Will COVID-19 Create a Real Estate Crash…. Mitigating Risk Through Multifamily Development During A Down Cycle
With Covid-19 redefining our idea of the word “normal” and affecting all areas of life in terms of elbow bumps instead of handshakes and questioning our economic recovery, we are playing the long game. Just like the pandemic, the nature of real estate is intrinsically a long-term investment. Aggressive allocation of funds for a “quick return on investment” is not how real estate experts play the game. Therefore, we can investigate what it is that will keep you safe investing in real estate during this interesting time, and how the pandemic may actually be a source of opportunity.
Many people’s jobs are being shuffled around, and some are left unemployed, some are furloughed, and the sources of income have been reduced. This has encouraged many people to turn towards renting multi-family housing, rather than making their desired home purchase. Despite these volatile and unforeseen circumstances, people will always need a place to live and this is why we have seen a surge in demand for multi-family housing during Covid-19 times.
I would like to strongly preface this by acknowledging the fact that we are uncertain as to what the future will hold as a result of COVID 19 or any other natural disasters. We have already seen the impact that the last several months has had on people’s income, equities, world stock markets, fixed income asset values, alternative investments, etc. However, I would remind you of the white paper that was prepared on the benefits of investing in fixed assets such as real estate during these “inherently risky times.” I stand behind the proposition that now is a good time to invest in real estate for the reasons stated therein.
With the foregoing caveat, there are no predictions right now that a real estate crash is on the horizon. In fact, in a recent article from Forbes Magazine they discussed the Darwinian effects of the COVID pandemic on real estate.
According to the Forbes article, “Every economic crisis is intrinsically Darwinian, producing winners and losers while shifting the natural balance of power.” It continues with “There are no simple answers. Opinions and models run rampant on how fast the economy will re-boot. Few economists believe that we’re in for the brutal elongated “U” that America experienced through the Great Recession. Most predict a more rapid corona “V”, especially for manufacturing and retail, pointing to the speed with which businesses and factories have re-opened in China and South Korea.
Buying a house, however, isn’t the same as turning the Frappuccino machines back on, or pulling the trigger on a bigger flat-screen TV in case we’re locked down again. Housing is an emotional, big ticket game, inextricably linked to macro-level downwind pressures on employment, wages, job mobility, the stock market, and ultimately, consumer confidence—whose quick resuscitations are still far from certain.”
There will be losers (single family residential real estate, hospitality, retail strip centers, malls, shopping centers, office, etc.) For the reasons outlined below, the multi-family, residential class, will be a winner. People will always need a place to live and if they cannot afford to buy a new home due to reduced income and wealth, then they will need to rent.
According to Bisnow, “The National Multifamily Housing Council’s rent payment tracker showed that 94.6% of rent was partially or fully paid in April, 95.1% in May and 95.9% in June, as reported by more than 11 million professionally managed market-rate apartment units.” The CEO of Nitya Capital, Swapnil Agarwal, spoke about how “people are starting to see how recession-resilient multifamily assets are, and what that’s going to do is really increase the demand for multifamily assets going forward… [He expects] in the next two to three months, the debt market will become very active, and as soon as that happens, there is a lot of equity being raised and just sitting on the sidelines.”
Not to mention the normalization of working from home to follow “stay at home” orders and to practice social distancing; people are in need of homes, multi-family complexes standing at the forefront. The real estate market currently makes up about 6.2% of the U.S GDP. This statistic highlights the reign of the real estate industry and showcases how, regardless of any external factors, real estate always returns to a happy equilibrium.
I am not underestimating the implications that come along with real estate at this time, such as project timelines being pushed back due to safety precautions and the hesitancy of potential investors. The psychology behind potential investors has shifted entirely, creating a sense of additional speculation before they would think of investing at this time. However, what many people don’t consider is how this introduction to a new world could be framed to work for you, as long as you take the steps necessary to carefully invest in properties that mitigate investment risk. These are things that, pandemic or no pandemic, real estate experts are prepared for in this industry, and I would recommend that you implement the following to mitigate risk during a down cycle and protect investor capital:
(1) Investing in properties with cash flow in mind – Do not be a speculators. Your investments should have plenty of cash flow being generated from the property. For any buy-and-hold investor, it’s all about this steady income, and not so much about rapid, forced appreciation and a quick payout. While that’s certainly an effective strategy for quick wealth-building, it’s not the best choice when the focus is on investments designed to last during a market crash. To insulate against such a crash, I want an investment that performs for the long-haul, month after month.
