Flexible structures are the best defense as the industry and the economy enter a second decade of expansion, according to The Habitat Co.’s Bryan Sullivan.
By Bryan Sullivan (MultiHousingNews.com Article) — As of July 4, the United States is in the midst of the longest economic expansion ever. Gross domestic product has been growing for 121 straight months, breaking the record of 120 months of economic growth set between March 1991 and March 2001. Our current cycle began in June 2009, and while it’s impossible to know exactly how it will play out, it shouldn’t shock anyone if our industry or the macro economy faces certain headwinds over the next few years.
The good news, at least for the multifamily sector, is that household formation, a key driver of housing demand, remains strong and vacancy rates are still trending below historical levels. According to the National Multifamily Housing Council, 4.6 million apartments are needed at a variety of price points by 2030 to meet demand.
But, how do we prepare for a potential hiccup along the way? Without knowing exactly how the multifamily winds will change, the best advice is to create structures that provide optionality to address unforeseen forces that could impact strategy and execution.
Revert to historical norms
While many markets have experienced (and in some cases are still experiencing) staggering rent growth, underwriting for new acquisitions and developments can’t be predicated on unsustainable metrics. Underwriting should rely on historical norms for rent growth and other variable projections to help create a responsible baseline.
Although it is unlikely that a market disruption would approach the severity of the great recession, at this stage in the cycle, it is still critical to understand the downside risks to assure an investment can withstand unanticipated pressures and allow for the proper upfront structuring options needed to provide future flexibility.
Know your tenants
Over the last 10 years, we have seen significant narrowing of income-to-rent ratios. Long overdue wage growth, really just seen over the past 12–18 months, has not kept up with the 3-plus percent year-over-year rent increases. As most strategies—even those for workforce housing—include new rent premiums, it is important to understand how susceptible your tenancy is to macroeconomic challenges.
While most investments will still target a traditional three- to five-year hold period, having options to extend the investment life and avoid selling into a challenging marketplace, can make the difference between positive returns and dipping back into your wallet. Consider the following:
If equity partners are governed by a fund life, do they have discretionary extension options?
Can you lock in longer term debt, even if it has a cost, that provides different prepayment options to avoid shopping for a refinance when banks go back into a defensive stance?
Can a property sustain itself with in-place cash flow if conditions don’t provide for projected value-add execution?
Even as investors struggle with current valuations, the real test is residual pricing. Based upon projected value-add execution and organic market rent growth, the resulting top line revenue growth and corresponding increased net operating income—even when applied to conservative cap rates—can generate residual pricing that nears or exceeds replacement cost.
Multifamily investors and developers have experienced success in primary, secondary and tertiary markets alike. But, when faced with challenging market conditions, are all marketplaces equal? We are proactively targeting certain markets, like Minneapolis and Tampa/Orlando, because we respect the in-place fundamentals that we believe will mitigate against future headwinds. Characteristics we look for include positive long-term demographic trends, sustainable job growth, population growth and strong absorption of new supply delivery. Minneapolis has shown remarkable occupancy resiliency in light of significant new supply, and Tampa/Orlando has continued to maintain a Top 5 national standing for job and population growth.
Are you being paid properly for risk?
Are you getting proper risk-adjusted returns? Due to the amount of capital chasing value-add opportunities, return yields have been compressed. It is difficult to justify taking on value-add risk, with only a few hundred basis points of premium, vs. core-plus opportunities, which have far less repositioning risk.
Sound opportunities still exist in today’s market, but success is much more reliant on well-seasoned operators and foresight into expecting the unexpected.
Bryan Sullivan is senior vice president of investments for The Habitat Co., a full-service residential real estate company in Chicago.