In any shifting market cycle, there are winners and losers. How can you be a winner? Can it be as easy as buy low, sell high? In a word, yes. But to buy good assets at an opportune time requires knowing what to buy, who to partner with, and when.
There are a number of market factors lining up to provide the types of buying opportunities we have not seen since 2009. Current capital markets disruption and the rapid rise of interest rates on the heels of a prolonged period of cap rate compression and strong asset valuations is putting a large number of owners in a position to need to potentially sell assets.
We are likely going to see high-quality assets trading not because of issues inherent with the underlying real estate, but because of the current lack of liquidity and near-term cost of debt. Owners that purchased assets over the past few years with variable-rate debt have seen their interest rates triple, a calculation they did not factor into their purchase price, debt-service reserves or operating cash flow. In addition, those owners with expiring debt or expiring bank-required interest rate caps may find it too difficult or too costly to refinance. As a result, undercapitalized operators or those without sufficient skin in the game are going to be motivated to sell or walk away from assets.
These near-term trades are likely to be repriced for the current distressed capital markets landscape. Many of the assets that trade during this temporary dislocation are poised to do so at a significant discount to both purchase prices we have seen over the past few years and replacement cost. We believe this buying window caused by capital market disruption will be relatively short term, and investors poised to capitalize on it will likely see outsized risk-adjusted returns.
Multifamily continues to be a bright spot of commercial real estate. It historically has been the strongest performing and most consistent real estate property type across cycles. Multifamily is an inflation hedge with the ability to adjust quickly to changing market conditions, as asking rents can be adjusted weekly and leases are typically annual. This ability to constantly reset rents allows the asset to stay in lockstep with the changing market and keep pace with the current rate of inflation. Multifamily also provides attractive tax advantages because land and property improvements are depreciable, offsetting otherwise taxable property income during the asset hold period.
Unlike office and certain retail, multifamily has remained strong throughout the pandemic and the current inflationary surge. Some of the best opportunities are likely to come in multifamily in gateway markets with strong underlying fundamentals. Those in supply-constrained markets, such as the western United States, are particularly well positioned for continued rent growth, unlike some low-barrier-to-entry markets (like the Sun Belt) that are delivering a high amount of near-term supply and will need time to absorb. Occupancy rates across these major metros remain high and rents remain strong, leading to the ability to acquire well-performing assets at attractive prices.
LEVERAGING INVESTING POWER
Now is a particularly good time for family offices and high-net-worth investors to look at commercial real estate opportunities and, in particular, multifamily. Not only do people believe we are likely to see attractive near-term buying opportunities, many investors typically active in multifamily are currently sitting on the sidelines. Many institutions are facing allocation issues or lack of liquidity because of investments elsewhere in their portfolios.
Open-ended fund managers are grappling with redemption requests, forcing them to act more defensively rather than having time to focus on buying opportunities. Pension funds (both domestic and international) are limited by allocation issues and lack of liquidity. Savvy and more nimble investors are going to be able to take advantage of near-term opportunities with less institutional investor competition because they can act faster, allowing them to respond to changing market dynamics more quickly.
With capital scarcer in the market than any time in the past decade, those looking to invest can command a premium for their dollars. Investors can be more discerning about their opportunities and get greater access to institutional-level operators than ever before.
WHO TO PARTNER WITH
Investors should look to partner with proven, cycle-tested operators. Spend time running operators through a due diligence process to ensure they have a track record that demonstrates their agility to respond to changing market dynamics and the ability to move quickly enough to take advantage of opportunities in a rapidly changing investing environment. Many operators were successful over the past 10 years, a “rising tide lifts all boats” phenomenon. So, successful performance over the past 10 years is not enough. Investors should require experience and demonstrated capabilities during prior recessionary and recovery periods in addition to strong performance over the past decade.
It is also important to make sure operators are properly aligned with investor interests and have sufficient skin in the game. Pick more simple structures with clear transparency into the economics and sufficient downside protection.
The winning investors will commit to managers who have the skill and expertise to source opportunities, apply an appropriate risk/reward analysis and successfully execute on the business plan to add value. Bold and agile investors who partner with the right sponsors are poised to reap the benefits of this current capital markets disruption.
Sean Burton is CEO and Jennifer Halvas is managing director of investor relations at Cityview, a Los Angeles-based real estate investment management and development firm focused on multifamily housing.