Multifamily: An Unassailable Asset Class Develops Some Cracks

As a provider of joint venture and general partner equity, real estate investment firm RanchHarbor has been seeing an influx lately of multifamily investment opportunities presented by sponsors as value-add. However, upon a closer look at the underwriting, these deals do not actually fit the typical value-add investment profile, says Adam Deermount, co-founder and managing director of the company. Instead, these opportunities end up being cap rate compression plays under the guise of value-add and are priced to perfection in today’s market. “Most of the return on investment is generated by rent inflation buoyed in the early years of the investment by positive debt service arbitrage due to interest only terms,” Deermount says.

Now here’s the rub: If a value-add opportunity requires market annual rent growth of 3% over annual expense growth of 2% to 3% over a five-year hold for the returns to work, it is not a really a value-add deal. ”True value-add plays have renovation or management or leasing risks so the increase in value from those activities should be enough to achieve returns in order to justify the risk on a shorter-term hold.”

This is particularly important in this current environment where net operating income growth in major urban markets is likely to see headwinds due to urban flight, a lack of affordability and a recessionary economy, Deermount says.