenants that set minimums on debt service coverage and debt yield ratios. As mentioned, with cash flows being squeezed, and especially if the rate on the loan is floating, a covenant might be breached. To cure the breach, the lender may require a “resizing,” or partial paydown, of the loan. That may require a capital call from the LP investors.
Capital Expenditures: When times are tough and cash is at a premium, property managers often defer capital improvements to the property. LP investors should inquire whether any budgeted capital projects are being put on hold that could result in less long-term demand for the property, particularly in value-add deals where the investment strategy was to reposition the property to attract higher rents.
Valuation: LP investors not only want quarterly distributions but value appreciation when the property is sold. When interest rates rise, capitalization rates typically follow, although not necessarily at the same pace. The value of a stabilized property equals its cash flow divided by the cap rate, so higher cap rates translate into lower values. There is evidence of rising multifamily cap rates in many markets, and the value depreciation will be accelerated by lower rent growth and higher operating costs.
Updated Performance Forecasts and Distributions: With so many factors influencing both the trend of cash distributions and the more uncertain outcome from property sales, LP investors should be asking their sponsors for updated cash flow projections, and the recomputed cash-on-cash return, internal rate of return, and investment multiple compared to those estimated when the partners made their original investments. The investors should also inquire how the sponsor is managing cash, including reserves, and whether cash flow is projected to support debt service through the remaining life of the deal.
Depending on the market and each investors’ return expectations, the multifamily family sector continues to provide great investment opportunities. However, the sector is different today than a year ago and investors should proceed with more caution. LP investors need transparency on the recent and anticipated performance of their multifamily transactions. That requires more communication with the sponsors, and the sponsors’ willingness to provide additional information about the impact of interest rate and market trends on property values and expected returns.
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Joseph Rubin has experience working with real estate transactions, governance and reporting and distressed debt restructuring.
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