In the wake of COVID-19, commercial real estate has been dramatically impacted by whether or not the tenants were designated as “essential” and if the tenant was able to continue generating income or revenue in a COVID economy.
In most states, even as construction and development were deemed essential businesses, construction starts plunged 22% below the first half of 2019, with commercial and multifamily construction starts in the top 20 metropolitan areas dropping 22% in the first six months of 2020. Multifamily developers in the earliest stages of their project struggled to obtain permits and faced construction delays, stoppages, and potentially shrinking rates of return.
Additionally, the lending market was effectively frozen from March to June. Even high-quality In commercial real estate, the sponsor is an individual or company in charge of finding, acquiring and managing the real estate property on behalf of the partnership. The sponsor is usually expected to invest anywhere from 5-20% of the total required equity capital. They are then responsible for raising the remaining funds and acquiring and managing the investment property’s day-to-day... More with common-sense projects–those with strong business plans and demonstrated market demand–struggled to secure a lender term sheet, creating additional headwinds on new construction. Many of the development projects our Investments team reviewed and ultimately rejected over the last few months could not produce those lender commitments.
On the flip side, thanks to reduced labor costs and volatile material costs (depending on the material), U.S. construction costs are expected to decline 2% to 5% on average in 2020, a sharp turnaround from the escalating prices over the last few years. Lower construction costs can lower the overall development cost, further increasing a project’s potential rate of return.
As we noted in our Investment Thesis, “We like the prospects of ground-up multifamily development projects already in progress in key markets, especially those projects that will deliver late in 2021 or 2022. Further entitlements for new developments will be greatly muted over the next 12 months, meaning fewer competitors when those projects that are already-in-motion hit the market.”
What’s Driving the Demand for Multifamily
Multifamily development has been in an expansionary phase for several years, driven by the growth of millennials moving towards rentership versus homeownership–the U.S. Census Bureau estimates that 65% of Americans under the age of 35 currently rent. And although 92% of millennials consider homeownership a good investment, 48% of young adults say they have to delay buying a home because of their student loans. This means they are living in multifamily properties for the foreseeable future.
However, the number of new apartments that developers will build over the next few years might be less than half of what was started in the years immediately prior to the pandemic, according to Greg Willett, chief economist for RealPage Inc. In Denver, developers broke ground on 16 projects between January and May, considerably lower than the same period last year. In Austin, the number of units dropped by nearly 1,800 in the same time. But Austin has one of the fastest-growing populations in the country, and Denver’s multifamily market is under pressure from its long-running demographic and economic expansion.
Other 18-hour metros with similar growth rates are also likely to suffer from a constrained supply in the near future.
How We’re Evaluating Ground-Up Multifamily Development Deals
The In commercial real estate, the sponsor is an individual or company in charge of finding, acquiring and managing the real estate property on behalf of the partnership. The sponsor is usually expected to invest anywhere from 5-20% of the total required equity capital. They are then responsible for raising the remaining funds and acquiring and managing the investment property’s day-to-day... More: Now, more than ever, sponsorship is key. Tenured & Enterprise sponsors who survived The Great Recession understand how to manage their businesses through a downturn. We’re looking for sponsors with experience in multifamily development during a downturn–not just management–and those with the local knowledge to understand the wants and needs of the market.
The loan status: If a sponsor is one of the lucky few who have been able to get entitled and a lender on board, they can construct during the downturn–taking advantage of decreasing construction costs–and begin to lease-up in 2-3 years with less competition.
The metro: While the economic impacts of COVID are hitting every city, we believe that those metros with strong demographic and economic growth pre-COVID should continue those trends thereafter.
The development risk: The opportunity to earn a significant profit is one reason why investors and developers pursue and take on the risks of development deals. The typical profit margin falls anywhere between 15%-25% and development projects often target higher returns to justify the added risk to investors. If the sponsor can build to a Yield on Cost (projected Net operating income (NOI) equals all revenue from the property minus all operating expenses. In addition to rent, a property might generate revenue from parking and/or service fees such as laundry, housecleaning services, pet rent, and more. Operating expenses include the costs of running and maintaining the building and its grounds, including insurance, property management fees, legal fees, utilities, property... More of the property, divided by the total development costs) of 7.5% and sell at an Exit Cap (the projected sale price divided by stabilized Net operating income (NOI) equals all revenue from the property minus all operating expenses. In addition to rent, a property might generate revenue from parking and/or service fees such as laundry, housecleaning services, pet rent, and more. Operating expenses include the costs of running and maintaining the building and its grounds, including insurance, property management fees, legal fees, utilities, property... More) of 6.0%, they can create a lot of value for investors, helping offset the potential risk.
What Are Renters Going to Do Next?
Pew Research Center recently reported that around one-in-five U.S. adults (22%) say they either changed their residence due to the pandemic or know someone who did. Some had to move out of college dorms that abruptly closed, left “hot spot” communities, or downsized from housing they can no longer afford. And still others realized that home can be anywhere when you’re working from home, and are moving to smaller cities with lower rents and home prices. Axios reported that “39% of urban dwellers said the COVID-19 crisis has prompted them to consider leaving for a less crowded place.”
What Do Investors Need To Understand?
We expect that more and more renters will be looking to migrate to 18-hour cities over the coming months, looking for more space at lower costs. We believe that ground-up multifamily projects that hit the market next summer and into 2022 will be uniquely positioned to reap the benefits of strong demand and low competition.