The way that COVID-19 has exposed multifamily property investors makes me think of Warren Buffett saying: “Only when the tide drops out do you figure out who has been swimming nude.” Investors are not to blame if a pandemic prediction is incorrect. After all, even experienced investors were unprepared for the economic collapse. They had profited from the expansion of the economy. Investors in multifamily apartments have learned some difficult lessons from the COVID-19 debacle.
Multifamily housing deceives investors into believing they are more secure than any other sort of investment. For instance, when asked to evaluate and manage a biotech company, potential investors would likely respond, “I can’t—I don’t know anything about it,” but when the topic of multifamily housing is brought up, everyone assumes they can purchase and manage a few properties. We have all lived in homes or apartments at some point. Everyone assumes they can do well and that it is simple since they have “been there, done that.”
Even with a lot of expertise, it can be challenging to manage multifamily buildings well. Securing the appropriate funding, implementing upgrades, daily asset management, and tenant retention are all complex tasks that require competence to do in order to turn properties into lucrative enterprises. You have to cope with several legal issues and intricate debt arrangements. The largest flaw in the procedure that investors miss is that they don’t value their time in the calculation, and it takes up a ridiculous amount of time.
Since the previous real estate downturn, multifamily housing has prospered and drawn many immigrants and do-it-yourself investors. While apartments have historically generated solid profits, landlords will need considerably more competence, not to mention substantial innovation in developing and implementing new methods, to prosper in the current economy and the inevitable stretch of widespread misery to come. It will be difficult for many owners to bargain their way out of a flawed business strategy as an increasing number of properties are in danger.
In both rich and poor markets, direct investors make expensive errors. The COVID-19 shutdown, however, has made some of the most difficult decisions more apparent than ever, and many investors risk losing their investments due to poor business strategies. Investors in multifamily housing have committed four significant errors that will have an impact on the health of their buildings when the commercial real estate sector shifts its attention to recovering from the epidemic. They are as follows:
Loan Risk: Putting a Lot of Money into Recourse Debt
Debt repayment becomes harder as vacancy rates rise and rentals decline. The cash flow situation will worsen. For a variety of reasons, a direct investor could lose a property. Undoubtedly unaware of it, one of my friends still reduced his margin for error. He took on recourse debt, which implies he is risking more than his equity in the home. The bank has the right to go after his assets if he doesn’t repay the debt.
The greatest private equity real estate businesses, like experienced multifamily investors, manage their risk. They set up distinct businesses to acquire and manage each property, invest the maximum amount of stock in each transaction, and solely use the collateral of the actual property as security. They do not cross-collateralize or jointly guarantee many debts with the same assets, and they agree to nonrecourse loans that do not subject the partners to personal liability for repayment.
The asset itself serves as the only form of security for nonrecourse loans. In an emergency, a direct investor with nonrecourse debt has negotiating power. Banks found themselves in the position of owning and maintaining substantial portfolios of foreclosed properties ten years ago, at the depths of the real estate slump. Since foreclosure would be costly to the bank in terms of time and money, borrowers may be able to renegotiate loan conditions or even purchase back the debt for less than they owe. That isn’t a choice with recourse debt. Forbearance is not something the bank is motivated to do. The borrower may still be pursued if the foreclosure process does not satisfy the obligation.
When a recourse loan was provided to my acquaintance, he was unaware of this, but a lender who insisted on these borrowing conditions must have understood the danger he was accepting. He was overpaying, providing insufficient equity, or purchasing a home with little chance of appreciation. Or perhaps the lender merely saw that he was embarking on a side endeavor without precedent. Nonrecourse loans will not only be sought after by seasoned investors or private equity real estate managers, but they will also be available at competitive rates. The bank is treated as a partner by an experienced real estate asset manager. Regular status updates are sent to lenders without their request. Asset managers for real estate build trust that gives them wiggle room in a crisis. They provide the lender with peace of mind that their money is in capable hands, allowing them to negotiate the finest loan conditions.
Concentration Risk: Disregarding Proper Preparation
Self-directed real estate investors, whether through direct investing or real estate asset management, frequently invest an excessive amount of their net worth in one or two transactions. There is a limited margin for error when risk is concentrated on one property, and even small issues can have significant effects.
