3 Strategies I Use to Succeed in a Cooling Multifamily (or Any) Market

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In a previous post, I discussed the possibility that the multifamily frenzy we’ve experienced over the past seven years may be cooling off. So, a lot of investors may be wondering about the best strategies to employ in the event that this little slowdown turns into a full blown downturn.

My strategy for multifamily investing in a downturn is the same as my strategy for investing any time.

Though there are many components to an investment strategy, I’d like to point out three strategic aspects that guide my thinking and our firm’s policy.

These strategic components are not necessary for any multifamily project to work. There are a lot of ways to make (and lose) a lot of money using a variety of multifamily buying and operating strategies. People have made a killing developing new multifamily assets, buying class C assets with momentum plays, and combining neighboring assets.

But I like the following three strategies because they have stood the test of time in a variety of economic upturns and downturns. And as we’ll see in a moment, the early effects of a softening in multifamily are adversely affecting some operators who depend on other strategies.

To give you a bit of context, my firm focuses on acquiring and operating commercial grade (100+ units) class B (20 to 50 years old in general) garden style (not high-rise) multifamily assets in large and growing cities.

Operators in other niches may benefit from these strategies, too. Even a new apartment developer can implement strategies #2 and #3 in their operations.

Three of our key strategies are:

1. Acquire value-add opportunities.
2. Buy for cash flow. Aim for appreciation as a bonus.
3. Cater to renters-by-necessity.

3 Strategies I Use to Succeed in a Cooling Multifamily (or Any) Market

1. Acquire value-add opportunities.

As I discussed in a previous article, it’s important to have some buffer in the event of lower rent growth and appreciation. Buying mismanaged, under-marketed, and value-add multifamily assets can provide this opportunity.

Though I haven’t seen this definition anywhere, the simplest way I can quickly explain the value-add opportunity is: buying an asset that has a given, known return (return on investment a.k.a. ROI) and meaningfully improving some aspect of the property in a way that the ROI on the improvements is much higher than the ROI on the asset as a whole. This meaningfully raises the blended average ROI on the entire project.

Here’s a simple example.

My company just acquired a 125-unit townhome community in Lexington, Kentucky. During the first week of evaluating this purchase, we noticed that the water and sewer bills were very high. The owner was eating that cost. Neighboring properties (our comps) charge tenants the full cost of water and sewer, plus other utilities.

One of our earliest steps in the due diligence process was bringing in a utilities consultant. This firm confirmed that the water bill was 110% higher than it should have been. (Yes, over double.) This amounts to about $60,000 per year, which is roughly 10% of the asset’s net income.

This could be due to a lot of tenant waste (“It’s not my bill”), but it is certainly more than that. There must be leaks in the system. In fact, we learned that the pool water level drops about six inches daily all season. (“We just fill ‘er back up everyday.”)

Related: How to Invest in Property When You Fear a Housing Bubble

The solution starts with installing individual water meters for every unit and the common areas. These web-interfacing units will allow us to identify the source of the problem(s) within weeks. And they will give us the opportunity to start billing back tenants for water and sewer if we choose to at some point (we will).

The cost of water and sewer meters is about $65,000, so a $60,000 annual cost reduction is a 92% ROI if we can achieve those savings. Not bad.

We also learned that we can install programmable thermostats at the same time (economies of scale since they share one router) for only about $12,000. This is a nice upgrade for green-conscious tenants. But it also provides us with an opportunity to bill tenants for gas usage (by using an established formula calculating temperatures, etc.).

If we choose to bill tenants back for gas, the savings should be an additional $27,000 or so annually. The ROI on this is over 200% annually ($27,000 ÷ $12,000).

Note that by spending the $77,000 to make these changes, we are theoretically achieving an increased asset value of a whopping $1,240,000.

Wait… what?

It’s simple. The value of a commercial multifamily asset is calculated by dividing the NOI by the cap rate. Assuming a 7% cap rate, we divide the annual utility savings ($87,000) by the cap rate (0.07) to achieve this result.

This is another reason I—and many others—love commercial multifamily. You can often “force appreciation” through simple changes (as opposed to residential real estate that is valued largely on comps).

These are two quick examples of value-add upgrades from my world. Note that many value-adds are achieved by upgrading interiors and increasing rents and other income.

