Founder & Chief Investment Officer at Caldera Real Estate Ventures, an external CIO & Asset Management Platform.
getty
I would like to discuss what I consider to be the unique benefits of commercial real estate (CRE) and introduce investment strategies within the multifamily rental segment.
According to findings in my company's white paper, multifamily—which constitutes approximately 70% of the $5.4 trillion U.S. CRE market—has delivered superior risk-adjusted returns to investors in the past and looks to continue to do so for the foreseeable future.
Based on some of this sector's strengths, here are some of the basics to master when looking into CRE, specifically multifamily.
Commercial Real Estate Investment Overview
Despite its complexity and high barriers to entry in developed markets, CRE distinguishes itself from traditional financial assets due to an array of benefits. These include:
• Diversification. Adding CRE to conventional portfolios is a commonly used method to reduce market volatility exposure.
• Tax Benefits. This includes depreciation allowances, tax write-offs, lower capital gain tax rates and tax-deferred hold/exit strategies such as 1031 like-kind exchanges and qualified opportunity zone (QOZ) investments.
• Inflation Hedge. Given its potential for long-term value appreciation, CRE is often considered an effective hedge against inflation.
Multifamily Trends
As the largest asset class in commercial real estate, the $3.8 trillion multifamily segment stands out for its stability, consistent cash flow and adaptability to market dynamics. The following are some of the positive fundamental trends that support the multifamily investment thesis:
Demand
The biggest demand driver for multifamily rental properties has always been urbanization. According to a United Nations report, by 2025, 89% of U.S. population is expected to live in urban areas, driven by two demographic trends—the aging population gravitating towards urban/suburban areas for better access to public facilities and an expanding immigrant population preferring to rent in city centers. Multifamily housing can help accommodate a rapidly growing urban population.
Supply
Since 2006, home construction has fallen by 55%, resulting in an estimated housing shortage of 3.8 million units in 2019. Labor and material cost escalation, global political upheavals, supply chain problems, as well as bureaucratic hurdles have only exacerbated the problem. The result is a demand-supply imbalance that is likely to put upward pressure on multifamily rents in the long run.
Stability
Due to its annual lease turnover, multifamily can mostly avoid volatility and seasonality. Additionally, I find that larger multifamily complexes are less vulnerable to the negative impacts of individual vacancies on the overall rent roll. A study by NMHC quantifies the risk-adjusted returns of all CRE sectors using standard deviation, showing that multifamily exhibits the highest return with the lowest volatility.
Multifamily Market Outlook
Driven by stronger-than-anticipated economic growth in 2023 and benefiting from factors like an enduring supply-demand dynamic, favorable trajectory of cap rates and declining property values, 2024 may present notable investment opportunities, particularly for those poised to act upon potential distress arising from refinancing pressures.
Housing Shortage Remains Unsolved
The elevated housing prices have led to a sustained growth of the renter population. On the supply side, multifamily construction starts have been decreasing since the third quarter of 2022 to less than 50% of the highest level in June 2023 (around 29,000 units). This pattern is likely to push rents up in the short to mid term.
Long-Term Rental Demand Persists
According to a study by Harvard University, rental housing serves nearly 44 million U.S. households. People seeking a lower cost of living, or "renters-by-necessity," occupy over 70% of rental housing and are expected to grow their presence. High-income households within the rental market, referred to as "renters-by-choice," also increased significantly.
Treasury Yields And Cap Rates
In July 2023, after the 11th rate hike since March 2022, the benchmark rates were brought from nearly 0% to a range of 5.25% to 5.50%. Likely, rising interest rates may impact cap rates, but cap rates don’t tend to fluctuate as much as treasury yields. They usually lag market moves by a few quarters and have a longer-term declining pattern.
The spread between 10-year treasury yields and cap rates is a widely recognized indicator of risk premium in multifamily investments. With this in mind, I believe we might be on the brink of a period where this spread widens due to rising cap rates and decreasing yields.
However, investors should pay attention to the fact that while long-term trends point to strong fundamentals for multifamily, short-term headwinds such as tightening credit, decelerating rent growth and new supply coming into the market may put pressure on investment returns. To achieve projections, investors may have to prolong their investment period and implement hands-on asset management strategies.
Opportunities In Multifamily
Below are potential strategies when navigating the current market:
1. Prioritize quality mid-market opportunities with higher than normal cap rates. Investors with dry powder may choose to purchase these assets all cash or with low leverage, endure negative leverage and refinance in a potentially better market in two to four years.
2. Deals with assumable financing that could deliver strong cash on cash returns. This is especially valuable for long-term owners and family offices. Investors should be cautious of refinancing underwriting and be diligent about loan terms such as interest-only term versus amortization, prepayment penalties, defeasance and yield maintenance clauses as well as exit/extension fees.
3. Value-add opportunities that have lower valuations due to expensive financing. Through this, rent growth can be achieved with hands-on, value-add strategies.
4. Recapitalization opportunities to own partial interests in quality properties. Investors should be wary about control/decision-making rights, entry valuation and operator fees charged to the joint venture/property level cash flows.
5. Adaptive re-use opportunities such as office to residential conversions. These investments require specialized expertise in due diligence, zoning, design and construction.
While the current dislocation in capital markets creates a strong argument for private debt/rescue capital opportunities, for equity investors, I think multifamily can present a good opportunity for mid- to long-term value creation with solid downside protection.
I also think that the window of opportunity before cap rates stabilize will be short, so many investors may not be able to react in time.
Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?
