As the multifamily sector seeks to recover from the volatility seen in 2020, there is much talk about distressed assets. Will there be a flurry of activity as properties move past key financial thresholds? Can cash-strapped owners pull enough properties back from the brink to slow down the wave? The answers may not be fully known for some time, but the hunt for distressed assets will drive a portion of investment activity for the next 12 to 18 months or more.
Many landlords are wrestling with the challenges of rising vacancy, rent collection issues, falling rents, increasing concessions, and, in some markets, higher operating expenses. It is inevitable that some properties will become financially distressed, yet others that are well capitalized or benefit from strong market fundamentals may ride out the storm with limited stress. In this evolving situation, where could investors look for opportunities and how can they avoid common mistakes?
What defines distressed?
Properties that fall into the distressed sale category typically move through a 12- to 24-month cycle of steadily declining operational performance before financial stress forces a distressed sale. The market is currently in the midst of this lag period, where some buildings that have encountered operational distress are not yet offered for sale. Well-capitalized owners will be better positioned to delay and avoid such an outcome.
Markets with growing demand, favorable supply conditions and a favorable cost of living, such as Phoenix, Austin, Texas, and Nashville, Tenn., are on investors’ radar as they remain well-positioned to support multifamily rental growth. Others making the cut include Charlotte and Raleigh, N.C., and some cities in Florida, due to positive demand and economic drivers.
Markets such as San Francisco and New York City, where the cost of living is high and the metros have experienced outward resident and corporate migration, are being viewed more cautiously at the moment. But they are also more likely to generate distressed investment opportunities in the near term.
What makes this particular downturn unique thus far is its uneven impact across markets and the extended duration of the typical distress lag period. Investors are watching the following dynamics:
- Generally, suburban assets are doing quite well while CBD assets struggle.
- Cities like Austin and Nashville are benefiting from in-migration while others such as San Francisco and New York suffer from out-migration.
- There is a lack of consensus and data over which elements of COVID-driven migration and work-from-home trends will become permanent and which will be either partially or fully reversed.
- Traditional market clearing mechanisms such as evictions and foreclosures have been paused creating uncertainty over the duration of the distress lag period.
In this environment, distressed property investors are wise to look more closely at how each project can be recapitalized or repositioned for the post-pandemic world. Which properties will have staying power for existing residents and which amenities will provide the right draw for new residents?
And, given the complexity of this cycle, investor’s due diligence should extend beyond the critical building maintenance and mechanical aspects to include a detailed understanding of market dynamics. Demand drivers, such as population and job growth, and inflection points in migration trends, are important indicators to watch. Supply and vacancy trends are also important. Is there a large flow of new construction that might compete with and outsell a five-year-old property? What is the market’s ability to absorb such supply and still generate future rental increases?
Finding the good in distressed assets
Once target markets are identified, distressed property investors might look closely at ownership categories. Among the ideal scenarios are mom-and-pop ownership with limited balance sheets who lack the strong lender relationships that might help them through a downturn. Owners that took on high leverage or bought at the height of the market are also good targets as they have the furthest to fall when the market resets.
Another scenario that bodes well for prospective investors is the asset whose market comparables provide evidence that a repositioning can drive revenues. For instance, if a property’s one-bedroom rent is $750 per month and the market comparables rent at $900 per month, can the investor identify a path to close that gap by upgrading the units’ interiors, the property’s amenities or both? Can this be achieved at a capital investment level that generates a meaningful return on investment?
Other factors to look for include strong amenities that appeal to target rental profiles and properties with desirable transportation connections—a shifting narrative as the market moves toward the post-pandemic world.
There may be many opportunities for investing in distressed multifamily assets, but the landscape is complicated and often shifting. Investors who focus on market fundamentals, sustainable demand drivers and the shifting landscape will be in the best position to identify investment opportunities and capture future growth in the sector.
David Ferrero, CFA, is the executive vice president of capital markets at The Laramar Group, a leading national real estate investment and property management company. Based in Boston, he has nearly 30 years of real estate investment management experience and directs the company’s capital formation efforts.