If you’re an Origin investor, you’ve seen our frequent webinars focusing on multifamily investing, Fund updates and current topics such as how to vet a real estate fund manager and how to balance your portfolio with multifamily real estate.
During these webinars, our investors ask a lot of smart questions about private real estate, so we recently decided to devote an entire webinar, called “Ask Origin,” to a question-and-answer session. We answered questions on everything from cap rates and interest rates to Origin’s strategy and approach to risk. Are you considering investing in private multifamily real estate? Want to understand how Origin approaches the market and our latest thinking on economic trends? Read on.
Q1. How will cap rates move as interest rates increase?
Interest rates made one of the most sudden swings in a decade, from almost 1% up to 3% in the first half of 2022. Yet we haven’t seen an equivalent movement in capitalization rates in multifamily investing, which indicate the rate of return an investor can expect on a property. Usually, buyers want a high cap rate, which indicates the purchase price of a property is relatively low compared with its net operating income (NOI). Yet the U.S. median real estate cap rate has shifted slightly to 4.5% from 4.7%, as measured by Real Capital Analytics. That’s because total return is a function of both cash flow and rent growth. If growth prospects are perceived to be high, cap rates will be depressed.
Cap rates will rise when growth slows—and growth is still robust, with housing shortages in several of Origin’s multifamily real estate markets, most notably Dallas, Austin and Charlotte, and rent growth in the 15% to 20% range. So, cap rates haven’t been affected by interest rates. They will be affected more by rent growth in the future.
Q2. What cap rates do you target to ensure a profitable investment?
In multifamily investing, rent growth is much more important right now than any other variable. The current market rewards new construction with higher rent growth, so we are not in the market for existing properties. It doesn’t make sense to borrow at 4% to buy real estate that will generate only a 3.5% or 3.75% cap rate. Instead, we are lending via preferred equity at interest rates of 12% on average and adding value to the properties, aiming for a future cap rate of 5% or 6%. Building to a cap rate in the future and adding value to the property allows us to manage interest rate risk. We’ve been in this defensive posture since before the pandemic because we saw a distortion in the market between replacement cost and the value of existing properties.
Q3. How will rising interest rates impact Fund performance?
We hedge interest rates several ways, using fixed debt when we can. Swaps and swaptions (swap option contracts) protect future cash flows and returns during construction. (A June 2022 webinar covers these derivatives in more detail.) In real estate underwriting, Origin looks for SOFR, or Secured Overnight Financing Rate, contracts that re-price every day. The Fed’s expected rate hikes for the rest of the year and the following year are priced into our underwriting.
Our base case is very different than two years ago regarding interest rates. Our real estate underwriting models now assume 4% to 5% variable interest rates. In general, we’re very conservative. We use HUD debt, which manages risk because it is insured by the Federal Housing Administration and is non-recourse and fully assumable. But it is only available to managers or sponsors that have stellar credit histories. On two of our Qualified Opportunity Zone projects, we have 30-year fixed rates of less than 4%. Forth at Navigation in Houston and the Rosie in Chicago are both in the process of getting HUD debt.
Q4. How does Origin minimize risk and loss amid rising interest rates?
When Origin underwrites multifamily development, our real estate underwriting models assume higher interest rates and cap rates. We hold fixed-rate debt and hedge interest rates. We manage risk internally. But above all, we add value with build-to-core, ground-up development. It might be counterintuitive to think that new construction is less risky, but when cap rates and interest rates rise, a core property cannot add value. In developing from the ground up, if margins are 35% or 40% and the economy turns around, it might shrink the margin to 10%. That means you’re just making less money. But any decline in an existing core property hurts equity considerably. This is why existing properties are more susceptible to rising interest rates than ground-up development.
Q5. Why are older multifamily assets being priced above replacement cost?
Replacement cost may not reflect prices, but it does help predict a project’s viability. A 20-year-old multifamily property now may trade above replacement value, but multifamily investors won’t want to own a 20-year-old property at $300,000 a unit when they can build new at $280,000 a unit. The distortions in the market are not rational. You have newer properties that are five years old that are trading 20% to 40% above replacement cost. What we know about distortions is that they work themselves out and the market normalizes. Replacement costs are subject to gravity: Eventually they come down to earth. This is why we are not doing value-add, we are not doing core-plus, we’re not buying existing properties right now. We’re building.
Q6. Is a correlated downturn possible across public financial instruments and private real estate?
Real estate is not immune to a downturn. But we have one thing going for us that’s truly unique. The biggest input into the consumer price index is the cost of housing, which is measured as rental costs. The CPI is rising partly because rents are rising. And in our case, our rents are going up quickly. Until that stops, we have incredibly sound fundamentals. Tenants have to delay home purchases because of rising interest rates. The price of housing for sale went up significantly, then the cost of borrowing has gone up in 2022 from 3.5% to over 5.25%. Private real estate fundamentals keep getting stronger. Hard assets are good inflation hedges, and a building is an amalgamation of hard assets such as lumber, concrete, steel and so on.