(2) Don’t buy properties that rent too high – I do not want to have the highest rental rates in the market. One of the things that past crashes have taught me is that people just don’t have money to spend on high rent during these times. Part of every paycheck will need to go toward housing, of course, but they’re not going to put more of that money toward it than they need to. Times are too tough for that during COVID 19, an economic crash, etc.! So this is when it pays to have a property that rents are at or below the median, rather than above. Those high dollar units are going to be the first to be vacated during a crash, so we target properties with median rental rates.
(3) Handling mortgages correctly and reduce debt – Do not over-leverage your properties, but use this economic downturn to capture some of the lowest interest rates in history. Having too much debt can spell disaster in a crash climate, so make sure you are securing amortizing debt and paying it down as quickly as possible. I realize that some people don’t share this philosophy, as financed real estate can be used as leverage to purchase more properties. However, I don’t think massive amounts of debt is ever a good idea, especially if the economy is struggling.
(4) Avoid properties that require major remodeling unless they are part of a specific value-add, redevelopment strategy. Unless a company has a tried and true value-add strategy to boost investments, searching for properties that are in need of a makeover is not the ideal path to travel down right now. Thankfully, the value-add strategy is designed to secure an exponential growth in value based on smart, strategic renovations. Additionally, this is the same method I would have recommended pre-Covid. I don’t acquire properties with significant deferred maintenance, but if I can invest $1, and by increasing rents, reducing expenses, and other strategies, I can get a $3 or $4 increase in value making it is a wise investment. Generally, properties in need of work on deferred maintenance fall below market value, which is the exact opposite of what you want during a crash situation. Unless you’re an investor who’s experienced with renovation and value-add work, it’s safer to buy properties in good condition that don’t have a lot of deferred maintenance.
(5) Diversification of assets. I cannot stress diversification of assets enough. Even if the strategy is narrowly focused on multifamily assets, the diversity within this class could range from independent living, age-restricted senior housing, market-rate traditional assets, attainable housing, value-add existing assets, differing geographic markets, differing product type (wrap-product, garden style walk-up, etc.), etc. One of the best ways to be protected in the event of a real estate crash is to make sure that our investments are diversified. Having investments with a variety of market backgrounds and types of properties is essential to mitigating risk.
(6) Analyzing “Macro-Location” Market Data. Only invest in cities that have a growing population, specifically from people migrating from other cities. These cities are typically a safe investment since jobs are increasing, and demand is likely to remain consistent. Generally, I am looking for a steady increase in the level of median household income. Typically, the formula is a 3 % increase in median household income for every 2% growth in population. This data point supports the growth in population and reiterates a sound economic foundation for your investment. Of course we focus on other “micro-location” factors such as vacancy rates, competitive set details, crime statistics, new construction, etc., but I always focus where a “rising tide of population will lift all boats.”
I am informing you of this because things are looking pretty attractive for multifamily real estate investors, contrary to popular belief. I have been studying the issue of potential economic downturn, continuously examining our situation to make sure that from a fiduciary standpoint, you should be always prepared for a crash.
We all remember what happened in 2008, and while I don’t foresee a burst housing bubble event recurring (namely because banks and other lenders have changed a lot of their lending policies since then), there are other ways an economic downturn can affect us. I don’t know when and what will precipitate it, but history has shown that we are doomed to repeat crashes, which are a normal part of the economic cycle.
Rather than praying such events do not occur, the competitive advantage includes being extremely selective with where you should invest through the 6-Step Model on how to Mitigate Risk. I believe that this approach, combined with this investment strategy, can help to mitigate risks during a down cycle.
Remember, just like the pandemic, the nature of real estate is intrinsically a long-term investment. Use this investment strategy to keep you safe in real estate and to recognize that multifamily truly will represent the “survival of the fittest.”
To read more from David G. Wallace see the rest of the blogs on the website.
