How to Capitalize on Multifamily Investment
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(Save the date: RealShare Apartments comes to the Westin Bonaventure, Los Angeles, October 24.)
LOS ANGELES-The high tide of single-family home foreclosures has turned five million homeowners to renters, and likely longer-term, if not permanent, renters. So says Eric Sussman, managing partner at Sequoia Real Estate Partners. Sussman recently chatted with GlobeSt.com on the subject of multifamily investment and how investors can capitalize.
GlobeSt.com: Why is there now a greater window of opportunity for investors to capitalize on multifamily housing investment?
Eric Sussman: Generally, commercial real estate has offered reasonable risk and stable returns over the long term, providing cash flows and the opportunity for growth, all while providing a hedge against inflation. We view multifamily housing as being far better positioned presently than other commercial real estate classes—office, retail, industrial, etc. for several reasons.
* Office and retail investments face considerable headwinds looking forward, including the continued shift to on-line retailing, global economic uncertainty, and a reluctance of firms to increase their hiring in any meaningful way.
*Homeownership is declining and renter-ship is increasing, increasing demand for rentals and pushing rents higher.
*Structural changes in the economy are cultivating longer-term renters, including an increase in those who will end up renting for their lifetimes.
*Acquisition costs of existing properties are often favorable in light of our expectations for future rent growth and for higher replacement costs.
*Interest rates for multifamily housing are at historic lows, and acquisition capital for properly underwritten transactions is plentiful.
GlobeSt.com: I have heard that investors sometimes find themselves “locked-in” multifamily real estate deals for protracted periods of time, with little flexibility for liquidity/exit? Any thoughts on that subject?
Sussman: I don’t think so. A well conceived private equity fund focusing on value-added, multi-family investment opportunities should not tie up the investor’s capital for more than five to seven years, and at times may be as short lived at two to three years. A fund needs enough time to identify and acquire opportunities, add value through renovations, and more effective management, and then monetize the assets (sale or refinance). Typically, the faster this cycle is completed, the higher the equity returns; a process that usually takes two to three years (to maximize the internal rate of return). So significant cash flows, or even a complete return of capital, can happen relatively quickly. Our funds are specifically designed not to lock in investors indefinitely, but to provide returns in excess of those offered by REITs, over a medium-term investment horizon.
GlobeSt.com: Why is private equity based multifamily real estate investment said to be superior to large institutional investment in commercial real estate?
Sussman: Several reasons. 1) Lower fees and costs: A properly structured fund has far more streamlined ownership structure, which should decrease operating costs, and hence, offer better returns. 2) Better financing: At present, debt financing for most commercial real estate (e.g., office, retail, and industrial) is difficult to obtain, and underwriting standards are very strict. On the other hand, Fannie Mae and Freddie Mac remain extremely valuable capital partners of multifamily asset investors, offering inexpensive financing, and a number of alternative financing vehicles.
Banks are also reluctant to lend to institutional investors in single-family homes, because of the perceived valuation risks caused by pending foreclosures and short sales and soft employment markets.
GlobeSt.com: What are the structural changes in US consumer lifestyles and housing consumption that are fueling the rapid increase in demand for rented multifamily housing?
Sussman: The high tide of single-family home foreclosures has turned five million homeowners to renters, and likely longer-term, if not permanent, renters. Furthermore, relatively high unemployment in most urban markets is slowing the formation of traditional households (via marriage and child birth), substantially depressing the demand for conventional single-family homes. The slowdown in single-family home buying has been accompanied by acceleration in the demand for apartments, driving up rents in many markets. Twenty- and 30-somethings are postponing families and many younger and recently divorced adults are doubling or even tripling up in shared apartments (if not moving back home with their parents), as they experience lagging real wage growth and reduced employment or under-employment prospects. This lagging household formation won’t last forever and when the pendulum swings in the other direction, the vast majority of these individuals will become renters.
Most Gen Y and Gen X working adults will be changing jobs many more times in their work careers than prior generations, requiring significantly more mobility in their housing arrangements. Many of these workers cannot be constrained by the illiquidity of home ownership. These individuals will prefer to live in rental housing units, in close proximity to desired amenities.