2. Buy for cash flow. Aim for appreciation as a bonus.

Real estate investors who bought for appreciation before the last downturn often got burned. When rents flattened, values plummeted, and ARM mortgage interest rates rose, millions of single family homeowners went to foreclosure. Some multifamily owners faced the same fate.

Those who bought with an eye to cash flow—and particularly those investing for the long-term—typically fared better. Many rode out the downturn and gobbled up more properties. Those investors are sitting pretty right now.

Rod Khleif, an experienced investor from Florida, was on my podcast. He told his tale of growing his net worth by $30 million in just one year (2006)—then watching it plummet by $50 million the following year. He eventually lost his portfolio of 800 Florida single family and multifamily properties to the bank.

What happened? Rod told me that his multifamily assets fared quite well during the downturn and would have survived. But he acquired his single family rentals with an eye toward continuing appreciation. Staggering appreciation.

Well, not an eye toward it. He was depending on it. Cash flow was a nice thing to have, but hey, his net worth was swelling like the national debt.

And so was his head (Rod’s own words).

Refinancing or selling properties was a critical part of Rod’s strategy.

Then the bubble burst. Values dropped by about 50%, he was underwater, and the banks were knocking on his door. Though Rod said his multifamily assets were still cash-flowing, his assets were cross-collateralized, and he lost everything.

Investing in multifamily assets for cash is perhaps the very best way to guarantee this won’t happen to you. Still, history shows us that investing prudently, with reasonable loan-to-value debt, in a great location will protect your assets.

There’s one more strategy that will help ensure the safety of your real estate investments.

3. Cater to renters-by-necessity.

There is a difference between catering to “lifestyle” tenants and “renter-by-necessity” tenants. Most multifamily investors I know, including my firm, cater to the latter.

Lifestyle tenants are those who can afford to rent or buy. They are often the tenants renting the luxury high-dollar apartments with impressive amenities like specialized laundry services and on-site restaurants. (I’ve heard that some even serve semi-boneless ham.)

Real estate investor Clayton Morris recently spoke about his $3,900 per month New York apartment with a Whole Foods on the street level. He shopped and ate many of his meals without leaving his building. They also provided all laundry services and two pools—one indoor, another outdoor.

Rent-by-necessity tenants, also known as “workforce housing” tenants, often rent because that is their only option—or at least their best option.

Investors catering to this class will often target class B or C apartment communities. These assets often provide steady cash flow and predictable appreciation.

Check out this data from Yardi Matrix.

On a national level (all cities included), overall annual rents increased 2.8% through October 2017. Renter-by-necessity rates grew at a respectable 4.1% in that period. Lifestyle rents grew at only 1.7%, dragging the average down to the 2.8% increase reported.

Related: Rents Dip Below Inflation, Home Appreciation Slows: Are Markets Cooling Off?

Catering to either class is fine, as long as you know the differing risks involved.

Think about catering to lifestyle tenants. It typically involves new development. It can take a year or more to locate land, then two years or so to draw up plans, take bids, and get zoning approval. Then one or two more years to build, and another year or so to lease up.

A lot can happen in that time period. Not only will the economy change, but tenant preferences can shift a developer’s business plan.

Developers catering to lifestyle tenants typically win big—or lose their shirts. I used to enjoy that type of speculation, but I’m long past that now. That is a younger and/or richer man’s game.

Compare this to targeting renters-by-necessity. Think about it in terms of both the tenants and the asset.

The tenants in workforce housing are not depending on large bonuses, commissions, or tech firm liquidity events to afford their monthly rent. They don’t have options to scale up or down in amenities, location, or rent. They are often limited in where they can live and what they can pay.

But this stability, this predictability, gives workforce housing owner/investors an advantage over the luxury/lifestyle operator.

What about the asset itself? As a buyer of a generally stabilized class B multifamily asset, I’m not waiting on zoning, design, bids, or construction. I’m not betting on the latest trends or demands for amenities and style. The asset is typically occupied, with a steady stream of cash already being generated the day the buyer acquires it.

The buyer and his investors won’t typically see a 25% IRR. But they will be able to sleep at night knowing that they’ve invested in a stable, predictable asset with decades of solid demographics backing it up.

Downturn schmownturn. I, for one, have no plans to deviate from my course. Not in this market or any other.

What about you?

Hopefully you’re on a multifamily course that will prosper during good times and bad, too. Tell us what you plan to do differently if this multifamily softening turns into a downturn.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.