In 2017, we launched MogulREIT II, our multifamily focused Real Estate Investment Trust (“REIT”) which has the objectives to realize capital appreciation in the value of our investments over the long term, and to pay attractive and stable cash distributions to stockholders. By the time we launched MogulREIT II, we had invested over $300,000,000 in commercial real estate and had reviewed thousands of real estate transactions across different US markets and multiple asset classes. It is our belief, after reviewing these CRE transactions in this stage of the real estate investment cycle, acquiring multifamily assets in secondary markets with a value-add component may provide attractive risk-adjusted returns. The following article will share how we came to this conclusion, but first a quick primer on “what is value-add multifamily” as an investment strategy.
In any given market there are typically a variety of housing options including trailer parks, single family homes, apartment buildings (from government subsidized to class A, B, and C), senior housing, and student housing. At RealtyMogul, we have analyzed or invested in each of these sub-asset types and have found that there is growing demand in many markets for Class B and C multifamily.
At its core, commercial real estate investing is a study in macroeconomics: if there is insufficient supply, but demand, then asset prices tend to go up. In some markets, asset prices have already risen. For example, in major metropolitan markets like San Francisco, the prices of apartment buildings are so high that despite high rents, the properties provide only minimal yield (3-4%) to owners/investors.¹ We are seeing rent prices that are so high that they get capped out by affordability, and sometimes even start to fall.² If the average rent for a 2 bedroom in San Francisco is $4,377,³ and the median household income is $77,734,⁴ then more than 2/3rds of that household’s income goes towards rent. With this unequal growth in rent prices vs. median household income, renters in the market may start to look to alternatives like moving further away or seeking roommates.⁵ Rents grew in 54 of the top 100 cities in the US in 2018, with 25 showing modest gains and only 28 cities falling.⁶ This is due in large part to the robust economy, where job growth remains steady and the unemployment rate is at or near all-time lows as of Q4 2018.⁷
At RealtyMogul we analyze market data to determine which markets have property values where rents are affordable and projected to grow. We believe there are still many markets in the United States that have job growth, population growth, and income growth – all factors that support rent growth and high occupancy. But value-add properties do not only rely upon continued rent growth. The properties are bought with below-market rents and are brought up to market, which means they do not rely upon rent growth once stabilized. We believe, the key to value-add properties is having local partners in these markets who can find properties to buy that are not being maximized due to poor management or failure of upkeep. This is where opportunities are for investors seeking yield when an operator can purchase an asset in a market that has low rents and/or higher than market vacancy, make capital improvements to the asset, and raise rents while reducing the vacancy to meet the market. This may sound complicated, but we believe there are operators who have strong market knowledge and have executed on similar business plans, refining their process to get a precise understanding of budgets, timing, and expected results. The outcome is to purchase and rehab a property at a total project cost that is lower than purchasing that same asset stabilized or building it from the ground up. Once completed, the rehabbed asset should have similar value as stabilized assets in the market, thereby creating value for investors in that asset.
Here is a quick example of how this works:
Harry buys a 100-unit apartment building that is 92% occupied and renting at 13% below the local market. He puts in improvements of $7,500 per door ($7,500 x 100 units = $750,000 for paint, new carpets, washer/dryer in each unit, a new roof on the building, and improvements to the pool and better landscaping). Harry then “turns” 6 units per month, which means the tenant moves out, Harry’s team fixes up the unit and then increases the rent to the new tenants by 8%. With rents that are still 5% below market, refreshed units, and a more aggressive marketing plan, Harry is able to bring the occupancy to 96%. When Harry bought the asset, it was at a 5.5% capitalization rate, which means his net operating income divided by the purchase price was equal to 5.5%, another way of saying this is his unlevered (no debt) return on his investment was 5.5% at the time of purchase. Meanwhile, stabilized assets in the market were selling at the time at a 6.5% capitalization rate. This means that if you took the average of the comparable sales in the market of stabilized assets using their net operating income and divided it by the sales price, the average would be a 6.5% unlevered return.
Stabilized operators use capitalization rates to set prices in a market because as a commodity, similar apartment buildings should all sell at basically the same price, all things being equal. Stabilized assets are those that are renting at market and have occupancy rates that meet the market average, so there is very little an operator can do but hold them for cash flow, and if they buy the asset all cash they will get a 6.5% return. But the value-add properties aren’t equal to other assets in the market. They are under-performing, need work and therefore should be purchased at a discount to the stabilized assets. The discount provided on the subject gave Harry an opportunity because after he successfully completed his business plan, the net operating income of the updated and stabilized asset divided by the total project cost (which is his asset purchase price plus rehab budget), is a 7.25% capitalization rate. When other assets in the market are earning a 6.5% unlevered return on their investment, Harry is getting 7.25% – due to the risk and effort of creating value for the asset with his rehab plan. (This example is strictly illustrative and not intended to be indicative of any future performance)
MogulREIT II works with operators like Harry to provide the equity capital needed to execute their business plans for value-add multifamily properties. Listed below are a few things to consider about value-add investing through a REIT.
