At Discover Multifamily, our number one priority is capital preservation. Once we feel that there is an extremely high probability of our investor’s capital being protected in the deal, we then shift our focus toward identifying the key drivers that will generate an attractive return on invested capital.
COVID-19 has brought many uncertainties in life as well as in the real estate markets. Personally, we feel that there will be an immaterial dip in pricing and the market will recover swiftly. Capital seeks attractive yields and safety during recessions whether “anticipated” or real. We believe multifamily and senior housing are the most compelling asset classes for capital flows.
On Wall Street, there is a saying that, “The players come and go, but the game always remains the same.” This is why we can postulate, but can never be as arrogant to admit that we know what could cause the US to tip into a recession. However, just because we might not know the “player” or root cause that causes us to tip, that does not mean we cannot factor in economic storms into our underwriting with conservative assumptions.
We certainly recognize that we might be buying in front of an 8-15 month recession and so our assumptions must change to account for less organic growth. Typically, less organic rent growth means lowered projected returns.
Dealing with uncertainty is the definition of risk; here is how we are dealing with this uncertainty in our underwriting in 2020.
Increasing Vacancy Assumptions
Our target markets have averaged between 94-96% occupancy for the last 5-8 years. With the possibility (or high probability according to people much smarter than I) of a recession occurring in the next 2-10 months, we believe that a readjustment to our vacancy assumptions is needed. Pre-COVID, we were underwriting to a 7% vacancy rate…. Even for the deals that were 95-96% occupied — remember conservative. Currently, we are underwriting to an 8-10% Yr 1 vacancy rate before trending back towards 7-8% vacancy upon stabilization.
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Lowering Rent Growth Assumptions
As many of you know, multifamily in our target markets has been on a tear these past few years. We have seen these markets as a whole average 1.8-2.5% average annual rent growth with some submarkets being north of 3%+. Owning a deal in a submarket that is experiencing this type of growth is phenomenal for your performance and investors’ returns. However, we would never underwrite to 3%+ rent growth even if there was a high probability (guessing) of this growth continuing. That is speculation, not investing. PRE-COVID we were underwriting to a 2% rent growth rate to remain conservative. Currently, we are underwriting to a 0% Yr 1 rent growth rate due to the obvious fact that if the economy slows down for 6-12 months underwriting to an aggressive rate would be speculative in nature.
Increasing Lender Reserve Requirements
Capital markets became severely dislocated in March and April due to the heightened uncertainty around COVID’s impact on the real estate markets especially surrounding rent collections. The securitization market all but stopped quoting, spreads blew out on Bridge Debt, and agencies required massive reserve requirements. Both owners and investors of multifamily assets breathed a sigh of relief when rent collections lagged last year’s numbers by only 1-3%. That being said, we had to adjust our underwriting to reflect the increased reserves that Fannie/Freddie are now requiring. Increasing our reserves also increases the amount of equity required from Discover Multifamily and our investors to acquire a new deal.
Terminal (Exit) Cap Rates
We are keeping our terminal cap rates consistent with Pre-COVID assumptions. The main reason is that we believe that COVID, as harmful and prevalent as this virus is right now, will not be a factor in 5-6 years when we go to the market to sell the deal. The .5-.7% terminal expansion that we always build into our underwriting provides more than enough of a buffer to remain prudent and conservative.
We are remaining extremely active in speaking with brokers, lenders, and underwriting deals to continue to have a deep pulse on the market. It is easy to formulate opinions as to where you think the market will go in the coming months to years, personally, anytime I have tried to predict I have usually been wrong. What separates the best investment firms and investors from the crowd is the ability to adhere to stringent emotional discipline and sound investment principles during times of crisis. This too shall pass and hopefully, we will acquire some great deals for our investors instead of formulating opinions, which could be wrong.
