We live in unprecedented times, with unique and continually shifting market conditions. Given the environment, many investors have been asking me questions such as “do great investments exist right now?” and “what does a good investment look like in the current environment?”.
I find the best approach to answering these types of questions is to bring things back to the basics…
In our experience with multifamily investments there are really three components to a great investment in the current stage of the market cycle – the quality of the asset and the story behind the business plan, an intelligent capital and debt structure, and operational excellence.
Quality of the asset and the story behind the business plan
In order to properly assess the viability of an investment, you need to first look at the story, and ask yourself “does the narrative make sense?”. There are a number of areas within the story that need to be assessed.
Before I do too much digging into the specific asset, I like to start with the quality of the market. This alone can save a lot of time, as there is no sense investing in a property that is located in a poor or declining market. First, I look for population growth, then jobs, and job diversity. The quality of these jobs is important. You want jobs that are in recession resistant industries and in larger, established companies.
Next, I look at median income to median rent ratios. In the midst of historic inflation, rent to income levels are very important – especially if your business plan relies on rent growth. You can only increase rents up to the point of affordability. Pushing rents beyond 33% of the income base of tenants will only lead to economic stress for those tenants and ultimately this will lead to stress in the business plan, in the form of bad debt.
When looking at the underlying asset I like to assess the risk by looking at the quality of the asset. I analyze the various risk factors for the asset such as the age of the property, the unit mix, the number of units, amenities the property has to offer and so on. I assign a score to each one of these categories and establish a risk profile ranking for the asset. Then, based on the scoring of this risk profile I look at the property’s potential competitive advantages relative to the comp set.
Ultimately, you want the ability to capitalize on the property’s competitive advantages in a cost-effective way. If the goal of the business plan is to increase the value of the property, you need to find a way to bring value to the residents, and the market. And this will work best when the asset has specific competitive advantages within the market, and when the market has strong fundamentals that will help to push the business plan along.
An intelligent capital and debt structure
This year has been an emotional rollercoaster for the capital markets, and the extreme shift from historically low interest rates to now rapidly rising interest rates has shown investors how sensitive real estate is to the cost of capital.
But more than just the cost of capital, real estate is also sensitive to the terms of that capital.
Many investors are learning the hard way the risks that come with variable rate, short term debt. Not only are these investors facing higher debt service costs today, but their ability to refinance into fixed rate debt in the next 12-24 months is becoming more and more of a challenge.
In a time where market volatility has presented investors with an ever-growing number of variables to manage, it is much simpler to simply remove one of these variables, by securing long term, fixed rate debt when purchasing an asset in today’s environment.
One of the hallmarks of real estate investing is the ability to wait out a recession and receive monthly cashflow while you wait for the market to recover. Long term, fixed rate debt provides you with the flexibility to wait out any downturn, whereas short term, variable rate debt simply does not.
We also need to think ahead to the exit. Prepayment penalties tend to be a feature of fixed rate debt. So, structuring the debt with the correct term and potentially negotiating more favorable prepayment penalties in return for a higher interest rate will often provide a better outcome for investors in the long term.
Operational excellence will be the difference
In the last couple of years, many poor business plans and average operators have been saved by a rising market. They say that a rising tide lifts all boats, and while this has absolutely been evident in good times, the rising tide is not something that we can rely on as we head into more uncertain economic times.
Given the current environment, you want a sponsor who can navigate these turbulent market waters and ensure that the investment makes it through the storm to see clearer skies.
The difference between solid returns and minimal returns in the next few years is going to be defined by the skill of the operator and their success in executing a well-formed business plan.
To ensure that you are investing with the right operator, it is important that you focus on the sponsor’s experience and how they run operations. You want them to present a compelling business case for the investment and focus on executing on their business plan year after year. This involves measuring performance against targets, pivoting where it makes sense and all the while communicating to investors what they are doing and why.
You want to be comfortable investing with the sponsor and know that the sponsor has a focus on operational excellence and a solid track record.
Opportunities exist in any stage of the market cycle
As an investor, I want to be continuously planting seeds and watching those seeds grow over time. This is how wealth is made. While I have never been a believer in trying to time the market, I absolutely do believe that it is important to adjust and be tactical in your approach depending on conditions at any point in time.
Ultimately, what this boils down to is focusing on the fundamentals – great markets, solid assets, intelligent use of leverage and an unwavering commitment to operational excellence. By following this approach, we are confident that we will find great investment opportunities in any stage of the market, be able to manage them through good times and bad, and ultimately provide investors with great outcomes on their investments.