4 Multifamily Investing Mistakes Will Threaten Success Post-COVID

Topic:  • By David Scherer • May 19, 2020 Views

4 Multifamily Investing Mistakes Will Threaten Success Post-COVID“Only when the tide goes out do you discover who’s been swimming naked.” Warren Buffett’s maxim comes to mind now that the COVID-19 has left multifamily real estate investors exposed. Investors can’t be blamed for not anticipating a pandemic. But even seasoned investors who enjoyed the economy’s high tide were not prepared for its retreat. The COVID-19 recession will teach multifamily real estate investors a few hard lessons.

More than any other type of investment, multifamily housing gives investors a false sense of security. For instance, if you ask potential investors to evaluate a biotech business and run it for you, they would likely say, “I can’t–I don’t really know anything about it.” But when you bring up multifamily housing, everyone thinks they can buy a couple of buildings and run them. After all, we’ve all lived in a house or apartment. It’s a case of “been there, done that.” Everyone thinks it’s easy and they can do it well.

In fact, it’s really hard to be good at managing multifamily properties, even with substantial experience. It takes skill to execute everything necessary to make the properties profitable, from securing the right kind of financing and making improvements to managing each asset daily and retaining tenants. You’re dealing with many legalities and complicated debt structures. Plus, it takes an incredible number of hours out of a day, which is the biggest part of the process investors overlook: not valuing their time in the equation.

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Multifamily housing has thrived since the last real estate recession, and attracted newcomers and do-it-yourself investors in droves. Yet while apartments have produced reliable returns in the past, it will take even more skill, not to mention significant creativity in planning and executing new strategies, for landlords to succeed in the current economy and the certain stretch of widespread pain to come. With a growing number of properties in peril, many owners will find it impossible to negotiate their way out of an imperfect business plan.

Direct investors make costly mistakes in good and bad markets. However, some of the most painful choices have been more obvious than ever in the face of the COVID-19 lockdown, and many investors may lose properties to flawed business plans. As commercial real estate shifts its focus to recovering from the pandemic, multifamily housing investors have made four major missteps that will affect the health of their properties. These are:

Loan Risk: Betting Big on Recourse Debt

When vacancy rates are going up and rents are going down, it’s harder to cover debt. Cash flow will get tighter. A direct investor can lose a property for any number of reasons. Still, a friend of mine gave himself less margin for error, probably without realizing it. He took on recourse debt, which means he has more at risk than his equity in the property. If he defaults on his loan, the bank can pursue his personal assets.

Experienced multifamily investors, like the best private equity real estate firms, limit their risk. They organize separate companies to buy and manage each property, put as much equity as possible into each purchase and pledge only the property itself as collateral. They don’t cross collateralize or guarantee multiple debts with the same assets, and they sign nonrecourse loans that do not hold the partners personally liable for repaying them.

With nonrecourse debt, the asset itself is the loan’s only collateral. A direct investor with nonrecourse debt has room to negotiate in a crisis. A decade ago, in the worst days of the real estate recession, banks found themselves owning and managing large foreclosed property portfolios. Borrowers could renegotiate loan terms, or even buy back the debt for less than they owed, because foreclosure would cost the bank time and money. With recourse debt, that’s not an option. The bank has no motivation to exercise forbearance. If foreclosure fails to pay the debt, they can keep pursuing the borrower.

My friend didn’t realize this when he was offered a recourse loan, but surely a lender insisting on these borrowing terms saw the risk he was taking. He was paying too much, or not putting up enough equity, or buying a property with low growth potential. Or the lender simply saw him taking on a side project without a track record. The experienced investor or private equity real estate manager not only will pursue nonrecourse loans but will get them at reasonable rates. A skilled real estate asset manager treats the bank as a partner. Lenders get regular status updates without being asked. Real estate asset managers establish a rapport that earns them leeway in a crisis. They give the lender confidence that their money is in good hands, which wins them the best loan terms.

Concentration Risk: Ignoring Sound Planning  

Do-it-yourself real estate investors tend to sink too much of their net worth into one or two deals, whether through direct investment or a real estate asset manager. Concentrating risk in one property leaves little room for error and every little problem can be a big deal.

During the 2008 real estate downturn another friend of mine bought a half-built development. It was a good price, but he had no development experience. Finishing the project took two or three times what he paid and tied up 70% of his net worth. No asset is worth that kind of risk. Only in real estate investing would an investor consider it. A more realistic look at diversification is to invest not only in multiple asset classes, but also multiple properties, so that a single troubled property does not decimate an entire investment portfolio.