COVID-19, or coronavirus, is an epidemic that has put the entire world under lockdown; shaking the foundations of the global economy and bringing down with it, people’s livelihoods. However, what the virus also brought was a tsunami of change. While this pandemic is something to be feared in terms of a health, economics and society, this change also brings an inherent, albeit unexpected, opportunity for those who are daring to ride the new waves.
As a consultant working with real estate developers whose focus is to build on the attainable housing model in the state of Texas, I am recommending that folks lean into the COVID Storm by adapting to the new environment and taking advantage of any unforeseen opportunities. While some see nothing but headwinds from the storm, I see these winds as a potential lift into the future and beyond.
The Attainable Housing Model
In its simplest form, the “Attainable Housing” model is the use of econometric data that analyzes over 30 open-source data sets in which to determine the exact census tract for a multifamily product. Through lower land prices, prefabricated construction methods, the temporary reduction in producer price index components and the near-record low interest rates, a developer can construct a high-end, Class-A multi-family product, yet places its product in a middle-class America Census tract, and can therefore thrive and profit on middle-class rental rates due to its reduced overall costs.
Infamous bank robber Willie Sutton was once asked by a reporter “why do you rob banks?” His reply, of course, was “that is where the money is.” In a similar fashion, the attainable housing model places its high end, lower rental rate model into the census tract that has the precise average household income, educational attainment, employment rate, growth trends, demographics, etc., and to place the product in the largest universe of renters possible … middle-class America. Some economists suggest that middle-class America, based on average household income and other data points, represents nearly 60% of all Americans. And, as a result of the current economic issues associated with COVID-19, there is little doubt that middle-class America just got a little bit larger.
Home Buying Impact
The largest single asset purchase that most Americans will ever make, is their home. However, due to the recent stock market decline of roughly 30% due to COVID -19, the average 401k value has dropped by 19%, causing heavy financial damage to people’s retirement as well as a potential source of equity for their home purchase. Although there has been a bit of a rebound in May and June, the consumer confidence has been shaken and many people have decided to sit on the sidelines instead of going out and making that large investment in buying or building a new home.
Furthermore, the headlines are riddled with the announcement of company closures, bankruptcies, jobs being furloughed, people being laid off and, in short, people losing their ability to qualify and pay for a new mortgage. It is hopeful that this growth in unemployment is merely a temporary situation, yet all of this has shaken the consumer confidence and the ability for people to invest in and purchase their new home.
According to the president of Cleveland-based TSL Consulting, Tom Malfa says that he forecasts that “home prices will drop 20% to 30% over the course of this calendar year.” It is uncertain as to whether or not that drop in home prices will actually occur, however, the demand curve will obviously be blunted due to the lack of liquidity brought on by the stock market drop, combined with the chilling effect of the drop in the Consumer Confidence.
“Already, experts are seeing slowdowns in home showings — which are now largely done virtually — and expect that permits for new construction might also drop.” Quotes similar to these are being written every day in dozens of articles nationwide … this one attributed to The Texas Tribune. Unemployment is high in every part of the globe. The massive loss of employers leads to the closure of many businesses. Another example, the Innovation Map, explains, “The analysis, published April 2nd, indicates business closures in Harris County — which represents two-thirds of the region’s population — have caused a 27 percent drop in the county’s daily economic output.” The senior vice president of research at the Greater Houston Partnership Patrick Jankowski, “anticipates the Houston area tallying job losses of at least 200,000.”
However, this does not mean that people are unable to work, as most essential retailers such as Walmart are still hiring and offering jobs to middle-class America. Walmart recently committed to hiring more than 150,000 new associates by the end of May. Since then, Walmart has had over 1 million applicants, hiring an average of 5,000 people per day. In addition, according to industry relationships and friends, they have seen little to no decrease in work demand and pricing in licensed professionals (architects, engineers, surveyors, etc.) in the past quarter, and hardly any drop for Skilled Trade Workers (electrical, plumbing, HVAC, etc.).
Although the most recent macro data is encouraging in that it shows that supported by lower interest rates, mortgage applications for house purchases have surged and are now running above their pre-virus rate and up by 2.7% year-over-year in May, it does, however, reflect that those home purchases are concentrated among older, wealthier individuals, who are less likely to have been laid off in recent weeks and who are more likely to have accumulated a pot of savings during the lockdowns. Consequently, such a “V” shaped recovery is unlikely to be replicated across the entire economy.
