Risks of Multifamily Investing
There has been a lot that talks about benefits of multifamily investing: economy of scale, cash flow, low risk, diversification, tax benefits, high returns etc. I have covered it here in my article back in April, 2023.
Not much has been talked about when it comes to analyzing risks, although numerous news articles came out saying multifamily real estate is in trouble: Houston Apartment Owner Loses 3,200 Units to Foreclosure as Multifamily Feels the Heat (April, 2023), 2 more Houston properties in financial trouble (Oct, 2023), Texas syndicator Elevate drives another Arbor foreclosure (Jan, 2024).
What caused these properties to default? And what are the risks of multifamily investing? Let’s analyze the fundamentals of value-add multifamily investment strategies first:
The value of a multifamily property = NOI / cap rate
where Net Operating Income (NOI) = Income – Expenses
WORST SCENARIO - DEFAULT
So, what could go wrong here? The worst scenario is when cash flow is negative, where income is less than expenses. This is where the property usually goes under or in technical terms, defaults. In this case, you usually have less unexpected income or more unexpected expenses.
What can cause less income?
Number 1 cause is operational risk. When it comes to value-add multifamily investment, we buy distressed or mismanaged properties, renovate it, replace bad tenants with good ones, hoping to raise rents and bump up the property value. Well, things can go wrong during the process when operators / syndicators ultimately won’t be able to bring high quality tenants in who pay the expected rents.
From what I know, the Houston apartment that defaulted in April 2023 which made national headlines was mismanaged. They have tenants in the apartment doing sex businesses and their occupancy rate was low, roughly 60% or so. Additionally, they have some debt issues as explained in the “more expenses” section below.
Another frequently mentioned cause for less income is market risk. Rents have undergone 11% increase annually during the pandemic; and now in 2024 it clearly slowed down, and in quite a few places, rent growth dipped into the negatives. Competition is also posing a threat when an area is over-built, and rents can either stay flat or dip.
Legal and regulatory risk is less mentioned. In reality, it rarely causes problems for value-add multifamily investment strategy, although it may be a big red flag for new development projects. One true story that I heard from an operator was that, for one apartment property they own, during the 2022-2023 pandemic, some tenants were no longer paying rents and the operator tried to evict the tenants. But the local judge was ruling in favor of the tenants, making the eviction work difficult. And the operator lost money on this deal.
What can cause more expenses?
Debt and financing risk is definitely the number 1 risk. Think about it, during 2021-2022, the interest rate is roughly 3%, now, the interest can be as high as 8%. Assume you bought the property using floating rate in 2021 without protection (rate cap), now in 2024, you will need to pay at least twice the debt amount compared to 2021. Even if your income may rise 20%, you might still get negative cash flow. Assume you bought rate cap back in 2021, and it expires in 2024, you would still have to pay a very high premium to buy additional rate cap extensions to avoid high debt. Where is the high premium from? Well, operators will need to do capital calls to investors to raise more money, which is what you see happening now everywhere.
Expense hikes may lead to higher costs. For example, a roof replacement may call for more capital to cover the repairs. These hikes may be well covered if we forecast a conversative capital reserve. Another highly discussed topic is the recent large increase for insurance premiums and property tax. But personally, I never worry about these two expenses. It’s a system change, and it applies to all properties in a given location. Eventually the cost increase will be reflected in the rent increase.
In sum, Operational Risk and Debt & Financing Risk are the main reasons for the property to default.
If we review the risks being discussed above, I’d personally contribute Operational Risk and Debt & Financing Risk to be the main reasons for a multifamily property to default. And if we have an experienced syndicator who would be able to manage properties efficiently and forecast the market properly, and a deal that we could minimize the debt & financing risk, the likelihood of default is slim.
BAD SCENARIO – UNDER THE WATER
Well, most properties that were bought during 2021 and 2022 are not in a default state. Rather, they are just under the water, meaning that their purchase price is more than the selling price if they were to sell now.
Again, let’s review our valuation formula: property value = NOI / cap rate. You might have a slightly higher NOI now, but if the cap rate changed from 4% to 6% (take Dallas Market for example), your property value still decreases 20% or more.
That’s why we are seeing an inventory of just 20% now of what it was back in 2021/2022. No one wants to sell to take a loss. Most properties on the market are from either not-so-serious sellers or have-to-sell type of sellers.
But what would happen to these under-the-water properties? Well, we will have to wait until the market bounced back. Investors may need to wait longer, and the returns may not be as good as the pro forma suggested at the sale in the future.
So, should we be scared?
“Be fearful when others are greedy and to be greedy only when others are fearful.” - Warren Buffett.
I ask myself the few questions:
Are these housing needed? Are there more people moving in and living in the area?
Will the interest rate (and cap rate) drop?
Is it a good buy when deals drop 20% of its value? Or do you expect them to drop more?
How to minimize the risks by stringently vetting the operator and the deal?
I have my answers and I’m bullish to buy now in 2024. And I don’t think I’m alone. It is well reported that BlackRock has put aside billions to buy commercial properties this year.
How about you? Please reach out and I’d love to discuss with you.
