How a Recession Impacts Origin’s Approach to Multifamily Funds
How does multifamily real estate preserve and grow wealth under economic duress? According to Origin’s proprietary suite of machine-learning models, MultilyticsSM, a recession in the U.S. is nearly 100% likely to occur by October 2023. We are doubling down on firmly established best practices to help recession-proof our Funds and have been taking multiple steps to preserve properties’ net operating income and investors’ earnings. In other cases, we have developed innovative, proactive measures to counter the worst effects of an economic downturn.
Even in a recession, the need for housing and the long holding periods of private equity real estate have combined to shield multifamily investments from market corrections. We use a barbell investment strategy for each asset, building value and protection with strong, creative capital structures. For example, our IncomePlus Fund is structured to protect capital and deliver distributions even in economic downturns.
How We Prepare Our Funds for Market Challenges
During a recession, renters are more sensitive to housing prices than homeowners, who can lock in costs with 30-year mortgages. As asset managers, it is important for us to prepare for the prospect of softening demand and declining occupancy, which can lead to lower property valuations. Slowing rent growth and rising interest rates are putting upward pressure on capitalization rates, eroding margins. However, even if cap rates expand significantly, our investment principal (and returns) will still be protected.
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We’ve always used a range of strategies to outperform industry returns in our markets. At the first sign of economic trauma, we stand firm on three fundamentals: picking the right places to invest, focusing portfolio formation at the lowest cost and highest margin possible, and controlling the cost of debt.
Origin’s acquisition team members live in expanding markets in the Sunbelt and mountain regions where population is growing. These markets stand to be less severely impacted by a recession and are more likely to emerge with stronger growth. Our team members evaluate properties or potential development sites in neighborhoods and submarkets using Multilytics, which predicts rent growth more accurately than standard industry techniques. In a recession, Multilytics goes beyond financial modeling to identify properties down to the block level that are most likely to produce high yields and long-term rent growth.
Portfolio Construction Helps Mitigate Recession Risks
In early 2020, we shifted our investment strategy to stop buying stabilized properties and focused instead on investing in preferred equity and ground-up development. At that time, older properties had begun trading at values in excess of replacement cost. This was largely driven by high rent growth and low interest rates; however, as we have seen, those tailwinds are not permanent. Developing a new property has been the best way to enter a market at the lowest possible cost. Investing preferred equity in ground-up developments provides further protection of our capital investment and controls downside risk in a recessionary environment. Below are two examples of our strategy in action.
Linden House is a 295-unit multifamily project in Jacksonville, Fla. We capitalized this investment using 65% senior debt and underwrote it to a return on cost of 5.97%. The return on cost is calculated by taking the net operating income projected at stabilization and dividing it by the cost of the project. The difference between the return on cost and the prevailing stabilized cap rates represents the project’s gross margin. In the chart below, the original pro forma is on the left; a recession rent forecast is on the right.
Cap rates for stabilized properties similar to Linden House reached as low as 3.75%. An increase in cap rates to 4.50% wipes out 50% of invested equity on a stabilized investment. However, because we employ a development margin of 33% (5.97% divided by 4.50% cap rate), we have an additional cushion if cap rates expand further.
Because we typically add a margin of safety in underwriting, the Multilytics’ recession rent is actually higher than our pro forma projection. The “multiple at 4.5% cap rate” column captures the return on our investment using Multilytics’ rents and a 4.5% cap rate. The next column, “% rent decline to breakeven”, represents how much Multilytics’ rents would have to decline before our invested capital is at risk.
Elan Rio Grande
Origin’s QOZ Fund II recently began construction on Elan Rio Grande, a 207-unit multifamily project in downtown Colorado Springs, Colo. We approved the investment based on a profit margin of 25% to 35% relative to the capitalization rates on stabilized multifamily projects in the market. Even if rent growth continues to slow or cap rates expand, this margin will protect our investment. But based on research from Multilytics, we believe rent growth will continue in Colorado Springs, albeit at a slower pace than 2021-22.