1. Potentially Lower Cash Flow to Start
It is important for value-add investors to note that it can take time to add value, which can mean some delayed gratification when it comes to receiving potential distributions. Operators of stabilized real estate typically make distributions on a quarterly basis and may wait at least one quarter to make the first distribution to investors because they may need to get a better understanding of the actual expenses of the asset. Distributions are made to investors from available cash flow, but the operator of a value-add project is putting money into the property to increase the value. Typically, value-add operators may make minimal distributions, if any, until the asset has been stabilized or, at the very least, the business plan is going according to projections. Typically, the value-add operator’s business plan is to provide potential distributions in the future once they increase the value of the asset.
As noted in the above example, assuming no debt is put on the property, Harry’s investors would get a 5.5% return if he bought the asset and did no improvements and didn’t increase rents. The return would be 6.5% if Harry bought a stabilized asset in the market that had market rents and market vacancy, and 7.25% if Harry is able to successfully complete his business plan post renovation and stabilization. Because it takes some time to execute the business plan, Harry’s investors may receive fewer up-front distributions with the hope of receiving more potential distributions in the future. Patience in the near term is required with value-add investing, in the hopes of greater returns in the long term.
2. Appreciation For Value-Add Properties Could Exceed Stabilized Assets Because Value is Being Created
When investing equity in commercial real estate, the benefit is not only the potential to receive cash flow from tenants during the hold period but also the potential for a share of profit due to appreciation at the time of sale. When buying stabilized assets, the rate of appreciation is typically underwritten as a steady, annual gradual increase depending on the state of the real estate market generally, and that appreciation compounds annually. Value-add assets, however, may have room for a spurt of growth as the properties are being improved at an overall price that is targeted to be lower than market values. If in Harry’s example he has created the value of a 7.25% cap rate asset in a market that is selling assets at 6.5%, he could sell his asset at 6.5% and achieve a 0.75% cap rate premium on the sale. MogulREIT II invests in operators like Harry and therefore may share in some of these profits as well. Here is an example of how a stabilized asset versus a value-add asset may fare comparatively in upside and downside scenarios. (This example is strictly illustrative and not intended to be indicative of any future performance)
3. MogulREIT II Offers Diversification of Markets, Business Plans, and Operators
When investing in a single value-add asset, one of the risks is that the operator does not execute the plan on time or on budget and that the operator could actually end up paying more for the asset than if they had purchased a stabilized apartment building. Underwriting and vetting the right partner limits the risk of this occurring and investing through a portfolio of value-add investments may provide diversification. MogulREIT II’s strategy is to invest in value-add apartment buildings throughout the United States, with different local operators who know their markets and have executed upon similar business plans before. MogulREIT II can also invest in different types of projects with varying degrees of scope. Some business plans use the cash flow of the property to fund the rehab over time, which may have a minimal impact to cash flow and potential distributions but may not result in a bump to rents or overall property value. Other business plans may have a plan to improve not just the internal units but to do a complete overhaul of the exterior, which may result in a need to capitalize the expenses up front and consider a longer period of downtime for the building. This may result in an extended period without potential distributions to investors with the business plan to have a greater impact on the overall value of the asset over time. This REIT’s strategy is to find different projects with different degrees of work required so that the portfolio may be balanced with a diversified mix of both potential cash-flowing and appreciating assets.
4. Market Growth is Critical to Success
One of the important aspects of investing in value-add apartment opportunities is to ensure the market supports the improvement to the building and the corresponding increases in monthly and annual rent for the apartments. We believe local operators have a finger on the pulse of the market and are close to the trends that can help make a property successful. Different markets may have different needs, and the successful apartment operator may understand and capitalize on those needs to ensure their projects are successful. For example, a Class C project in one area of the market may be nestled among other Class B assets (nicer quality and higher rents), and therefore be a great target for a value-add business plan that may bring it closer in quality to the assets in its market. Alternatively, a Class C asset that is in an area where there are few high paying jobs may not support a business plan that may increase rents to be unaffordable to most local residents. Knowing neighborhoods and local markets at such a granular level we believe is critical to successful investing in secondary market multifamily assets.
With many new data sources available to track macro and microeconomic trends, we believe it is important to identify and analyze those markets where the rate of growth is still poised to likely occur. Looking at the REIS / Freddie Mac rent growth data by market for 2016 and 2017, markets like New York, Orange County and Los Angeles enjoyed the greatest rent growth from 2000-2007, whereas markets like Colorado Springs, Dallas, Ft. Worth, Nashville, Seattle and Sacramento had far better rent growth in 2017 than New York.
