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.