And with physical distancing likely to be required for the foreseeable future, there are still some industries that will simply not recover providing credibility to the idea that the residential housing market will stage only a partial recovery this year.
The Perfect Storm
The universe and size of the ‘renter pool’ is growing due to the void in home purchases, lack of liquidity, unemployment trends and the consumer confidence has chilled the enthusiasm of people wanting to rush out and make an investment in a home. Consequently, the psychographic impact of the current environment is forcing people to continue to rent.
The Pew Research Center defines middle–class or middle–income households as those with incomes that are two-thirds to double the 2018 U.S. median household income of $63,179 (per the Federal reserve of St. Louis). According to this formula, Pew would determine that middle–class Americans have median household incomes ranging from approximately $41,698 to $126,358. As a result of the lower average household income, due primarily to an increase in unemployment and first-time recipients of federal assistance, “middle class” America just got a little bit larger due to COVID-19.
However, in terms of construction, the largest single two line-items of a real estate development generally are the “Hard” Construction Costs and Interest Expense. Looking around, it is apparent that goods such as gasoline, cars, entertainment, hotels, cruises and airline tickets have become cheaper. This is also true for material goods, or “hard” construction costs. According to the Markets Insider, there are visible drops in prices for wood, metals, and oil and natural gas.
What this means for those in construction and manufacturing, the cost of raw materials is significantly cheaper, thereby resulting in a better opportunity for those who wish to develop and build assets like multifamily housing. According to an article from PNC Insights, “Overall, the cost of materials used to build multifamily housing had been expected to rise somewhat more than the rate of inflation overall in 2020, after rising just 0.7% in 2019, according to the ACG’s analysis of the Producer Price Indexes kept by the Bureau of the Labor Statistics. That’s a slight rise compared to the 4.2% increase in 2018, as investors and contractors worried about a series of ongoing disputes between the United States and its largest trading partners.” However, this rise has not materialized.
From an interest rate standpoint, COVID-19 brought an extraordinary amount of uncertainty and considerable risk to the economy, according to the minutes of the Federal Open Market Committee (FOMC). Interest rates will be kept near zero until a recovery is firmly in place and the Federal Reserve is committed to using a full range of tools to support the US economy. Fed officials also noted on April 29th that a second wave of the coronavirus outbreak with another round of strict restrictions could drag the US economy deeper into recession prompting a jump in unemployment and renewed downward pressure on inflation. Consequently, the Fed left the target range for its federal funds’ rate unchanged at 0-0.25 per cent on April 29th.
So, what does all of this mean?
At a point in time when many people are sitting on the sidelines and wondering what to do, my recommendation is to take a contrarian view and lean into this storm. I believe that renter demand for attainable housing has and will continue to grow for the foreseeable future. Additionally, if you use an econometric model to make data-driven decisions as to precisely where we look to place the rental supply, god things can happen. These micro and macro data points are more important now than ever because without even knowing it, they have helped protect us against unforeseen volatilities in the economy, such the black swan event we witnessed in Covid-19.”
As a result of the producer price index reductions in the ‘hard construction costs,’ the general contractor community is expecting a 2% to 5% savings if you lock in your prices now. Furthermore, my financial advisors such as Jones Lang LaSalle (JLL) are encouraging people to take advantage of the bulging capital markets that are in need of placing debt capital at highly attractive rates.
Yes, each and every one of us has witnessed an overall change in how people live, work and even socialize as a result of COVID-19. The decrease in employment, captivity resulting from a forced “shelter-in-place” mandates, a downward pressure in the stock market and reduced wealth have all had an adverse impact on consumer confidence. But I see this present situation as a buying … no, a “building” opportunity.
In short, you should use these headwinds as lift to rise above the issues and drop its shoulder and push through with its strategic plan for growth. And if ever asked in the future why you chose a specific location in which to develop a multifamily development, you can respond by saying … “that is where the tenants are.”
To read more from David Wallace (Former Mayor of Sugar Land), see out blog section.