Since I feel we are in the 9th inning of an 11 inning ball game, I decided to pass on a Class-A deal in a secondary market.
Real estate is one of the best risk-adjusted investments out there. In private placements or syndications we are able to crowd-invest in larger & more stable assets while maintaining control with operators who are aligned in our best interests. By going into a project properly capitalized with adequate capital expenditure, budget, and cash reserves, you are able to remain steadfast through softness in the market where rents stagnate and vacancy decreases.
Pause there. In troubled times what happens?
People lose their jobs and there is a bit of shuffling.
Yea, people need housing, but there will be some vacancy as some people will lose their jobs and be displaced elsewhere.
Following this train of thought…
In a recession, the high end or class A will be hurt the most. It is Class A workers who fulfill much of he discretionary services. We are already seeing softness in rent by rent decreases in class A of the high-end markets such as Seattle and San Francisco.
For example a once $1,700 one bedroom is now $1,625.
Most deals model for 1-5% in annual rent increases or escalators. Other than the Cap Rate to Reversion Cap Rate truck, this is the second most manipulated assumption in investment modeling.
In this unfortunate but natural event, the A-Class renters will fall to class B housing. Some homeowners will even lose their jobs creating foreclosed investments for smaller investors in the single-family home scale.
What’s happens to the B and C class renters?
It is likely that they will also lose their jobs at higher or lower rates, but that is up to debate. In the same fashion as the A-Class renters, the Class B/C renters will downgrade to make ends meet.
I imagine this similar to a game of musical chairs (where the chairs are getting crappier and crappier). Or it looks a lot like the natural housing shuffle in the summer near colleges with people moving in and out. The landlord/investor is likely to see increased vacancy.
Multifamily occupancy varies from 85-95% in stabilized buildings. Some markets are hotter and some are colder. It is important to use the correct assumptions depending on the markets. For example, Dallas typically sees 92% occupancy while Oklahoma City sees 89%.
One of the reasons we love multifamily is because of the decline of the middle class and the need for more scalable workforce housing.
When I travel to Asia (which I see as a more mature society, for better or worse) there is a much larger wealth gap than in the USA. People are living in cramped apartments or very rare single-family homes. And they are driving a Mercedes on barely enough money to share a family moped. This is the trend that the USA is following.
As with many things, you need to look past the headlines and the general data. Instead of analyzing a whole asset class, as the media likes to do, let’s break down vacancy in terms of classes.
Here are some typical vacancy rates (notice the spread).
Class C 4.5%
Class B 5.0%
Class A 5.5%
Why? Because there is just more demand for the lower class properties cause there is more demand than supply.
Many times the business plan is the be the “best in class.” For example, businesses want to be the best mobile home park or best high end remodel because you attract the richest customers in that niche.
I like to monitor the number of new units coming online because that is your downward pressure. It is rare that new builds are for Class C or Class B.
The micro-unit trend is an attempt to build for Class C and B tenants due to the need. But often the numbers don’t make sense when you have purchased the same building materials and mobilized the same crews to build a Class B asset as opposed to a class A asset.
Let’s go through that Armageddon example again.
Class A will have to drop rents severely and see great vacancy.
Class B and C will see vacancy come up too as people are losing their jobs but should see some absorption from ex-A Class tenants.
Mom and dad will also see some absorption as deadbeat son or daughter move back home.
Shows like Friends and How I Met Your Mother will go on for another decade.
Note: one can argue that class A+ will not be affected at all which I believe is true. That’s why we are trying to invest right to enter that untouchable status.
I remember when I sat through the same economic presentation at work from 2010-2014. The sentiment at the time was that it was going to be an extremely slow recovery. It makes sense that the length between the 2008 recession and now is very long which is why I mentioned an 11-inning ball game.
This is why I took a set back from some pretty Class A deals because I asked myself the following questions:
1) What will happen to the rents if IT should happen?
2) Is the modeled 90% vacancy rate going to get blown up?
Class B and C apartments in strong submarkets will perform best over the long term. If you ensure the loan term is long enough so you don’t get hurt then you should Outlast the bumpy ride ahead.
Beware of the self-destructive behavior of not investing. You know what I mean… are you someone who self-sabotages?
Understand the micro and proceed if the numbers make sense.
I have to admit Class C and B assets are boring but work especially in a sellers market because 1) they cashflow and 2) have a forced appreciation value add component to give you levers to pull in tough times.
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