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As we get further into 2023, there's a lot of buzz, a lot of excitement and a lot of concern across the board in basically all markets.
Today, I want to talk about the main challenges and, more importantly, the opportunities that we’re seeing specifically in the multifamily real estate market.
Managing Debt
First and most obvious, debt is a tremendous factor these days and one of the main challenges we see for 2023 is managing that debt due to lower LTVs (loan to value) and higher interest rates. When you're looking at debt as an owner and an operator, one of the main challenges right now is that LTVs have gone down significantly. In the past, operators and real estate owners, specifically for multifamily, could have found deals where we could have financed at 75 to 80% LTV. 80% was not so conservative, but 70-75% was pretty standard.
Today it's hard to find those types of deals because lenders are being very conservative and very careful because interest rates have gone up. When lenders are looking at an asset, they're looking at the cash flow and NOI (net operating income), and they anticipate what the debt service would be; the amount of debt payment every month, every quarter, every year.
They need to maintain a certain DSCR (debt service coverage ratio). It could be 1.25, 1.4, 1.5. The DSCR basically dictates the maximum amount of loan proceeds. I remember when DSCR was 1.2, and now it's generally over 1.5.
Sometimes that means that you need a lot more cash flow, which has forced LTVs to go down. We've seen LTVs at under 50% up to maybe 60%. It's climbing back up, but it's a significant drop from where we were a couple of years ago. That means investors need to raise more money; more equity is needed to close the deal, and that puts more pressure on yields.
The way to overcome that in terms of interest rates is to go with fixed rates and not fluctuating interest rates. It's not going to impact your property that much when it comes to the LTVs, you just need focus on driving higher yields.
Increasing Vacancy
Another challenge everyone is seeing is that multifamily vacancy rates are on the rise. One reason is that many cities have removed their restrictions on evictions, and we’re seeing a lot more tenants are being evicted.
However, you need to understand that there's a difference between physical occupancy and economic occupancy. For example, with physical occupancy, if you have 100 units and 5 of them are vacant, you're at 95% occupancy or 5% vacancy.
When it comes to economic vacancy, the question is how many of those hundred doors are actually paying? Going back to the example of a hundred units, five are vacant and 95 units are occupied. But out of the 95 occupied units, five tenants have stopped paying you. You are technically at a 90% economic occupancy because only 90% of the doors of total doors are paying. This has been a very common occurrence post-Covid, especially as some rental assistance programs have ended.
There is a positive aspect to this, however. Right now, despite physical vacancies on the rise, new tenants are coming in and these are tenants that don't have any evictions in their credit history or in the background search. These tenants are going to pay their rent. We're now replacing tenants who haven’t been paying rent with good tenants that can actually pay.
This is where location also comes in as part of your strategy. For example, in the Sunbelt markets where we like to focus, the migration into that area still continues to be really strong.
We want to make sure we’re acquiring assets in an area that's still in high demand, and the demand continues to move in the area to make up for those tenants that we're having to exit. Location is one of the things too that's very important for all investors to take into consideration; are the areas you’re focusing on continuing to grow?
It’s also important to understand the tenant base and for that specific property. Maybe household income in the area is low and they're not going be able to cope with the increased in cost of living. Location is a cliché in real estate but today, more than ever, you don’t want to just bet on the location, you need to consider the tenant base. If you’ve got strong tenants in fields like healthcare or IT, they’re more likely to care about their credit score and won’t just disappear in the middle of the night without paying.
Increased Cost of Materials
Finally, If you have a value add strategy, like we do at Blue Lake Capital, you’ve definitely noticed that CapEx projects are more expensive than they used to be. We have seen a lot of improvement with supply chain, so the lead time is not as long as it has been the past couple of years, but with inflation and increasing demand, the materials are still more expensive.
This is something to keep in mind when you’re underwriting new deals. It’s very important as a sponsor to know that you’ve underwritten the deal with current costs.
All of those challenges might sound daunting, but we’ve found that when a market is most challenging, this can create some of the best opportunities if you’re nimble and have a strong business model.
