Applying the Value-Add Mindset to Class A Properties
- Jan 29, 2020
The strength of the multifamily market was in full force in 2019. Heavy transaction volume and high prices persisted as large amounts of capital looked to be deployed into the asset class.
At Castle Lanterra Properties, we believe multifamily remains and will continue to remain the most attractive major asset class from a risk-reward perspective. There are, however, important market shifts occurring that investors will want to take note of moving into the new decade.
Specifically, in certain markets, excessive amounts of capital chasing value-add investments have driven values up and yields down to levels that are similar to—or even lower than—traditionally less risky asset types such as Class A and Core. We saw the beginnings of this trend in 2019 in several of our markets, including Seattle, Denver, Tampa and Miami, and we expect this to continue.
Depending on the specific needs of your firm and the risk-reward profile of your portfolio, this could require strategy shifts moving forward. At CLP, we have started to shift our focus toward the Class A and Core market space and away from value-add properties, even though value-add has traditionally been our bread and butter. In some cases, we strategically exited value-add investments made earlier in the cycle so that we could redeploy capital into newer properties in infill locations.
Room for Improvement
While market forces necessitated these strategy shifts given the risk-reward profile we adhere to, we believe that there are several benefits. First, by investing in Class-A multifamily or new construction in submarkets with long-term growth prospects, you eliminate the upfront costs of value-add. Second, you can still employ your firm’s existing value-add skills and mindset when purchasing these properties, focusing on those that have either been overlooked in the market, suffer from poor management, and/or have yet to completely season in the submarket due to quick lease-ups. This allows for additional returns by putting best-in-class management in place and improving marketing/leasing practices.
Investing in apartments provides an inflation hedge and downside protection because the income allocation is spread out across a large number of leases, minimizing exposure if one or more tenants move out or default. This is not the case in other institutional real estate asset classes such as office or retail where anchor tenants can largely drive the success/failure of an investment. Also, apartment leases typically have a 12-month duration, providing the ability to adjust rents on an annual basis in line with inflation while office, industrial and retail are mainly defined by long-term leases that can erode income over time.
In addition, multifamily is less correlated to broader economic shifts when compared to other major asset classes. Not only is housing a fundamental human need, but rental demand in a downturn can benefit from a shift away from home ownership, as we saw in the last downturn. Economic downturns often more severely impact office and retail, where tenants can go out of business, and hospitality, where discretionary spending can drop quickly.
Although certain portfolio shifts may be necessary for multifamily investors moving into the latter stages of this real estate cycle, particularly as demand for value-add heats up in certain markets, multifamily will remain a key component of any balanced commercial real estate portfolio well into the new decade and beyond.
Elie Rieder is the founder and CEO of Castle Lanterra Properties.