From 2020 to 2022, rents in markets like Tampa, Orlando, Phoenix, and Austin grew 25%+, SOFR hovered around 0%, and occupancy in the hottest markets exceeded 96%. It was good to be a landlord. Equity capital was abundant, and transaction volume was breaking records. Then the party ended. Rent growth turned negative, SOFR peaked at 5.40% in 2023, and transaction volume plummeted as sellers canceled sale plans.
The same markets with properties trading at 2 to 3% cap rates saw their values cut by 20 to 40% as cap rates doubled in some cases. With rent growth turning negative and debt costs spiking, it was difficult for buyers to justify paying peak market pricing for assets which no longer could demand record high pricing.
Investing in multifamily can yield strong returns, but, as was seen in 2020 to 2023, can come with volatility too. How does an investor capture net positive returns from this private real estate investing?
Manager Selection
Tenure of fund managers is valuable. Longer time in the business means more experience for different market cycles. Managers will experience periods of both outperformance and underperformance over the course of their careers. Investors should seek managers with a demonstrated history of successfully navigating multiple market cycles. While no manager consistently outperforms in every environment, the strongest managers tend to outperform their peers over full market cycles.
Macro Trends
Manager selection is the most important decision an investor makes. Once an investor identifies strong managers, macro trends should not be ignored. Great properties operated by outstanding managers acquired at the wrong time of the market cycle often produce underwhelming results. Average acquisitions run by average operators acquired at the right time in the market cycle can produce acceptable, but not outstanding, returns. The common factor in these two scenarios is that macro trends either hurt or impair individual asset performance. Market forces, such as cap rates, leverage, debt cost, rent growth, and liquidity in the capital markets at the time of sale, can override specific asset performance.
A Manager who is forthright in discussing macro risks often has the foresight to structure the acquisition to minimize the impact of these risks during the hold period. Common tools used include longer hold times, avoiding bridge-to-permanent debt business plans, a business plan showing NOI growth because of year 1 focus on improved operations, unit renovations, and/or increasing revenue through rental rates and increasing Other Income.
Investment Timing
Borrowing a phrase commonly used in the stock market, “dollar cost averaging” applies to private investments too. Much like most prudent investors would not go all-in with their entire life savings in a single public equity in a single transaction, private fund investors should take a long view of markets and deploy capital across different vintages in appropriately sized allocations. This strategy allows investors to create a more durable stream of returns instead of periodically, and disproportionally, investing in private funds.
Property Level Debt
Some of the most spectacular blowups from the COVID era were a direct result of large amounts of floating-rate short-term debt on individual assets. The combination of increasing interest rates, cap rates, and slowing rent growth leveraged unsustainable amounts of cheap debt, placing many highly leveraged investments under severe financial stress, with some resulting in a complete loss of equity and, in certain cases, losses to lenders as well. If these properties were owned debt-free, the NOI would suffer, but the property would not be facing foreclosure notices from its (non-existent) lender.
Debt is an important tool in multifamily investing when used responsibly. Guardrails on debt should be in place to allow for sufficient free cash flow even if operations are not hitting proforma.
Summary
Investors can improve the probability of long-term success by focusing on four principles:
Important Information
This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.
The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.
Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.
Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.
Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.