Our preferred equity positions produce an average yield of 12.1% and originate at a loan to cost of 82%. Factoring in our expected return, stabilized asset values would have to decline by more than 25% relative to our current projection, which incorporates Multilytics’ recession forecast, before our return is at risk. A further decline would have to occur before our initial capital investment is in danger.
How We are Managing the Cost of Debt
Real estate is a good inflation hedge only when lending costs are under control and rent increases are not consumed by rising interest payments. Due to rising inflation, we hedge variable rate risk with swaps and swaptions to keep debt service within the budgeted range.
Earlier this year, for instance, we paid $18.5 million for swaptions that were subsequently sold, generating a 149% gain and a net profit of $27.8 million in less than eight months. Another $25 million of unrealized net gain is currently estimated for swaps and swaptions that we still hold, for a total profit of $53 million applicable to future interest rate payments. The net cash realized from the sale of these swaptions still hedges against higher interest rates, allowing for greater predictability of future cash flows. These profits can offset higher future interest rates if needed. If future rates decline around the time we place permanent debt, all or some portion of the realized gains on the sale of these swaptions will enhance investment returns.
The chart below illustrates the benefits of our current strategy and how interest rates would negatively impact our yields with and without hedging. We assume a 5% annual interest rate within our most recent portfolio valuation, and what happens to the cost of debt if rates increase. Although our returns would be impacted by sustained high interest rates, our hedging strategies substantially mute the blow. The cash flow protected over a 10-year hold is demonstrated in the far-right column.
Weighing the Risk and Reward of Construction
When it comes to our ground-up construction efforts in a recession, the next step is to lock in labor and materials costs. Compared with acquiring stabilized assets, developing new ones has a higher risk and return profile. But by controlling costs, we can raise the potential reward and lower the risk.
In underwriting a development like Elan Rio Grande, we apply a conservative pricing strategy that looks at future commodity prices for items such as steel and lumber and allocates more money for potential price increases. In addition to a typical 5% contingency for construction (say, $2.5 million), we assume $1 million for rising construction costs to see if the deal could withstand the price volatility. For example, if a deal with $3.5 million in contingencies—which assumes no rent growth—can pencil to a 30% or greater margin, it is worth doing. If a deal falls below those profit thresholds, we will allocate capital to investments with less potential risk.
By employing these strategies, we have developed new construction at a profit margin 30% to 40% higher than the returns of competitive existing assets. A lot of things might erode that margin in a future downturn. But given the higher profit margins of new construction, a lower return would not put equity at risk.
Improving Cash Flow With a Tenant Relations Focus
In a recession, cash is king. As asset managers, it is critical for us to preserve cash flow. While it may make sense to raise rents aggressively and risk losing some residents in an expanding market, in a contracting market it’s necessary to make customer service and lifestyle improvements that provide a better value. Making amenities more attractive and vibrant helps tenants build friendships and create relationships with fellow tenants, which can make them less willing to move. While we have always done this, we are sharpening our focus on tenant relations in our current operating assets and will implement strong tenant programs in our development projects when they are ready for occupancy.
A tool we have long used to attract and retain tenants is our online reputation assessment (ORA) score. Satisfied tenants are an apartment community’s best ambassadors on social media and in personal recommendations. We have eight operational assets in our current portfolio, with an aggregate ORA score of 74—an increase of 4 points from six months ago. Over the same period, the national average decreased slightly to 62.7 from 62.8.
These proactive steps to help us get through a recession and take advantage of stronger rent growth once the economy stabilizes are only a start. Our team is always working on innovative tenant retention strategies and was in the vanguard in March 2020 when COVID hit. Their leasing innovations included self-guided tours, virtual showings and resident reviews to raise our rent rolls. While we are proud to stand on our past record, we are equally intent on building on it with new innovations.
Staying Profitable to Get to the Other Side
No one can predict the effects of a recession, if and when one occurs. However, it is a good defensive tactic to stabilize cash flow as long as possible and get to the other side of a downturn. We knew that the 16% average rent growth that our markets enjoyed in 2021 was not sustainable, and we didn’t manage our Funds as though it was. With the built-in costs of debt under control and cash flow maximized from improved operations, rent increases can go straight to the bottom line. All of this puts us in a better position in a recovery.