When talking with passive investors and sponsors I hear a lot of misconceptions about how the current pandemic is affecting different property asset classes. Many investors compare today’s economic downturn with the great recession of 2008, but the two are not alike because the reasons for the problems were different, and the impact on people is different as well.
There are 3 misconceptions that I keep hearing over and over, and those are the ones that I would like to share with you. As you’ll see, they have a major impact on the different property asset classes that investors and sponsors like to purchase.
For those who are not familiar with the different property asset classes, here’s a quick refresher. Class A properties are high-end, mostly newly built buildings in the best neighborhoods, located in the best areas of town. They are generally either newly built or up to 5 -o-10-years old and usually have no deferred maintenance.
Class B properties are a bit older than Class A, but they still have good amenities and were generally built in the 80’s and 90’s. Usually, these properties have low to medium-low deferred maintenance.
Class C properties are older than those in Class B, and were built in the 50’s and 60’s. They often have a lot of deferred maintenance and usually have lower rents because they attract tenants that aren’t that financially strong.
Class D properties are older, similar to Class C properties, but the property has been neglected and need significant repairs. Tenants in these properties are usually looking for cheap rents and finding good tenants can be difficult.
The asset classes that performed well during the “great recession” are the ones you want to invest in now.
During the great recession, a lot of homeowners lost their homes. Many of those homeowners purchased their homes without having the necessary resources, income, and down payment, and ended up losing their homes. But people still (and will always) need a place to live. Those homeowners couldn’t afford to rent in Class A multifamily properties, and for many, Class B was expensive as well.
So, how did this impact the market during the great recession? The asset class that was in high demand post the 2008 recession was Class C properties. Many investors purchased Class C properties during that time, thinking that if another recession were to occur, they would have the ideal property to rent. After all, it was the most resilient asset class during the great recession. However, the current pandemic changed that, as the those who lost their jobs and fueled the 13% unemployment were mostly service workers with low paying jobs – the classic Class C and D property tenants.
Unfortunately, it meant that many of those tenants couldn’t afford Class C properties and could only look to rent Class D properties. Class D properties became the leader in rental demand during the pandemic, not the Class C properties that investors had thought would take the lead. While Class D properties are in great demand, they do have many challenges with rent collections and more deferred maintenance.
Sadly, for many investors, Class C properties didn’t turn out to be the “winning asset class” that they thought they would be. This shows me you can learn new things from each recession, and that you simply can’t replicate the same thinking and strategy each time, as it might not protect you during the next downturn.
Deals today should have high returns because you’re buying in a down market.
During the great recession of 2008, the market was down, and real estate investors who were able to purchase properties at the right time in the right market were able to generate high returns. While we’re now seeing a down market due to the COVID-19 pandemic, conservative investors and sponsors like myself should actually expect lower returns, not higher.
When purchasing a property, the property value is based on Net Operating Income (income minus expenses) divided by the cap rate. When it comes to estimating the IRR, the resell price has a major impact on the profits. So, if you estimate a very high exit price, you will see a high IRR and cash-on-cash.
The higher the cap rate, the lower the price, and to be on the safe side, we always assume a higher cap rate when we sell the property, because we are assuming that the market will be worse than it is now. If you assume there will be a higher exit cap when you sell your property than the current cap rate, your returns will be lower, and it’s always better to assume worse market conditions and lower returns. If you got it wrong and you were able to sell the property at a much higher price, then your returns will be higher, but assuming the worst means lower returns, and a much more conservative approach.
Rent growth is another reason that returns may be lower. Before the pandemic, we would assume that there would be rent growth of 3% to 4% each year. Now, we’re assuming rent growth of 0% to 1%, especially during the first year of operations. It’s due to the uncertainty of rent collections, occupancy rates, and fluctuating employment numbers because of COVID-19. Nobody really knows what rent growth will be, so it’s best to estimate low.
Another reason returns may be lower since the pandemic is that renovations are being done slower and premiums might be lower than expected. Our business model is to purchase properties and do value-add renovations in order to increase rents. Though we haven’t stopped renovating during COVID, we have adjusted our model to Renovations on Demand. When a new prospective tenant shows up to see some available units, we show them a classic (non-renovated) unit and a renovated unit and let them choose which one they want to rent. The choice is theirs, and surprisingly, over the past three months, over 70% of new tenants chose the renovated unit.
However, this slower renovation pace does certainly impact the returns, which are lower. Prior to COVID-19 we assumed that we would be able to rent every available unit, which might amount to ten to twelve per month. Post-pandemic, this is being done at a much slower pace, which ultimately impacts returns.
Lastly, we underwrite a higher delinquency and vacancy, just to be on the safe side. Taking all these factors into consideration, it’s easy to see why, at least on paper, returns should be lower.
It’s risky to invest in real estate now.
Realistically speaking, there were bad deals before COVID-19, and there were good deals as well. There are bad deals now, as there are good deals. It might be slightly riskier now due to some uncertainties, like employment, occupancy rates, and lower rent increases, but most can be mitigated.
To better understand how risky an investment is, you can look at the break-even point of the property. So, for example, if the break-even point is 60% occupancy, that means that if 40% of your tenants are leaving or not paying rent, only then are you breaking even. And remember, that’s just breaking even – it’s not losing any money. That’s a very extreme scenario, even during the pandemic, considering that current occupancy rates are 92% to 95%.
While there is some risk investing during a pandemic, if you assume it’s too risky to invest in multifamily real estate now, you’ll be missing out on some potentially profitable deals. Each market is different, and tenants are different in different areas as well. You have to do your research; a good starting point is www.citydata.com. You can find employment figures, comparable rents, crime statistics and so much more. By doing your due diligence on specific areas, you’ll have a better idea of which markets are considered a strong real estate market.
There are many misconceptions about investing in multifamily real estate during the pandemic, but I’ve highlighted the top 3 for you to consider. These are the ones many colleagues and investors are talking about. They include the misconception that asset classes that performed well during the great recession would perform well now. Actually, the Class C asset class that performed well during 2008 is not where you want to invest now; you should be looking at Class B properties instead. The second misconception is that you should expect high returns during the pandemic because you’re buying in a down market. On the contrary, you should expect lower returns now than during the great recession. The last misconception is that it’s riskier to invest during a pandemic, but in actuality there were bad deals prior to COVID-19, and there were also good deals. There are good and bad deals now as well, and by not investing due to fear of risk, you’ll be missing out on potentially good investment opportunities. Do your due diligence and research the markets you’re considering before you invest. Every market is different!
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
Ellie is the host of REady2Scale , a podcast that focuses on the "APS" of real estate: Asset, Process, and Strategy. Each episode discusses how investors can scale their real estate portfolio and/or businesses.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.