Last spring, the capital markets almost universally contracted in response to the COVID-19 pandemic. Since then, a few intrepid investors have deployed capital. In both cases—the sudden down market and the beginnings of recovery—performance has been uneven across markets, submarkets and even block to block.
While there have been attempts to correlate what’s happening now with what happened in 2008-09, they are two wildly different scenarios, according to David Ferrero, executive vice president – capital markets at The Laramar Group. Following the Great Recession, investors were worried about putting their money back into play too early and “catching the falling knife” of an economy that hasn’t yet begun to bounce back.
“Applying that analogy to today, instead of thinking of it as a single falling knife, think of yourself standing at the bottom of a set of stairs and somebody drops 10 or 20 or 30 knives,” Ferrero said. “They’re going to hit different stairs and bounce in different directions. Some may go harmlessly by you and one or two could hit you in the jugular.”
Predicting when—or where, or in which sector—the markets will recover is tricky, given how uneven performance has been since the start of the pandemic. This is particularly true when it comes to buying distressed multifamily assets.
Operational stress, financial stress
There is a delay between operational and financial stress within the multifamily asset class. Rising vacancies, falling rents, increased concessions are all examples of the former. These precede the latter, when owners face the prospect of breaking their loan covenants. Finding that inflection point between operational and financial stress is, in theory, the key to knowing when to scoop up a distressed asset. There is a catch, however.
“There’s a further lag between the time when that proper level of financial distress hits and it gets fully priced into the market,” said Ferrero. “You see changes in pricing really displayed in terms of the clearing prices or the selling prices of properties. We’re in that lag period right now.”
One central truth of acquiring a distressed asset—whether in the midst of a bull or bear market—is that the fundamentals of commercial real estate investment still apply. Picking up a building for a song is of little value if there aren’t strong enough demand drivers sending renters to that property.
Is there good transit access? Do people desire to live in that neighborhood? What amenities are there? These questions are just as valid for a dilapidated, six-unit walk-up as they are for a Class A, 60-unit new development.
Due diligence is a necessity ahead of any commercial real estate acquisition, but even more so in the case of distressed multifamily properties. When a prospective buyer is sizing up an asset, they should direct that same critical gaze upon the current owner.
How did ownership respond to the operational stress that led up to acquisition negotiations? Did they defer roof maintenance that was already several years overdue? Did they lower underwriting standards for new residents and essentially change the nature of the property? Did they agitate their current renters so thoroughly that none will renew at term’s end, despite new ownership?
Chicago creates a unique problem. Every major CBD has felt an urban-to-suburban migration as a result of the pandemic, but what gives national investors greater pause here are underlying property tax uncertainty and a perception of higher crime rates. Add to that the fact that Chicago is not a growth market like Austin, Nashville or Raleigh, and these investors are less eager to place their capital in Chicago.
“What’s interesting to us is, if you look at the transactions that are clearing, the sales that are getting done, it appears to us that there was a roughly 100-basis-point gap in initial yield spread,” Ferrero said. “That spread is considered huge by most investors. Our operating assumption is that the national market is looking at Chicago and saying, ‘pricing there has to change even more before we’re willing to take the risk that we perceive exists for investing in the Chicago market.’”
Wait and see
The general consensus, based on prior cycles, is that it can take 12 to 24 months before operational distress is fully reflected in the sale prices for assets in the marketplace. For this reason, a lot of people are simply waiting.
“You keep hearing people saying that they are building dry powder. That basically is a signal saying they are building a war chest,” Ferrero said. “They are collecting capital or saving funds that they will deploy when they think things are safer.”
Before the pandemic, we had begun to see family formation among the millennial cohort, leading this long-renting generation to begin settling in the suburbs. Once COVID-19 hit, there was suddenly even more migration to the suburbs.
This was due in part to residents fleeing density for the relative safety of bedroom communities and because jobs that required a commute downtown suddenly shifted online (or, unfortunately, evaporated). Understanding which portion of these migration changes are temporary and which are permanent is difficult because we’re still in the middle of the crisis.
But one thing is clear—20-somethings, regardless of what generational label one applies to them—still desire live-work-play environments close to the CBD. Many investors will take a wait-and-see approach before they’re ready to reinvest in multifamily assets. Others will be less cautious and dive in early. Somewhere in between, demand for rental properties, both stabilized and distressed, will be on the rise.