Which Real Estate Assets are Struggling Today?

[Ellie Perlman]

The COVID-19 pandemic has caused an upheaval in almost every industry, and that includes real estate. Many real estate investors are scrambling to determine whether their investments will be able to withstand the impact that the pandemic has on the economy. There is no right answer, as there are many different types of real estate investments, including commercial, retail, and multifamily.

While there will certainly be some real estate investments that will have adverse effects due to the pandemic, not all will be struggling. In addition to the type of real estate involved, the location where the investment is located might also play a key role as to whether or not the impact will be more or less severe.

Property Type 1: Those in COVID Hot Zones

You don’t have to be an expert to realize that real estate assets located in pandemic hot zones will not perform well. Originally, the hot zones were located in New York along with cities in the Northeast corridor and the Midwest. Today, those hot zones have shifted (to California for instance), and will continue to shift. However, one thing is clear: many people in the hot zones are moving either to other states, or to the suburbs where it’s less crowded and exposure is minimized.

I like to review reports, and in doing so I found an interesting correlation between last year’s performance and this year’s. One report in particular showed that over the past 12 months, the average return on multifamily properties was around 5%. If you look at markets that were in the hot zone like New York, the average return was around 1%. In Los Angeles, the average return was 3.75%. This shows the correlation between areas that were struggling with COVID-19, and their average returns over the past 12 months. It also shows that you want to avoid investing in assets located in hot zones, because they’re simply not performing that well thanks to the pandemic.

Property Type 2: C and D Asset Classes

The asset classes that are struggling the most right now are Class C and Class D properties. Class A properties are the luxury multifamily properties with all the amenities and are usually new construction or built within the past 7 to 10 years. Class B properties are somewhat older than Class A and may have some deferred maintenance. I like to buy Class B properties, as they’re the ones that we can renovate and upgrade in order to increase rents.

Class C properties are much older, usually built in the ‘60’s, 70’s and 80’s, and are located in areas that are not ideal. Class D properties are the oldest ones and have the most deferred maintenance. They’re often located in areas that are the least desirable, and have trouble attracting tenants.

The reason that Class C and D properties are struggling now are because the tenants are usually employed in the service industries, which have low paying jobs. These are the people who have lost their jobs due to the pandemic and are having the most trouble paying their rent. Currently, Class B are the highest performers, followed by Class A. Only then does Class C show up, followed by Class D as the lowest performing asset.

Property Type 3: Hands-off Sponsors

Even though I live in Southern California, most of the properties I own or manage are located in Texas, Georgia and Florida. Part of our process in managing our assets is to contact the property management company to review reports that include occupancy rates, vacancy rates, rent collections, and other metrics that show how the property is performing. Since COVID-19 began, we’ve been having these talks on almost a daily basis in order to stay on top of our property’s performance.

We’ve found that assets with hands-off sponsors are simply not doing as well as assets that have aggressive sponsors who are in constant contact with their property management companies. By having daily contract with property management companies, we can look at numbers and see when properties are moving in the wrong direction and adjust our approach on the spot, rather than waiting for a period of time to pass. This quick response is what helps to keep our assets performing well. If a sponsor is “hands-off,” it may take time to see that there’s a problem with the numbers, and if too much time elapses, it may be hard to fix the problem.

Property Type 4: Downtown Locations

Other assets that are not performing well in this post-COVID-19 market are those located in downtown areas of large cities or in a very crowded submarket. The reasons is that tenants are concerned about being infected with the virus based on how crowded the market is, and they’re moving in with family and friends in other states or less crowded areas. This eliminates having to share an elevator with 300-500 tenants, minimizing their exposure.

This impacts the properties with reduced rent collections, increased vacancies, and often requires property managers to offer different types of rent concessions and move-in specials in order to attract or retain tenants. That is why these types of properties are not performing well. The more frequently the property is reviewed and implemented with needed intervention, the better the asset will perform.

Property Type 5: Overpriced Properties

The final type of properties that aren’t doing well are those that were overpriced when purchased. Prior to COVID-19 , the market was strong, prices held steady and sponsors were projecting growth to investors. The problem was that prices were driven up by the strong market, and sponsors and their investors were overpaying for properties because there was a shortage of multifamily properties in strong markets. Another reason for overpaying was that many new sponsors wanted to get in on the growth of multifamily properties. They pushed aside running numbers and good judgment and overpaid.

For example, prior to COVID-19, investors were paying $135,000 per door for units that should have sold for $120,000. The sponsor figured that if he or she renovated 10 to 12 units per month and increased the rents by a $200 premium per unit, they would have enough cash flow to pay for the higher prices. But then the pandemic came along and many sponsors and investors found themselves holding on to properties that they overpaid for and realized that they weren’t going to be able to do value-add and renovate their properties in order to justify the premium they had anticipated.

Sponsors who did overpay for multifamily properties before the pandemic hit are finding that they are paying a very large portion of their monthly income to the lender. Those payments don’t leave much money at the end of the month for anything else. Sponsors who overpaid and still anticipated 9% cash-on-cash returns for the year aren’t coming anywhere close to that number.