Another acquaintance of mine purchased a partially completed complex during the housing slump of 2008. Although the pricing was reasonable, he lacked any development experience. Seventy percent of his total worth was used to complete the project, which cost up to three times what he paid. That type of risk is unworthy of any asset. An investor would only think about it in real estate investing. Investing in numerous asset classes and properties is a more practical way to diversify, preventing the devastation of a complete investment portfolio by a single bad property.
The amount of cash flow needed can vary depending on age and investing objectives, such as saving for children’s college expenses, retirement income, or estate planning, but I think real estate should make up 15% to 30% of a portfolio. A real estate investment should also maintain roughly 30% of its value in liquid assets like REITs. It equates to about 10% in REITs and 15% in real estate private equity for investors who have 25% of their net worth in real estate. However, diversification in that 15% of the investment made for the long run is as crucial. At least ten transactions should be funded by a private real estate allocation, spread across many locations and diverse property types, such as multifamily housing and mixed-use buildings.
Instead, what frequently occurs is that a group of friends will pool their resources to make a single investment, spending more than any sensible plan would suggest. Naturally, the project calls for more stock, and not all of the partners are now flush with cash. The cycle continues, and the partner with the strongest balance sheet ends up contributing the most stock and taking on the most risk—possibly at the expense of making friends—in the end.
Operation Risk: Taking a go at both hiring’s and keeping employees
Millions of renters’ financial situations have been impacted by lockdowns. In the upcoming year, people will have to make difficult decisions regarding the value they receive for their rent, whether they are renting four walls in a boring suburb or a Class A luxury complex in a trendy area. Tenants in offices and factories experience the same disturbances.
Tenant retention and filling open positions will face intense competition. Virtual leasing, with a visually appealing website and video tours, has become a regular practice after a prolonged period of social estrangement. Operators should not only conduct a thorough examination of the competitive market but also conduct a covert audit of their assets and their rivals. The operator must have sufficient knowledge of occupancy, rentals, and costs to assess and oversee the performance of anybody else doing that duty, whether it is a superintendent, leasing agency, or multifamily property management business.
A key differentiation will be the quality of the tenants’ services and experiences. It takes more than just collecting rent by visiting the property once a month to develop personal ties with renters. No matter what additional difficulties they encounter, the operator must foresee their requirements, address their complaints right away, and foster an environment where renters will want to persevere.
The main players who have the resources, staff, and knowledge to meet new demands will benefit from the COVID-19 recovery. The only issue left is: am I keeping up? It applies to direct investors and real estate asset managers, regardless of the degree of service or rent. Is it possible for me to acquire, display, and maintain a clean, secure space that provides value to the renter, in the same way, experienced owners in this business do?
Time Risk: Shortening an Investor’s Engagement
What could go wrong with an investment in multifamily housing? As it turns out, quite a lot. Investors who previously believed they were generating passive income now need to move quickly to address or prevent unforeseen problems. The notion that multifamily buildings manage themselves is ridiculous. Asset management and asset acquisition take time, as does even the due diligence required to oversee such duties. Miscalculations might have disastrous effects during a crisis.
As I said above, no one chooses to purchase a biotech company to operate on the side. Most individuals wouldn’t have an understanding of how to assess the company, the cost, or the operations. Yet so many investors feel at ease making real estate investments without considering the potential cost of devoting time away from their pursuits or the expense of competing with the full-time specialists employed by the real estate business.
A family member is a good example. She is 78 years old, resides overseas, and is seriously considering purchasing real estate in Florida. She told me, “I believe it’s a fantastic bargain. I have this guy who finds the properties and handles them, so it’s not too hard,” but if I were her, I’d want the information on paper so I’d know it’s a good deal. Even so, it’s difficult to think that a multimillionaire real estate private equity manager would be more beneficial to her than her person in Florida.
This perspective is perplexing given how successful the best real estate asset managers are. All an investor needed to do was purchase shares of multifamily housing REITs, which have more than tripled their value over the past ten years. Direct investors must be responsible for their actions if they value their time. What else might they do to get greater results than merely investing in assets that are professionally managed?
Investing Isn’t for the Inexperienced
Put all of your financial eggs in one basket and monitor them carefully, the industrialist Andrew Carnegie told students of finance. However, he made the point that inexperienced people shouldn’t invest. It takes time and knowledge to comprehend and effectively handle them. Real estate has been a wonderful investment during the last ten years, and many do-it-yourselfers have prospered. Investors who still think they can outsmart the pros in the post-COVID-19 era can only hope their good fortune continues.
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