The timing of the next recession is still anyone’s guess, yet surveys show that an economic slowdown is at the top of multifamily investors’ concerns for 2020. Although the cut in interest rates may have averted a recession, other factors—as rising construction costs, trade conflicts, slowing growth nationally and worldwide as well as increasing political tensions—point toward an increased uncertainty in the next several quarters.
While the safest plan for times like these is moving ahead with caution, especially since multifamily assets are generally among the least vulnerable in recessions, veterans and newcomers alike can benefit from clearly defined strategies. Susan Tjarksen, managing director at Cushman & Wakefield, and Brad Feldman, senior managing partner with Interra Realty, provide insight into assets that make sound investment during slowdowns, ways to diversify a multifamily portfolio and what to expect this year.
What are the multifamily market’s potentially vulnerable spots right now?
Tjarksen: Providing value-add improvements to properties or units that didn’t get a rent lift big enough to cover the improvements. In addition, overpriced one-bedrooms in Class A are vulnerable in a downturn—you can’t get a roommate in this space to split costs and rent is rarely marked down enough to make it “affordable.” In these cases, studios become a better option for most renters when money gets tight.
Feldman: Generally, the multifamily market remains strong. Interest rates remain low, and rents—after plateauing for a bit in 2017—are still seeing growth. However, there are two major vulnerabilities. First, the competitive nature of the market with high demand/low supply can be concerning if buyers aren’t smart and (don’t) underwrite properly. Second, in our area, the elephant in the room is uncertainty around real estate taxes. Given we have a new assessor (in Cook County, Ill.), Fritz Kaegi, it will be a couple of years before we know for sure the impact that changes will have on the commercial real estate industry across all counties. Despite the uncertainty, we have had another strong year in sales in 2019, and it looks like 2020 seems to be on pace for much of the same.
A popular strategy when facing a downturn is diversifying a portfolio. What does diversification look like today? Which property types would make a good investment in a slowing economy?
Tjarksen: Diversification in a downturn is always a good play. Co-living and micro-units both are fairly recession-proof due to lower chunk rents on a per-bedroom basis than studios or one-bedrooms. Further, these buildings tend to have less amenity space, so operating expenses can be more tightly managed.
Short-term rentals are another way to diversify a multifamily portfolio. The benefits of this strategy are twofold: units are leased faster and at higher rates, and apartments that might otherwise sit vacant in a downturn are more likely to be occupied, at least temporarily. A concept that gained popularity through homesharing platforms like Airbnb and VRBO has given rise to startups that are servicing this fast-growing sector of the market.
These companies lease all or a portion of units in a building through a master lease with ownership— sometimes during the lease-up period—and deliver a more consistent level of service, on par with what guests would experience at nearby hotels. In addition to providing access to physical amenities, these providers may also offer services like food delivery and refrigerator stocking, as well as discounts to local attractions and gyms.
Feldman: For our clients, diversifying by submarket—not having all of your property in a single neighborhood—is key. Our developer clients may recapitalize and deploy the cash in other projects. Multifamily tends to be the top of the food chain in a slowing economy. People always need a place to liv,e whether it’s in an apartment building, condo or single-family home. Retail seems to be the trickiest these days, given the 800-pound gorilla of Amazon, which has affected a lot of mom-and-pop retailers, as evidenced by more retail vacancies and longer lead times in securing tenants. Diversifying should alleviate some risk that is in the market, whether it means leveraging debt more comfortably or underwriting projected rents lower and expenses higher.
What’s the best strategy emerging multifamily investors should adopt in the face of a potential downturn? How can an economic downturn be turned into a benefit?
Tjarksen: The lesson from the last recession was that the first person to make it to market won. Re-sizing rent before your competitors do can help to ensure higher retention rates.
Also, a huge attraction in uncertain economic times is a shorter lease term. This allows the renter to feel more in control and, therefore, likely to renew as they don’t feel “stuck” for longer than they can afford.
Feldman: One strategy for emerging multifamily investors would be being choosier. Underwrite with more cushion. Have projected rents up 1.5 percent rather than what we’ve seen in recent years (2 percent to 3 percent) and also stress expenses at a higher level given the unknown with how taxes are going to play out in years to come.
During the most recent real estate crash, investors found opportunity in others’ mistakes, whether a foreclosed building, a note sale or some level of distress. This go-around, nobody expects things to be as ugly, but corrections in markets do happen and are healthy. Given the plethora of capital that exists, opportunities will remain competitive. And for discerning buyers, opportunities will be especially good because not everyone is immune from overleveraging, underwriting aggressive rents that don’t pan out or going too light on their expense load. It’s safe to say that when the market does turn, there should be some opportunity even if it’s not to the magnitude of the last crash.
What are your predictions for the multifamily market in 2020? What are the main trends and challenges to look out for?
Tjarksen: 2020 is going to continue to be a strong market for multifamily housing. The true winners are going to be the developers that figure out how to provide units for the key workforce in all major urban markets that make between 60 to 100 percent of Area Median Income (AMI). These workers have good credit and critical professions—for example, teachers and nurses—but simply can’t afford to pay 35 to 60 percent of their incomes on housing (Chicago is at 30+ percent while San Francisco and New York City are at 50+ percent).
Some topics to be cognizant of and solve for are a national trend toward rent control, rising real estate taxes to cover municipal deficits, inclusionary zoning requirements for affordable units and the increase in sustainable building code criteria.
Feldman: For 2020, I expect the market to remain very competitive even with a steady stream of new development on the horizon. Buyers will be cautious in making sure their deals underwrite, but cheap debt, high demand, and the continued perceived safety of multifamily investments would seem to have the market positioned for continued growth even if it’s at a slower clip than in years past. Real estate taxes and their uncertainty will continue to be the one aspect to be mindful of. Renters still want to be in buildings that have the bells and whistles, are close to public transportation, entertainment, the lakefront and major thoroughfares. Newer Class A buildings have upped the amenity ante with on-site chefs and coffee shops in addition to providing new “standard” features, such as pools, game rooms, entertainment centers and libraries.