Less Competition
We’re definitely seeing opportunities in the market right now and one one of the best things that happening now is that there are fewer active buyers. A lot of groups are basically sitting on the sidelines, and that presents more opportunities if you can close on deals. You don't have to overbid or bid against yourself to win a deal if you know the assets you're looking at.
In addition, the reality is that some groups are too small to qualify for lender, and can’t raise the equity that's needed with Lower LTVs. They don't have the track record to secure the right type of financing, which actually provides a greater protection for investors in the market today.
Not every deal is a great deal, but we’re seeing get a lot of off market deals directly because sellers don't want to take the chance of going through the entire process and market a deal that takes six months just to find out that they can’t sell at the price that they want or need to get in order to exit. So they go to brokers and ask them for their best five or six groups. That’s where we’re seeing a lot of activity now. If the seller knows you can close, they might select you as a buyer, not necessarily the highest bid.
More Assets Under Water
One of the most frequent things we’re seeing in deals now is that there are a lot of assets out there that are under water.
There are a number of reasons for this. For example, perhaps it’s a situation where a sponsor bought an asset a couple of years ago with the intention of making some improvements and then exiting, but the cost of projects have increased and now it's hard for them to exit. We’re seeing more and more of those types of deals.
We also see assets that are distressed because the debt. There’s been a lot of pressure on cash flow as interest rates have continued to increase, so we are being approached by sponsors that are asking if we want to come in, take the GP and infuse capital into those deals.
Most of these deals don't work, but we do see more opportunities with assets that are in great markets with strong demographics and demand drivers, but just the debt was too aggressive and the assets are under a lot of pressure.
Institutional Assets Hitting the Market
This is even happening with some of the biggest players in the market; even some of the largest REITs are out there needing to liquidate and sell assets. It’s not because the assets are not performing, but their investors want to take profits, forcing the REITs to exit and free up liquidity. That’s presenting a huge opportunity as a sponsor, you have a chance to acquire an institutional level asset from a really strong operator that is being forced to sell.
I think this is an amazing opportunity because it has nothing to do with the asset. They also need to liquidate quickly, so we see cap rates jumping from 2.7% or 2.9% all the way to 4.5% even in strong markets like Texas and Arizona.
This is a very, very exciting market for us because this is where the opportunities lie. There are fewer buyers competing for deals, there are assets that are under water and need rescue capital, and also you have big funds that are liquidating assets.
As long as you stay consistent and disciplined and underwrite conservatively, you can seize on those opportunities, and they're pretty much everywhere.
Key Takeaways:
- We’re seeing a number of challenges in multifamily markets today: increased vacancies, increased cost of materials for CapEx projects and a challenging debt market.
- These challenges can create opportunities for good sponsors. Some assets are underwater and we’re seeing more activity from large institutions, even as there’s less competition in the market.
- If you stick to your plan and let the numbers do the talking, you will be able to uncover some great deals while others are sitting on the sidelines.
Now is the time to make your move and buy smart, but it’s also a great way to look at life. You can see struggle and pain in everything, or you can look at a specific situation and say, “okay, what good can come out of it?”
If you look at the most successful people in the world, especially in real estate, they're always great at seizing opportunities and jumping at it where others were more hesitant or frozen by fear. If you let the numbers talk (and numbers always talk), then you can find those great assets, great opportunities. It really depends on how you look at things, not just with investments, but life in general.
If you’d like to invest with us, or just connect to find out more, send an email to info@bluelake-capital.com or fill out our investor form at https://www.bluelake-capital.com/new-investor-form. Our Investor Relations team would love to connect with you.
As always, be bold, be great and keep pushing forward!
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About Ellie Perlman
Ellie Perlman is the founder of Blue Lake Capital, a commercial real estate investment firm specializing in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology.
Ellie was the original host of REady2Scale, a podcast she created that highlights the assets, processes, and strategies for the multiple approaches to successful real estate investing.
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.
You can read more about Blue Lake Capital and Ellie Perlman at www.bluelake-capital.com.
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