At Origin, we buy or build multifamily properties that will yield the best possible returns and tax advantages for our investors. These private real estate investments have ranged from core-plus and value-add property to ground-up development that become stabilized assets in our Funds. But in 2021, we decided to focus fully on ground-up development when our research showed it had the greatest potential to realize the highest expected returns. Many of our investors have asked us if this represents a permanent change in our strategy.
The short answer is no. We structure each deal to maximize marketplace fundamentals and profitability. But we’re dealing with multifamily, a property type that has enduring demand. So deciding whether to invest in an existing property and improve it, or build a property from the ground up, is largely dictated by replacement cost analysis. That analysis compares the estimated cost to construct a new building and compares it to the cost to acquire an existing, similar building.
Why Replacement Cost Analysis is Indispensable
Multifamily real estate’s fundamentals roared back from the initial stages of the pandemic and have continued to boom. As well, the shift to hybrid and remote work provides a strong tailwind for residential real estate. But at the same time, economic issues, from rising prices and interest rates to housing shortages and tight supply chains, are making it difficult to buy homes. The advantages for multifamily has been high rent growth, low vacancy rates and increasing demand in virtually every market of the country. Rents rose approximately 17% year over year in August, Real Estate Weekly reported at the time.
Builders are responding to renters’ demand for multifamily housing with ground-up construction—but that takes time. Concurrently, investor demand for multifamily properties has been rising so quickly that a glut of capital is available to invest in existing buildings. Properties that used to sell at or slightly above replacement cost have been trading at 20% to 40% above replacement cost since 2021.
As a rule, you don’t want to buy real estate significantly above its replacement cost. An older building will need significant renovations to meet the same level of finishes, amenities and energy efficiency as a newer building. So, if demand in a market is high enough and replacement cost analysis shows it is profitable to build a new property, that will happen. It’s also the better option for two reasons: Tenants will prefer newer apartments, and the building can eventually be sold at a higher profit margin.
Profits Lower the Risk of Ground-Up Development
Even as valuations on multifamily real estate rose, properties continued to sell. Low interest rates meant investors could still break even: It was possible to borrow at 2.5%, buy a property with a 3.5% cap rate and still get positive leverage. At the same time, inflation was heating up and everyone assumed replacement cost would be even higher in the future.
Today, replacement costs vary but are higher, and so are interest rates at 5% or more. So, if you bought a property at a 3.5% cap rate, unless it sees very high rent growth, owners could face debt payments higher than their cash flow, or massive negative leverage. At the same time, new buildings are expected to continue selling at 20% to 30% above replacement costs. So as developers, we may sell the apartments we are building and stabilizing at a significant profit to the next buyer.
Of course, overall rent growth may eventually start to slow. If this happens, a lot of fund managers and investors will have overpaid for those existing multifamily properties and won’t be able to refinance. This is a plausible scenario in the next 18 months or so. As loans come due, managers will need to produce more equity. Otherwise, lenders may repossess these assets and sell them—likely below replacement costs. While we can’t predict the future, this scenario did take place in many instances from 2012 to 2016.
Market Fundamentals Dictate Multifamily Deal Structure
We have been focusing on ground-up development for two reasons: We’ve been earning 35% to 40% over replacement costs—a robust profit margin—on buildings we have developed. At the same time, we’ve used a capital structure that puts us far down on the capital stack to minimize losses. Our IncomePlus Fund, which focuses on preferred equity and common equity positions, is so protected that returns have only gone up.
When the market shows significant signs of moderation, we’re positioned to do less ground-up development and restructure our deals and business plans accordingly. We can provide preferred equity or buy distressed assets that will yield higher returns for investors in a distressed world.
Ground-up development—the foundation of our Growth Fund IV—has been based on market fundamentals and the replacement cost analysis we do when we underwrite assets. Each deal’s capital structure allows us to respond to changing marketplace fundamentals to maximize the profitability of every asset in our Funds.