The 2022 National Multifamily Housing Conference (NMHC) was recently held in Orlando, Florida. Roughly 7,000 people give or take attended. This event attracts the top Multifamily real estate investors and brokers across the country. If you did not listen to the latest Old Capital podcast, check it out here: Episode 258. Paul, Michael, and James go over what they learned at the event and talk about what is going on in the market.
One of the big takeaways I got is that there is going to be more money this year chasing less deals. Everyone is bullish on Multifamily. Multifamily owners have enjoyed a great ride of market appreciation. The stakes are getting higher as the market continues to go up significantly. The agency lenders Fannie Mae and Freddie Mac are averaging around 50% leverage in hot markets. This is prompting buyers to go further out on the risk spectrum and use Bridge Loans to get more leverage.
It is important to understand the risks when investing in real estate. Less leverage is less risk and conversely more leverage is more risk. Here is a rundown of the real estate risk spectrum from the textbook Real Estate Finance and Investments: Risk and Opportunities.
Core Real Estate
This investing strategy is on the lower end of the risk spectrum. It involves the acquisition of a well-occupied, stable cash-flowing apartment building. The target Internal Rate of Return (IRR) is 7% to 9% and the leverage is 0% to 30%.
This type of investment does well in a downturn. The tenant base is stable and diverse. The building is typically newer and needs less maintenance. The property will not go under water with that low of leverage. The holding period is often longer than a value-add deal. 10 years versus 3 to 5 years.
A core real estate play could be a considered a safe yield play for institutional investors looking to protect large amounts of capital. It is akin to fixed income whereby the yield is like bonds. One reason more money is chasing fewer apartment deals might be because bonds are becoming less reliable for fixed income. They also get eaten up by inflation. Core real estate will still get a reliable return and rise with inflation. Expect more institutional capital to seek this solution.
Core Plus
This strategy requires the acquisition of a core-type property that needs some relatively minor enhancement; submarket can be secondary. It is a similar strategy to core real estate. The building will likely still be in the Class A range with maybe a little more leverage. The leverage target for this type of investment is greater than 30% but less than 60%.
A lot of deals that I currently underwrite in the DFW market fall into this core plus strategy if the General Partners decide to pursue agency debt. However, Class C deals can be excluded from Core Plus because the tenant base is not as reliable, and the property requires a lot of maintenance.
Class C and Class A are trading at similar cap rates and leverage so there is a lot of competition for newer assets. Someone new to the Multifamily space will likely not be able to win an A Class deal so they might have to pursue a value-add strategy and go after a smaller Class C deal.
Value-Add
Value-add requires a significant value enhancement needed through operating, releasing, or redevelopment. This is a popular strategy among Multifamily syndicators who want to hold for 3 to 5 years.
The target IRR is 12% to 16% and the leverage is typically greater than 60% but less than or equal to 70%. As I mentioned previously, the deals currently coming to market do not qualify for leverage a value-add requires. It is becoming increasingly popular for Syndicators to secure a non-recourse bridge loan to get higher leverage.
The lender will require experienced borrowers and look at the story of the deal. They will typically see what the Debt Yield (DY) is going in. Debt Yield is Net Operating Income (NOI) divided by the total debt. Example: NOI is $200,000 and the loan amount is $4,000,000. DY = $200,000/$4,000,000 = 0.05 = 5%. A lender will usually have a minimum requirement of 4.5% and want to see the DY come up to 7% by the end of year 3. The bridge loans terms are 3 years with two 1-year extensions. Most lenders will require the DY to be at 7% or higher to extend. Exceptions can be made based on the strength of the borrower and business plan.
Investing in a value-add deal requires a closer look when using that much leverage with a short timeline. Vetting the experience of the borrower and business plan is essential.
Opportunistic
Some of the value-add strategies border on the line of opportunistic. This strategy requires re-positioning of an ailing property, ground up development, emerging market investments, and buying entire companies with owned operating assets.
The target IRR is over 16% and the leverage is greater than 70%. An opportunistic real estate play is riskier, but you know the saying: more risk, more reward. I think it personally comes down to the individual’s risk tolerance. If you are young and you have a long-time horizon then more risk is fine. If you are older and trying to rely on a fixed income, then investing or acquiring Core Real Estate is safer.
Opportunistic deals might require heavy capital up front and will not cash flow as well as some other strategies. However, as the business plan develops or the property gets ready to sell, there could be a bigger return.
Conclusion
There is an overview of the main real estate investment categories. It covers the risk spectrum from least risk to most risk. There can be variations to the strategies. Some investors can do Core deals with more than 30% leverage and some value-add deals might use less leverage.
Do your homework when investing and understand the risk that you are taking. Some Multifamily operators can get themselves in quite the predicament if the market shifts when leverage is high and timelines are short.