Cash flow needs will vary with age and investment goals, from saving for children’s college tuition to retirement income to estate planning, but I believe that real estate should account for 15% to 30% of a portfolio. It’s also important to keep about 30% of a real estate stake in liquid assets such as REITs. For investors with 25% of their net worth in real estate, that’s roughly 10% in REITs and 15% in real estate private equity. It’s just as important, though, to have diversification in that 15% invested for the long term. A private real estate allocation should fund at least 10 deals, in different cities, in various categories like multifamily housing and mixed-use properties.

Instead, what happens often is that a few friends will get together on a direct investment and spend more on that one deal than any logical strategy would dictate. Inevitably the project requires more equity, at a time when not all the partners have cash on hand. The cycle repeats, and the partner with the best balance sheet winds up putting up most of the equity and taking most of the risk—maybe losing friends in the process.

Operation Risk: Leaving Recruitment and Retention to Chance

Lockdowns have disrupted the finances of millions of tenants. Whether they’re renting four walls in a sleepy suburb or a Class A luxury complex in a hot neighborhood, they will have to make hard choices in the next year about the value they receive for paying the rent. Office and industrial tenants face the same disruptions.

The competition to fill vacancies and retain tenants will be fierce. An extended period of social distancing has made virtual leasing standard practice, with an attractive website and video tours. Operators must not only undertake an accurate competitive market analysis, but also do secret shopping of their own property and its competition. If someone else is doing that work, whether it’s a superintendent or leasing agent or multifamily property management company, the operator needs to know enough about occupancies and rents and expenses to evaluate and supervise their work.

Tenant service and experience will be a critical differentiator. Building personal relationships with tenants takes more than walking the property once a month to collect rent. The operator must anticipate their needs, respond quickly to their concerns and create an atmosphere tenants will not want to give up, whatever other challenges they face.

The COVID-19 recovery will favor the big players who have the capital, personnel and expertise to respond to new demands. That leaves one question for both direct investors and real estate asset managers, at any service or rent level: Am I keeping up? Am I as good as the sophisticated owners in this industry at acquiring, presenting and maintaining a clean, safe place that offers value to the renter?

Time Risk: Selling an Investor’s Involvement Short

What could possibly go wrong in a multifamily housing investment? A lot, as it turns out. Investors who thought they were collecting passive income now have to get working, and fast, to fix or head off unexpected issues. It’s unrealistic to think that multifamily properties run themselves. Acquiring and managing assets, or even performing the due diligence to supervise those tasks, takes time. In a time of crisis, miscalculation could be catastrophic.

As I noted above, no one decides to buy a biotech firm to run on the side. Most people wouldn’t know how to evaluate the business, the price or the operations. But so many investors are comfortable making a real estate investment without acknowledging the cost of competing with the real estate industry’s own full-time professionals, or the opportunity cost of taking time away from their own activities.

A family friend is a case in point. She’s 78 years old and living abroad, yet seriously debating whether to buy buildings in Florida. “I have this person that finds the properties and manages them, so it’s not so hard,” she told me. “I think it’s a good deal.” If I were her, I’d want the details in writing so that I’d know it’s a good deal. But even then, it’s hard to imagine that she would be better served by her person in Florida than by a multimillion-dollar real estate private equity manager.

What makes this mindset so puzzling is that the top real estate asset managers are very profitable. Multifamily housing REITs have returned more than triple their value over 10 years, and all the investor has had to do was to buy shares. Direct investors who value their time have to hold themselves accountable. What can they do that would produce a better result than simply investing in professionally managed assets?

Time Risk: Selling an Investor’s Involvement Short

The industrialist Andrew Carnegie advised students of finance to “put all your eggs in one basket, and then watch that basket.” Of course, his basket had a lot of eggs. But his point was that investments aren’t for the dilletante. They take time and expertise to understand and manage properly. The past decade has been a good market to own real estate, and many do-it-yourselfers have done well enough. In the post-COVID-19 world, investors who continue to believe they can beat the professionals are just hoping their luck holds out.

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David Scherer

David Scherer formed Origin Investments in 2007, along with co-founder Michael Episcope. He has over 20 years of experience in real estate investing, finance, development and asset management.