Meanwhile, rising gasoline pricing is increasing demand for higher-density, urban housing settings that are closer to employment centers. Downtown areas are no longer centers for the less affluent, but rather preferred lifestyle environments for younger workers seeking convenient access to work, restaurants, and entertainment. Gen Y’s and Gen Z’s value social fabric and density. Additionally, these groups are often burdened with significant student loans—the balance of which remain at record highs—reflecting the increased costs of higher education and declining real wages. This increased debt burden will significantly delay acquisition of single-family homes for many.
All of aforementioned changes in US housing consumption strongly favor apartment renting versus home ownership, and we believe these trends are longer-term and structural. Rental data, home ownership rates, and apartment absorption statistics all speak to these trends, while new apartment construction lags. Increased demand and stagnant supply are recipes for real and sustainable growth in multifamily assets.
GlobeSt.com: How are interest rates propelling opportunities for multifamily real estate investment?
Sussman: With 10-year US Treasury Bond rates hovering below 1.65%, owners or acquirers of multifamily properties are able to obtain acquisition or recapitalization financing at record-low rates. While rates available to qualified homebuyers are also at all-time lows, low rates themselves will not create sustainable demand for single-family homes without employment and real wage growth. Meanwhile, we expect inflation to remain low for the foreseeable future, as a result of the weak employment levels, uninspiring wage increases, and anemic GDP growth rates. The Federal Reserve has publicly stated its intention of maintaining low rates through 2014. To the extent that inflation were to rear its head, the shorter-term nature of apartment leases should allow landlords to realize higher rents, while owners of commercial properties subject to longer-term leases would not have such flexibility. Leading commercial real estate industry forecasts such those issued by Urban Land Institute, Jones Lang LaSalle, and Grubb & Ellis all point to multifamily real estate as the real estate investment/return growth opportunity for the next several years. We echo these sentiments.
GlobeSt.com: So how can investors best take advantage of the current multifamily investment growth and return opportunities?
Sussman: We believe that the greatest “alpha” opportunity (returns relative to risk) resides in medium-sized (50 to 200 units), value-added, class B and C properties, and private equity real estate funds focused on this particular niche. REITs and other institutional investment funds typically focus on larger, turnkey, class A projects, which have minimal, if any, opportunity to add value through active management and/or asset repositioning. Moreover, large institutional investors offer minimal management interface and bring with them high overhead, management, and marketing costs.
For example, Sequoia Real Estate Partners offers access to the “middle-market” multifamily niche, focusing on class B and C acquisitions (workforce, blue-collar housing), 50 to 200-unit properties (on average), located close to major employment centers. Such properties offer greater potential for rent increases, and improved cash flows after skillful repositioning (often via exterior and interior renovations, and added amenities) and re-marketing.
GlobeSt.com: What is the impact of market timing in multifamily housing investment timing?
Sussman: “Smart money” does not follow the investor herd. In the last commercial investment cycle, it was the early private real estate equity fund investors (circa 2001-2003) who enjoyed the strongest returns. Of course, these were the years when the least capital was raised, and people who dove in with the herd from 2004 through 2008—when capital raising peaked—lost money. The current multifamily investment cycle may last another 24 to 36 months. Potential multifamily real estate investors should not wait to commit in 2014 or 2015.
GlobeSt.com: Where do profits come from at the time of sale of a well-executed, value-added multifamily investment?
Sussman: Lower cap rates and greater post-sale profit contributions accrue from skillfully executed, cost-efficient renovations and improved management efficiencies in our experience. After these improvements, Sequoia is typically able to increase rents 20% to 30%. Profit contributions from merely holding the property, what’s known as a “core” strategy, typically generate only a minor share of post-sale profit. We specifically examined one of our projects for this breakdown and found only 16% of the profit was due to market improvements, while 84% was directly a function of smart renovations and improved management, both of which translated into substantially increased rents and a very large profit when sold in just three years.
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