As high-net-worth (HNW) investors and family offices look to increase their portfolio allocations in real estate, the multifamily sector continues to offer attractive investment opportunities. HNW investors demanding predictable cash flows from core properties or value‑add yields on ground-up and redevelopment projects can meet these objectives in the multifamily sector. In this context, what are the market cues that can help pick opportunities that will generate returns that align with portfolio goals?
Risks and rewards of multifamily investments
While gateway markets such as San Francisco and New York City are attractive, they have also experienced significant multifamily development. That new supply can dampen rental rate increases, and when factoring in the high cost of entry in gateway markets, returns are more quickly impacted when rent growth stagnates. Conversely, secondary markets, like Salt Lake City and Denver, have seen comparatively less new development despite strong population and job growth. We think that these markets provide more predictable returns and a more attractive option for HNW investors.
Millennials are increasingly demanding more rental housing, and developers are responding with designs and amenities that serve their predicted behaviors. The increase in the development of smaller units in urban environments is one example of this. That said, investors need to exercise caution when too much of this type of product is being delivered in certain markets. Like generations before them, millennials will eventually look to purchase homes in good school districts for their families, and likely in more suburban areas.
Separately, growing contingents of older renters want higher-quality finishes and amenities. Many assets, even those just 10 years old, do not reflect the preferences of these renters, creating an opportunity for savvy investors to acquire and implement a redevelopment strategy.
Increasing ROI on multifamily investments
Multifamily can be a strategic long-term investment opportunity for HNW investors, but there are important things to note in the achievement of yield. Location, asset quality and strong market fundamentals must align with investment strategies and sound underwriting. The management of an asset is also a key driver for success.
Implementing upgrades to finishes, amenities and technology, including package management, smart thermostats and security systems, are additional means of effectively adding value and enhancing returns. As an example, energy-efficient upgrades can both reduce operating costs and result in financial savings when using agency debt.
Package management is another example of changing tenant needs. The growing adoption of e-commerce has tenants receiving far more package deliveries than just a few years ago, and successful communities will effectively manage this influx of deliveries. Enlisting third-party vendors that have developed innovative solutions to the problem of package theft is highly attractive to renters who shop online.
Multifamily investment mistakes to avoid
Is there too much capital in your target investment market? If so, unrealistic rental growth assumptions or underestimated increases in operating expenses will impact the integrity of the pro forma. Will cap rates hold? In markets where cap rates have dropped below 4 percent, the margin for error is magnified. Accuracy is a must when assessing risk in an ultra-low cap rate environment.
Adequate underwriting of capital costs is another area for caution. The old standard of $250-per-unit capital reserve may not hold up in the face of changing tenant preferences, especially when considering the costs of keeping up with advances in technology.
There are a variety of factors that we believe will result in increasing opportunities—in the right apartment markets—for HNW and family office investors. As construction lenders reign in new lending and equity investors become more cautious, we expect the current development pipeline to shrink. When combined with the changing demands of renters by choice, we believe that there is an increasing opportunity to improve existing apartment assets and generate attractive returns.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on value-add investing by providing debt and equity capital to owners and operators of commercial real estate, as well as buying direct investment for its own account.