We have all undoubtedly experienced a unique last year and a half or so. With the onset of the COVID-19 pandemic, the economy tumbled into its first recession in over a decade. The subsequent legislation — stimulus packages and eviction moratoriums — has brought about both positive and negative impacts on multifamily real estate investors. Still, we are faced with ambiguity and instability because no one truly knows when the situation will be resolved.
In the midst of this pandemic-induced economic recession, a new president was inaugurated and the balance of power in the House of Representatives and the Senate shifted. This provoked an additional degree of uncertainty.
Will the new administration authorize additional economic stimuli? When will the eviction moratorium end, which was recently extended to June 30th? Will former President Trump’s tax cuts remain in place? Will President Biden’s $2 trillion infrastructure and $1.8 trillion family package pass, and how will it impact taxes if it does? Will the 1031 exchange go away?
These questions and many more are top of mind for multifamily investors. What can you do to protect your investments?
Ultimately, your decisions as to when and how to invest should not be based on who is president, who controls the House or Senate, or which part of the market cycle we are in. Investors have made money investing in multifamily under both a Democrat- and a Republican-led government, as well as during economic expansions and recessions. If you want to set yourself up for success in 2021 and beyond, here are three simple principles you must follow.
There are two major pathways to make money when investing in multifamily real estate: appreciation and cash flow.
Market-driven appreciation is when the value of a multifamily investment “naturally” increases. This is commonly motivated by compressing capitalization rates or increasing rental rates due to rising demand. For example, according to Apartment List’s National Rent Report, rents were up ~3% nationally in 2018 and ~2.1% in 2019. As long as you invested in a market that experienced rent growth equal to or greater than the national average, your investment appreciated in value.
However, due to the COVID-19 pandemic, national rental rates decreased by 1.2% in 2020. In many markets, rental rates fell more than 10%, with San Francisco experiencing a 27% reduction in rents. Therefore, if you invested in a multifamily property in early 2020 and based your analysis on the assumption that rents would continue to grow “naturally”, your investment has almost certainly decreased in value.
In other words, buying for appreciation might be great during an expansion, but because no one can consistently predict if the ball will land on red or black, buying for appreciation is comparable to gambling.
The ideal approach is to buy for cash flow. Cashflow is the profit generated by a multifamily investment after all expenses are paid. Simply put, buying for cash flow means that the investment will generate a monthly profit from day one. The success of the deal is less based on market-driven appreciation and more on how the investment is currently performing.
When you buy based on cash flow, fluctuations in rental rates will still impact the value of your investment. However, since the property is generating a profit from the onset, you have a built-in buffer. At the minimum, you can cover your expenses and not be forced to sell.
Because the value of an investment is always subject to fluctuations in the market, you must also secure long-term debt.
Imagine your business plan is to perform upgrades on 100% of your units over a 24-month period with a goal of increased revenue. You secure a three-year bridge loan with the intention to refinance into a conventional mortgage once the renovations are completed. If everything goes according to plan, that’s great. Now, imagine, if you will, a global pandemic breaks out during year two and you are unable to achieve your desired rent increase? Once the bridge loan’s term ends you will likely need to bring cash to the table for closing costs. What’s worse is that you may not be able to secure a refinance at all. Now, you’re facing foreclosure.
To avoid these scenarios, it is recommended to always secure debt for a term that is at least twice the length of the business plan. In other words, if you expect renovations to take 24-months, secure debt with a loan term that is at least four years long. This, like buying for cash flow, will provide an extra safety net.
The final principle is to create a sufficient reserve budget. Currently, conventional lenders are requiring higher reserve budgets. On some loan products, this could mean upwards of 18 months of principal and interest. Keep in mind, requirements of this amount are in response to the COVID-19 pandemic.
Even when lenders are not requiring large cash reserves, you must voluntarily elect to place funds in an account as a safeguard. This will protect you against fluctuations in the market and cover other unexpected events over the course of the business plan’s execution. This includes an upfront fund at closing and a portion of the revenue each month.
A cash reserve is the final safeguard in the event of a major recession and negative cash flow. It will allow you to cover the debt service and expenses and avoid a situation where you’ll be forced to sell.
I have faithfully adhered to these tenets since I began raising capital in 2015 to buy multifamily real estate in the form of apartment communities. By practicing these principles, my company was able to add just under $300M in assets in 2020, despite the pandemic. This past year has increased our portfolio to over $1B in assets under our management.
Regardless of how long the pandemic lasts or the legislation passed by the government, if you stick to these three principles – buy for cash flow, secure long-term debt, and set aside adequate cash reserves – your portfolio will not only survive but thrive throughout your real estate investing career.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.