Real estate experts see that there are still pockets of the country that have investment opportunities due to continued job and income growth, and while many in these markets may choose to buy homes, the trends underscore that millennials and retiring baby boomers are increasingly choosing to rent.⁸ For example, we have found opportunities in some of the Texas markets, where job growth trends support increases in multifamily occupancy and rental rates. We believe this makes Texas an attractive geography to acquire underperforming assets and make capital improvements to meet market demands.
5. Historically Low-Interest Rates Make Multifamily Investing More Attractive
One of the impactful aspects of commercial real estate investing has been the ability to use “leverage” – meaning debt placed on the property – to increase returns. By using leverage, the investors in the deal may receive returns earned on the entire project but are only contributing a small amount of capital and borrowing the rest at a lower fixed cost that does not share in any of the upsides. What has also been true in recent years is that interest rates for borrowing money to purchase multifamily properties have been historically low. The chart below shows a 54-year historical chart for the ten-year treasury note, a popular index used to price loans for multifamily properties. In addition to traditional bank financing, multifamily operators can also turn to government agencies – Fannie Mae, Freddie Mac, or Housing and Urban Development (HUD) to provide financing for multifamily projects across the United States.
One of the results of readily available access to debt capital for multifamily properties is that property prices have remained strong, the market remains robust for sales, and investors can potentially increase their yield by using leverage. For example, Harry buys the 100-unit apartment complex in our example above for $10,000,000 and puts $750,000 into improvements. Once stabilized, Harry gets a loan from a bank for 75% of the project, or about $8,000,000, at a 4.5% interest rate and keeps in the project the remaining $2,750,000 in equity. After the property pays the mortgage, the rest of the cash flow on the entire value of the asset is distributed to the investors, and because the 4.5% rate is less than the return of the project at 7.25%, we have “positive leverage” and the returns to investors are potentially “juiced” (increased exponentially). See below an example comparison chart to show the difference in returns on the same asset, selling at the same price after a 5-year hold both using no debt and using leverage.
6. Positive Tax Treatment is Provided at Both the Property Level and the REIT Level
Commercial real estate has long held a position as an investment type that enjoys favorable tax treatment at the entity level. When a property is purchased, the asset can immediately begin to depreciate certain capital expenses at the asset level. With a value-add project, there are more capital expenses that can be used to offset income at the asset level, and because it is a multifamily asset there is a 27.5-year straight line period, as opposed to 39 years for other commercial real estate property types. As a result, value-add multifamily projects receive beneficial tax treatment at the entity level that is passed on to the investor, in this case, a REIT. The REIT then receives beneficial tax treatment as a pass-through entity, and the 2018 Federal tax reform bill provides a 20% deduction on pass-through income. Because REITs are mandated to distribute at least 90 percent of their income, REITs do not pay taxes on the distributed income. The end result is that because shareholders only have to pay dividends at their individual tax rate, and not the corporate tax rate of the REIT, the 20% pass-through deduction reduces the top tax rate on REIT dividends from 39.6% to 29.6% for a tax-payer in the highest tax bracket, and those shareholders in the lower tax brackets pay even lower rates on the same dividend.⁹
7. Net Asset Value (NAV) is Impacted by Cash Flow, Appreciation or Depreciation
Another factor an investor in a REIT may consider is how investing in a value-add growth strategy, that includes both potential cash flow and appreciation, impacts the net asset value (“NAV”) of the underlying shares of the REIT. As previously discussed, MogulREIT II, with the objectives to realize capital appreciation in the value of our investments over the long term; and to pay attractive and stable cash distributions to stockholders, is a REIT that invests in multifamily value-add projects, and these projects need to complete a business plan to create additional value in the asset. In the early days of a growth REIT, investors may not see the value creation reflected in the shares of the REIT. As a non-traded public REIT, MogulREIT II has set the initial NAV price at $10.00 per share, and this price will not change until the portfolio of assets is established on or before October 1, 2019. Because there are value-add investments that are being made with capital in the REIT, until value is created there may not be an impact to NAV. However, it is possible that once the value is created in the underlying assets that the REIT’s value could increase, and would be reflected in an increase in the price of the NAV. That said, if the property values of the assets in the REIT decline due to market conditions, the NAV could be negatively impacted and would decline in price. If property values decline due to market conditions, value-add strategies that create sweat equity, instead of paid-in equity, may act as a mitigating factor.
While it is getting more challenging to find value-add projects, we believe that this stage of the real estate investment cycle acquiring multifamily assets in secondary markets with a value-add component still may provide attractive risk-adjusted returns. MogulREIT II has emerged as a reliable capital partner to operators nationwide who have demonstrated success in the value-add acquisition strategy and MogulREIT II will continue to follow the trends and invest accordingly.
To get a more general overview of the value-add investment strategy, download our flyer “Value-Add Investing."