In most multifamily pitch decks, you can find arguments relating to the secular demand drivers for apartments, such as student debt burdens preventing millennials and future generations from buying homes, post financial crisis disenchantment with owning a home, and the increasing rent versus own cost gap. While all of these trends and others are great news for long term multifamily owners, those trends don’t typically result in short to medium term price increases for value-add multifamily investments. Furthermore, because these trends are both widely known and accepted as fact, these considerations are already factored into today’s pricing of assets. In the end, there is really not much value in these long-term trends, especially for a two to five-year, value-add business plan.
A great follow-on point is that these types of widely-known demographic tailwinds are also known by developers who then create more supply fueled by their excitement over current and future demand. This new supply dampens the positive effects of demand drivers which ends up resulting in little change to net operating income. Ian Ippolito (The Real Estate Crowdfunding Review) wrote a great article about this topic. The only caveat is that owners will see a material increase in their NOI if their property is located in a supply constrained market. Developers have a much harder time developing in places like San Francisco or New York City, since both have geographic/physical constraints to development, difficulties with entitlement as well as much higher costs for materials and labor. Mobile home parks, as an asset class, also exhibit severe supply constraints in the face of rising demand – but for a different reason. Sam Zell (one of the best real estate investors of all time) jokes that mobile homes suffer from a unique problem known as “not in my backyard”. Lastly, workforce housing, which sometimes can be bought for half of replacement cost, also has somewhat of a supply moat around it. However, cheap apartments aren’t fully insulated from new supply risk as class B and C rents react to the class A rental market which does fluctuate based on new supply.
At the end of the day, we do not invest based on macro forecasts, and instead focus on deals where value can be created through the purchase (low basis) and implementation of a business plan, and/or capital structure. We look at market rent growth in our model as somewhat of a necessary evil, meaning if you project no rent growth, your returns will always be too low and you won’t end up buying anything. Nonetheless, our rent growth assumptions vary based on the strength of the market. For example, in primary markets and great locations, we assume 3% rent growth which enables us to more effectively compete on price. In tertiary markets, we assume only 2% rent growth even if rents have grown faster historically. This allows us to factor in the additional risk taken by investing in a smaller market, which many believe are more susceptible to job losses. Additionally, we demand a higher minimum IRR hurdle from tertiary markets.
Another way macro forecasts are incorporated into underwriting is through the exit cap rate. Again, if you aren’t reasonably aggressive with your exit cap rate assumption, your projected IRRs will always be too low and you won’t end up buying anything in today’s competitive market. With that being said, we still aim to accurately assess market cap rates and assume an appropriate expansion based on the business plan, location, and hold period. Nevertheless, projecting a sale price three to five years out into the future is always speculative and therefore we always focus on the on-going cash flow the investment projects and not relying solely on the sale to achieve our desired returns. Furthermore, strong projected cash flows post-stabilization or post-renovation is indicative of an increase in value and suggests that a higher sales price is warranted.
Another interesting pitch is the idea of buying a property with minimal or no deferred maintenance and upgraded amenities so the only focus of the value-add business plan is on “income producing capital expenditures”, namely interior renovations. The market is currently flooded with deals which have new roofs, upgraded amenities, and no deferred maintenance, yet the interiors are “untouched”, leaving lots of opportunity for value-add investors. This begs the question, “who are all of these foolish sellers leaving so much meat on the bone!?” The reality is, these sellers are not idiots as they are able to extract massive value out of curing deferred maintenance and spending capital on non-income producing renovations via a sale which is completely based on pro forma. Specifically, sellers are able to sell their ugly classic interiors to buyers who are tripping over themselves to renovate units for $100 pops at 4% cap rates. Sellers can get a similar price without spending the time, effort and money to renovate the units! Additionally, these sellers don’t have to bear the risk of trying to push rents to higher level and be forced to re-tenant the property. Because valuations for interior-focused value-add properties are so high, there is really very little increase in returns by focusing on this business plan. On the other hand, the owners who are spending money to replace roofs and perform concrete repairs may not be getting a rent premium for doing so, but they are receiving outsized value upon sale.
For example, an operator who spends $100,000 replacing his or her roofs (assuming they need replacement) is going to see a price increase in excess of $100,000 because his or her property will be much more marketable and buyers will be willing to pay more to eliminate the uncertainty surrounding deferred maintenance. Next, think about it from the buyer’s perspective, if you think you may have to spend $100,000 to replace the roofs on your potential acquisition, you’re probably going to factor in $125,000 or $150,000 (because everyone underwrites conservatively, right?). Furthermore, because you’re contemplating an acquisition which has deferred maintenance you will also logically be concerned you will encounter other surprise deferred maintenance and thus you should demand a higher IRR from the investment due to additional risk.
In sum, remedying deferred maintenance is indeed a value-add activity comparable to interior renovations, if not better. Going against conventional wisdom, we look for properties which have deferred maintenance, lower occupancy, and many other issues which often deter the vast majority of buyers. Additionally, when properties have deferred maintenance which necessitates a substantial capital expenditures budget, they typically also have higher vacancy, which requires bridge loan financing, which further alienates stabilized buyers. Even if the vacancy is above 90%, thus qualifying the property for agency financing, the optimal debt for the project may still be a bridge loan.
To recap, beware of promises of success based on macro forecasts and secular demographic trends as well as vanilla value-add stories. The data does not support the claim that trends like “America is becoming a renter nation so there is increasing demand for apartments” and other macro trends truly increase cash flows in the near term. This is because these trends are widely known and are thus already incorporated into today’s pricing and developers create new supply in the face of these long-term positive demographic trends, offsetting the purported benefits. In order to achieve outsized returns, today’s value-add investor must uncover or create unique opportunities through creativity and a willingness to go and do what/where others are not.