Houston’s multifamily sector has certainly faced its share of challenges over the past few years. In 2017, Hurricane Harvey rendered between 7 and 11 percent of the metro’s units uninhabitable. Further, significant fluctuations in oil prices have also affected the city’s real estate market. Year-over-year rent growth, as of March, came in at a tepid 0.6 percent, while occupancy rates declined to 92.4 percent, according to a recent Yardi Matrix national multifamily report.
However, it is not all doom and gloom. A number of investors are finding innovative ways to ensure returns on their investments. Some 14,000 units are under construction across the metro, the vast majority as part of luxury developments. Significant capital deployment is also underway in the realm of value-add acquisitions.
Sanmore Investments, a multifamily developer and redeveloper based in Houston, has been involved in the market’s value-add arena for more than five years, acquiring and rehabilitating several properties in the metro. Owner Boris Sanchez discusses recent trends in Houston’s multifamily sector and how investors can make their value-add acquisitions shine.
How would you describe the overall appetite for redeveloped multifamily properties in the Houston metro?
Sanchez: At Sanmore, we have personally seen the demand for our turnkey properties increase to an all-time high. However, in the last six months, that demand has been met and exceeded by the demand for value-add properties. As other areas of the country tighten, Houston’s higher cap rates and landlord-friendly laws have become more and more attractive to investors. In addition, we have seen a record number of residential investors turn to commercial for more opportunities, stronger economies of scale and less hands-on management. This is all coupled with Houston’s strong economic growth and growing population, creating a red-hot multifamily arena in Houston.
Considering the metro’s slow overall rent growth this year, how can investors best maximize their returns?
Sanchez: I believe slow rent growth is a tail-end effect of the recently seen oil bust and Hurricane Harvey. Further, I believe this positions Houston at an advantage compared to other big cities experiencing record-high rents. When the next nationwide economic slowdown happens, Houston will be better prepared to tackle underemployment as rents will be more affordable and employment opportunities more abundant than comparably sized cities, which would be combating vacancy with rent rate rollbacks and development slowdowns or stoppages. If Houston investors maintain a clear, viable path towards income stabilization and don’t overbuild, I believe they are in for a prosperous and healthy investment experience.
Given declining occupancy rates in Houston, how can a redevelopment best compete with a newly developed community?
Sanchez: These are two completely different investments in my opinion, as one is creating equity from an already-existing property and another is creating a long-term cash flow vehicle for its investors, so it largely depends on the end goal. Further, as builders and rehabbers ourselves, we have always seen slower occupancy in brand-new developments than in rehabbed properties, so that should be kept in mind. Investors looking for a redevelopment play should focus on value—bringing tenants great amenities and services for an affordable rent—as opposed to multiple-month concessions and luxury-styled pools. In any event, Houston apartment occupancy is already bouncing back on an all-class average so we should be seeing increased absorption this year.
Tell us about a recent project you were involved in and how it is indicative of trends in the metro.
Sanchez: In the last few years, Sanmore has focused on the largely ignored Eastside of Houston. We have explored larger multifamily redevelopment in this area by acquiring 50- to 70-year-old product and adding Class A finishes, good amenities and plenty of value while keeping a conscious mind on price. We priced ours just $140 above market, thinking we could fill up units as they got remodeled. We were pleasantly surprised to see demand soar, and our waitlist filled in record time.
This sparked the attention of at least one developer, which bought 4 acres just around the corner from us and started building a 230-unit complex. This surprised us, since a certain rent must be demanded on brand-new product to meet cost, which means they must be more bullish than us about rent trends in the area. This ultimately is good for us redevelopers since our rent floor is more flexible, so—worst-case scenario—should an economic slowdown happen, we can cut back on rents to keep us at a healthy occupancy. In the best-case scenario, if the local economy keeps blossoming, we can compete with the brand-new product as well.
What are three of the most important criteria to consider before making a value-add acquisition?
Sanchez: The most important criteria of all is to have a good, conservative plan keeping in mind uncertainty. Some investors underestimate having a solid comparable-filled proforma. In our team, we take designing a proforma just as seriously as we take auditing existing leases. We mystery shop our competitors’ properties, obtain and walk sales comparables then get to know our potential tenants, asking where they are employed and where they’d like to be in the future. Parallel to this, we also maintain an open line of communication with local appraisers. This allows us to have a solid plan on differentiating ourselves from competitors, always providing the maximum value, bang-per-rent-dollar. For us, it’s all about differentiation.
Second, all value-add investors should perform a stress test on the financials of the property. What happens if the worst happens? How many tenants could you afford to lose in the future should a local recession occur? How much can you lower your rents and stay afloat? If there is one thing the banking and lending industry has taught me, it is to think of the worst-case scenario.
Third, having a reliable, quality contractor is crucial. Making sure you understand that you don’t know what is behind the walls is a good starting point for a conservative, solid rehab budget, which should be the centerpiece of your value-add project.
As a bonus point, make sure your marketing is on par with your goals and take ownership of it. Never underestimate the power of an aggressive manager—but on the other hand, don’t leave everything to one company that hired another company that hired an employee to oversee your leasing. Interview these folks personally or, if you can, employ them directly and make your goals and budget clear. You can never go wrong with a nice commission package either.
Which submarket do you see as the most promising for value-add investment opportunities?
Sanchez: I’m partial to East Houston, which is experiencing unprecedented growth. The Eastside is still laden with opportunity and land for development. The city seems to agree with me, as there are several projects developing in the area, including connecting our second international airport to the METRORail network, for example.
What challenges do you see on the horizon for the Houston multifamily market in the next five years?
Sanchez: As more and more investment dollars are poured into Houston, it is imperative that all investors maintain a conservative mind and not overbuild. Although history might prove the “it will fill up eventually” mindset correct one day, we have to be careful and plan for the unplanned. As much as we may or may not like it, Houston is heavily dependent on the oil and gas industry, which is tied to the Class A multifamily industry.
Since people tend to scale down in an economic compression, we have to make sure Houston is an affordable place to live. Fellow Class C investors sometimes swear that (this asset type is) recession-proof. As studies have shown, it is not—both Class B and C apartments also experience expanding vacancies. Investors with the greatest flexibility in rent will be proven to be the longest lasting. There is a lot to be said for not overleveraging and not counting on an all-positive economic future.
Further, just because it’s a bad neighborhood now doesn’t automatically mean it will be a good neighborhood in five years, as numerous local investors believe. In the same spirit, just because Houston has no zoning, has landlord-friendly laws and a good Section 8 program, it does not mean that it will be so in the near future. Laws and ordinances can change overnight, but the best investor plans for the worst and is always pleasantly surprised.