As the apartment market continued to sizzle midway through the decade, few anticipated that investors would remain just as bullish on the multifamily sector as the decade reached its tail end. Yet as the calendar flips to 2020, many investors remain active and hungry and are prepping to raise funds for the next year.
That’s not to say potential changes aren’t in the works as the industry might soon experience a significant shift in the owner-operator model with regard to pricing and equity. Operators that have a large footprint in various markets—and can leverage a reputation for being able to source off-market deals and manage more difficult transactions—will still have their fair share of investors.
They’ll have to be nimble, however, because while equity will continue to be available, it will become more difficult to attain. The low-interest rate environment is fostering competition for acquisitions, which is creating some unique investment scenarios, such as sub-five cap rates in secondary and even some tertiary markets where demand is still outpacing new delivery.
As we bid adieu to the strongest decade the industry has ever experienced, here is a look at the current equity landscape as we enter a new one.
The various types of investors remain prevalent, from high net-worth individuals to pension funds, family offices, hedge funds and longtime institutional players, but the strategies and the cost of equity may be changing. The risk to the owner-operator model is especially prominent with the bigger institutional players that might be more inclined to vertically integrate due to the inflated cost of assets. These investors anticipate savings through vertical integration as opposed to paying an owner-operator to source overpriced deals for them.
Another potential change with the institutional equity providers is the tendency to modify their internal rate of return threshold due the high-cost environment. In some cases, they might lower their IRR threshold from 20 percent or high teens down to mid-to-lower teens. What they will not lower, however, is their preferred return. In fact, some might actually raise it in order to guarantee that they hit their threshold before sharing any upside. When there’s a preferred return of 12 percent as opposed to 9 percent, it makes it more difficult for the owner-operator to profit.
The flipside to that notion is that the owner-operator’s promote may be greater once the preferred return threshold is reached, and there could be more opportunity to benefit through a multi-tiered waterfall. Many larger equity firms already have implemented such a model that allows the investor to realize its higher initial return targets but also share the profits with the operator through increasing the promote at various thresholds. Such a structure is quite lucrative to the operator on a truly high-performing asset.
When it comes to the type of properties investors seek, value-add remains the hottest commodity. Brokers can get buyers into a frenzied state by labeling a community a value-add asset, even if it’s an older, more difficult deal. They are selling that the prototypical multifamily investment dream still exists: While you might overpay initially, the property will flourish so prominently with completed capital improvements that you’re going to have a home run at the end of the day.
As such, everything is being labeled as value-add. Currently, most of the marketed properties are assets that have already been vastly considered and picked through and would generally undergo a Stage 2 or Stage 3 value-add renovation. Many older communities, such as those built in the 1960s and 1970s, also attract investors, even if they might be more difficult to operate, renovate or maintain. The equity is there for virtually anything in the value-add space.
Some longer-term investors are starting to hold back on value-add and looking to core or core-plus assets. They are being more patient with their money as opposed to needing a three-to-five-year quick return on a value-add deal. Traditional value-add players will continue to closely peruse those opportunities, but more and more are beginning to diversify what they do. They’ll now consider core, core-plus, lease-ups and even affordable.
View of affordable housing investment
The affordable housing crisis is frequently talked about, but little headway is often made. Investment opportunities abound and can certainly be profitable, though a few hurdles unique to affordable housing often create pause for traditional investors.
Timing is one of those factors, as some affordable deals can take nearly a year to close, and some equity players don’t have the patience to ride out a transaction that will take so long. Affordable housing deals are often accompanied by complex legal issues, related to bonds, tax credits and other financing vehicles requiring that the investor and operator work with multiple interested parties, such as local and state housing agencies, banks, bondholders, and trustees. Such a process creates a longer closing period than conventional or value-add deals.
Lastly, affordable housing ROI has a defined ceiling when you’re restricted as to how much you can move rents, even if you make upgrades to the property. These concepts scare some investors, which means there is less competition. But it doesn’t make them any easier to transact, which is part of the reason why the affordable housing conundrum continues to exist.
Overall, multifamily investors remain active. A select few are sitting out with the market so hot, but they remain eager to put their money to work. New funds are continually being raised by groups that may or may not have real estate experience that want to get in on the action and take advantage of the homeownership-averse, rent-driven millennial demographic.
While changes to the owner-operator model might make investment opportunities more difficult for newer organizations without a proven track record, multifamily money remains largely available as we enter a new decade.
Stephen Catarinella is the Vice President of Acquisitions and Business Development Manager for CAPREIT.