The Tide is Receding in Commercial Real Estate. Who is Swimming Naked?

This timeless adage by Warren Buffet, the Oracle of Omaha, still holds true. During a market upswing, everyone looks like a genius. It’s only when the market shifts that we discover who is truly prepared and who is exposed (aka naked). This is precisely what’s happening in the world of commercial real estate today. While it poses risks for careless operators and their unfortunate investors, it also opens up opportunities for the rest of us.

There are a few sources of distress on the horizon. The first is in commercial office space, where the ‘work from home’ trend is tanking office occupancy rates, especially in high-cost metropolitan markets like New York and San Francisco. While there may be opportunities, such as converting office space to residential units, there will also be significant challenges as lease renewals for office space come due in the next few years. We’ve likely not hit bottom yet in the office segment.

Personally, I’m more interested in the residential apartment space, which operates under different dynamics. While the fundamentals of the apartment market remain solid (as discussed in my previous piece), some apartment owners are in trouble. Take, for instance, Applesway Investment Group, an apartment operator that lost four properties (3,200 units) in Houston to foreclosure in April. They acquired C-class apartments, allegedly mismanaged them, and lost residents. Additionally, they financed the units with variable-rate debt, which then skyrocketed when interest rates spiked. A similar fate awaits other inexperienced owner-operators.

Applesway serves as a valuable lesson in picking winners in apartment syndications, which I still consider an excellent avenue for high returns with limited effort. Here are the key factors I consider when evaluating apartment deals and their operators.

1) Operator experience level: This is the most critical factor to assess in any real estate syndication. How many years of experience does the operator have? How many deals have they successfully executed? Have they (or someone on their team) weathered a real estate downturn before, or have they merely ridden the wave of recent rent growth, possibly masking deeper management issues? Regarding property management, do they outsource to proven third parties or possess extensive in-house experience? Are they patiently waiting for good deals or buying properties solely to maintain deal momentum?

2) Debt strategy and risk mitigation: Many argue that this is the top priority at present. Operators who obtained variable-rate debt in 2021 and 2022, expecting to secure a 3% interest rate upon refinancing, are likely facing significant challenges. Experienced operators would have secured something called a ‘rate cap’ – an insurance policy that limits the potential increase of a variable rate loan. Unfortunately, many newcomers did not employ this strategy.

When evaluating deals today, it’s crucial to assess the conservativeness of their debt plan. Ideally, they have already locked in a favorable fixed rate or inherited a low-interest rate from the seller. Alternatively, they may be assuming less debt overall (aka below 60%). If they do have variable-rate debt, it’s even more important to have confidence in their plan to generate returns that surpass the high end of their potential debt financing. Otherwise leverage backfires.

3) Quality of the business plan. For those primarily experienced in single-family ‘buy and hold’ strategies, this may be a new concept. In multifamily investing, the business plan usually holds greater significance than the property itself. Referred to as ‘value add,’ this plan aims to increase revenue or reduce costs to enhance the property’s profitability. Unlike single-family properties, the final sales price of a multifamily property is directly linked to its income, not comparable sales.

In recent years, ‘value add’ typically involved upgrading units and raising rents. However, given the significant rent rate increases of recent years, this strategy may be less reliable. Instead, do they have plans to reduce costs, such as an agreement with the local government to cap future rent growth in exchange for tax incentives? Alternatively, does the operator intend to acquire undervalued properties with a solid turnaround plan? This could create a buffer in case of trouble.  In any case, I want to see a track record of successful execution of similar plans, regardless of what the plan is.

4) Conservative assumptions: How likely is the operator to execute their plan outlined in point three? As a general rule, I prefer deals with solid projected returns that I am highly confident will materialize over those with excessively high projected returns but based on weak assumptions. Keep in mind that desirable properties often attract significant competition during the bidding process. Inexperienced operators may adjust their assumptions to make the numbers “pencil” to justify the purchase price. If they win the bid, they will present the deal to you in terms of the projected Internal Rate of Return (IRR) over the investment’s lifespan.

However, the IRR is simply a result of those key assumptions, so they need to be easily attainable. One critical assumption is rent growth – the annual rate at which the operator plans to increase rents. I prefer to see a maximum of 2-4% growth per year. Furthermore, any rent projections should be supported by comparable properties in the market. Another metric to focus on is the exit cap rate – if they purchase a property with a 5% cap rate, for instance, and assume a 4% cap rate when selling (meaning they assume the market will pay 20% more for the same income stream at sale), skepticism is warranted. The deal is only as good as the assumptions made during acquisition.  The more conservative the better.

5) Quality of the asset: You might have expected this factor to be number one. While the property itself holds importance, multifamily investing heavily relies on the operator’s ability to execute their plan. Nevertheless, the quality of the building, its age, market, and submarket remain essential considerations. Location remains key.

In the case of the Applesway debacle, their investments focused on C-class buildings (older properties in less desirable locations). There is nothing inherently wrong with C-class properties, but two critical points should be noted: First, the purchase price should reflect the additional risk and costs associated with this property class. Second, expertise in managing this type of asset is crucial. Operators should demonstrate numerous successful examples since these assets are more challenging to manage. Furthermore, a prime location is always desirable, with excellent job growth, population growth, and ideally, proximity to solid schools and transportation access.

6) See #1 above. An experienced and successful operator would have addressed all the aforementioned factors. They would have a reasonable debt plan and appropriate risk management measures in place. They should present a detailed plan for value creation, cost reduction, or acquiring undervalued properties (or a combination thereof). The assumptions underlying their execution plan should be realistic and, ideally, conservative. Patience is also key, especially given the macro uncertainties surrounding interest rates and the economy today. Operators should select the very best deals among hundreds, and we investors, in turn, should choose among the best operators and their very best deals. In other words, the cream of the crop.

What am I currently seeking? In addition to the above, I’m actively searching for savvy operators who can acquire good assets from poor operators. I am not predicting a total collapse in the apartment market, but property values are declining, and undoubtedly, some excellent properties will become available. However, I am willing to exercise patience and allow the best operators with strong balance sheets to uncover these gems. Then, I will make my move. Make sure to subscribe to receive my next article.