In 2021, the 22% return in the IncomePlus fund proved the strategies worked. This year might be more difficult, but risk management will make a huge difference. We’re defensively positioned by the 40% margin in construction and the capital structure protection in preferred equity.
Q7. How are rising labor costs, maintenance, capital expenditures and property taxes impacting Fund returns?
This is really a question about the impact of inflation today. Construction costs—lumber, steel, labor—have gone up over the past two years on average around 40%. A building priced and built for $50 million two years ago now costs $70 million. But rents in some markets are up $300 to $500 per month. A 300-unit building may cost $20 million more to build, but the value of $400 more in rent has exceeded $30 million. So the spreads have maintained significant margins despite rising construction costs. If you want to beat inflation, you have to be in the assets that are creating inflation. In five years, today’s prices will look cheap; replacement costs just continue to go up.
Q8. How is Origin addressing supply chain issues and labor and material costs?
Our real estate underwriting models assume inflation factors that would have been perceived as quite high three to five years ago. For example, operating costs are a huge component of future net operating income. We are increasing operating costs 4% to 6% a year. Also, we are putting an additional 1.5% per month contingency in our construction budgets, buying lumber to lock in prices and getting guaranteed maximum price (GMP) contracts faster to lock in labor costs. And on the ground, we’re trying to figure out ways to get GMP contracts faster and lock in prices. We want to lock input prices of commodities as well.
And then we have to consider: How do you store it? What are the extra labor costs of moving lumber twice? What’s the warranty issue of holding lumber for months longer than normal? You really get into the weeds quickly, but the weeds matter. There’s no way you can predict or hedge costs unless you’re actively buying or dealing with those costs, which we are. So, investors should be concerned about input costs and supply chains and need to ask asset managers what they’re actually doing to mitigate these issues. We build a huge margin and preserve the margin by controlling the uncontrollables.
Q9. If inflation spins out of control, would the government reestablish wage and price controls as in the 1970s?
If rents are driving inflation, California, Illinois or New York might consider rent stabilization but rent caps would be unlikely where we invest. Do you really think rent control is an option in Texas? We focus on pro-business, pro-growth states like Georgia, Florida and the Carolinas. More often, we see economic incentives being extended to multifamily developers to build more affordable housing.
But this idea of the impact of inflation is circular. Rents are driving up that inflation. If you’re in the right locations and cities, you’ll benefit from that growth. Multifamily has been the highest-returning, lowest standard deviation real estate property type for 30 years. Few investments are as well shielded from disruption as multifamily. In 50 years, I’m not sure we’ll work, shop or entertain ourselves the same way, but I am sure that everybody will still need a place to live.
Q10. How do you use swaps and swaptions? What’s the downside of using derivatives?
In the case of swaps (which is explained in question 3), there is no downside in the sense that we’re fixing an interest rate that should be fixed. Swaps typically hedge cash flow during construction. If we were to lose on higher cash flow, we’d be winning on lower borrowing costs. Swaptions are an insurance policy or option, so you are paying premium. The downside would be if it expires worthless and you paid a premium for a hedge that didn’t work. We made a lot of money on swaptions, but the inverse is that borrowing costs are higher.
Q11. How do private multifamily valuations compare to public multifamily valuations?
We follow apartment REITs in our markets such as MAA and Camden Property Trust as a leading indicator of multifamily property valuations in the public market. The public REIT equivalent cap rate right now is about 4.8%. That’s not necessarily where cap rates are going, because a public REIT is not a piece of real estate, it’s an operating company. A public REIT must amortize tens of millions of dollars and it has administrative expenses, so 4.8% can look more like a 3% return to investors.
Private multifamily cap rates are now 4% to 8%. That’s lower than they were at the end of 2021, when there would have been 20 bidders on a property. Now there may be two to three bidders, and almost every deal put under contract this year has fallen through or the buyer comes back and tries to negotiate for less. Sellers want last year’s pricing, and that doesn’t exist. Enormous returns are still out there, but those true outlier buys, the sub-3% cap rate stuff, that’s over. So, to some extent, the public REITs are reflecting the private markets with lower cap rates and repricing.
Q12. As an investor, how can I assess risk in equity deals?
First, if you want to look at a deal and make an educated decision, you need to do the underwriting. Run the numbers and take a hard look at the results. But to do this, you need grounding not only in finance but also rent growth, competition, return on equity, cost of debt and all the other idiosyncratic inputs of a business model that takes all these variables into account. Once you do that, you can ask: Are cap rates trending rents? What’s the cap rate drift? What’s the return on equity and spend? What’s the cost of debt? Is the model achievable? What are the returns?
Unless you’re an expert in property underwriting, how can you possibly know all of that? To invest on a deal-by-deal basis, hiring a consultant would be a really good use of money. If you put $1 million into a deal, spend $5,000 on advice from someone who understands real estate inside out.