When the COVID outbreak first began in March of 2020, the fear was minimal. As time progressed and the reality of the dangers from the pandemic evolved, countless things began to change in the country in ways that most people couldn’t possibly imagine. Real estate was no exception, and while many of the dire predictions never came to pass, every facet of all types of real estate classes felt COVID’S impact.
Now that the pandemic is better understood and there is finally light at the end of the tunnel thanks to the development of vaccines, some of the major impacts on real estate have stabilized. However, the real estate market is still pivoting in response to COVID, which has changed everything from the way deals are funded, to how investors are investing their money, to the type of markets investors are now looking at, and to adjustments they’re making for income expectations. It has to do with the uncertainty in the market, and everyone is wondering what to expect in 2021.
Just as the virus is evolving with variants, the response in the real estate market is fluid and the market is continuously pivoting. I have noticed 3 distinctive changes that I’ll share with you and look at some of the main ways that this is happening. Hopefully, you’ll have a better understanding of what to expect during COVID.
Change #1: Some Investors are Diversifying and Adding Debt to Their Portfolio
Prior to the COVID outbreak, real estate investors were interested in equity. They were purchasing single-family homes and small multifamily properties as investments, and sponsors were purchasing large multifamily properties in major markets. Now, due to the uncertainty in the market due to COVID, through equity is still a very strong investment strategy, some investors who were not interested in debt, are shifting and diversifying their portfolio to include debt.
One of the ways of using debt to invest in multifamily real estate is through a debt fund. A real estate debt fund is private-equity capital that lends money to real estate buyers. They’re either lending directly with sponsors or putting funds into a deal.
Investing in debt can come in several ways: one very popular way is to invest with a sponsor who places the capital as debt for other real estate deals. Debt funds lend money to real estate investors. It could be a bridge loan or a long-term loan, for any type of real estate. As a passive investor, the fund you invest in will take a first position. Meaning that if the borrower defaults on his loan, the fund is first in line to seize the property as a collateral, sell it, and pay the debt before other creditors.
Another way debt funds are adding debt is by buying agency debt directly from agencies like Freddie Mac or Fannie Mae. They are basically buying the bonds, so the returns may be lower than owning the property on the equity side, but the risk is lower than owning the property on the equity side.
Preferred equity funds are another way of putting debt into real estate deals. Preferred equity offers an investor a less risky equity position than common equity. This enables sponsors to increase their leverage by financing a project beyond the mortgage. The preferred equity is considered a higher priority to the equity the sponsor has in the project. Preferred funds operate like a secondary debt, but they are technically equity holders in the deal, even though they are normally paid a fixed rate.
Sponsors are also now offering two different classes of investors. For example, they have a Class A investor that receives a 9% cash-on-cash return and are paid first, but they won’t participate in the sale of the property. Class B investors receive only 7% cash-on-cash, but they will participate in the sale of the property after the hold period, which is usually from 3 to 5 years.
To benefit in both ways, some investors are splitting their investment. For example, they’ll participate by investing 75% of their funds as a Class A investor, which is similar to a debt investment, as this class only gets a fixed return (normally 9%) and no participation of the property sale at the end of the hold period, and 25% of their funds as a Class B investor, which is a standard equity class. By doing this, they receive a higher cash-on-cash during the life of the deal, as well as some participation in the sale of the property at the end.
Change #2: Moving to Secondary Markets
Pre-COVID, most investors looked to invest in primary markets like New York, Chicago, Los Angeles, and San Francisco among others. With COVID causing economic hardships and unemployment people began moving to secondary markets like Austin, Phoenix, Atlanta, and Dallas. Investors and sponsors followed suit.
The secondary, and tertiary markets offered a better climate and were more affordable. Small and large tech firms alike began moving to these secondary markets and began bringing the demand for multifamily properties with them. Tenants began to see how much more they could get for their money in these markets compared to the high rents of New York and California.
For example, a studio apartment in New York City could cost as much as $3500 per month. For a lot less, a person could lease a well-appointed 2-bedroom apartment in one of the secondary markets. That accounted for the major influx of people to Austin and Miami. Also, California tenants were moving to Arizona and Texas where their money would go much further. This was not only in terms of lower rents, but lower taxes as well.
Another force driving demand for multifamily properties was the fact that many of the tech firm’s employees didn’t necessarily want to purchase a home. Many Generation Z people tend to be willing to move for better employment opportunities, generally every 18 months. It’s much harder to move around when you have a home to sell.
Thanks to the demand, rents began to increase as well. As an example, we were able to increase rents in one of our Atlanta properties by 40%. The trend of moving away from high-rent primary markets started before COVID came on the scene, but the pandemic has accelerated this trend, which continues today.
Change #3: Adjusting Investors’ Expectations
With the uncertainty in the economy, and the real estate market in particular, investors began to adjust their income expectations. Until the pandemic is significantly curtailed, I don’t expect multifamily investments to provide the same returns we saw as recently as 2 years ago. It’s simply a function of the market.
Currently, investors are happy with a 6% to 7% cash-on-cash return, and a 13% to 14% IRR (Internal Rate of Return). While the returns are lower than they were a few years ago, the 6% - 7% cash-on-cash returns are still better than other types of real estate assets, like office and retail. You have to remember that the higher the IRR, the riskier the investment.
By adjusting their expectations to accepting a lower cash-on-cash and IRR, investors are still able to participate in multifamily syndications. They realize that things are not the same as they were pre-COVID, and as long as the uncertainty continues, lower returns are simply a fact of life for investors.
COVID has brought a myriad of changes to the country in general and to multifamily real estate in particular. There are 3 distinct changes that I’ve seen which are causing the real estate market to pivot.
First, investors are shifting more to debt. This debt is used to leverage a real estate investment. A debt fund is one way this is being used, where a portion of the required down payment is made up of debt. Another way is by buying agency debt directly from Freddie Mac and Fannie Mae. Debt funds are purchasing the bonds, so the return is lower, but the risk is lower as well.
Sponsors are also offering two classes of investors: Class A that earns a 9% cash-on-cash return but doesn’t participate when the building is sold, and Class B, which earns a 7% cash-on-cash return, but investors in this class are able to participate when the building is sold.
Another change is that companies and tenants are moving to secondary markets, like Austin, Dallas, and Phoenix, and sponsors followed. This is creating a demand in these markets for multifamily properties, which has helped us raise rents despite a pandemic raging.
The third change I’ve seen is that investors are willing to adjust their expectations due to the uncertainty that COVID has caused in the real estate market. This willingness to accept a lower cash-on-cash and IRR (Internal Rate of Return) enables them to continue to participate in multifamily investments. When the uncertainty due to COVID abates, returns should go back to pre-pandemic levels.
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About the Author
Ellie is the founder of Blue Lake Capital, a commercial real estate investment firm specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institution