We’re not going to beat around the bush and get right to the point. Investors will need to adjust to a “new normal” just as real estate operators have been adjusting their operations and underwriting to account for the rapidly rising interest rate environment and a looming recession. This means that investors should expect lower projected returns as well, perhaps in the range of low to mid teen’s IRR for class B & C value add properties, and be comfortable with a longer hold period which is what we’ve typically underwritten for in the first place. No more 20 to 30% IRRs or 2x to 3x EM returns in less than 2 years for a while.
Let’s face it, we experienced (and benefited from) significant rent growth, NOI increases and property appreciation in the past couple of years that were unsustainable. The Fed’s aggressive tightening of monetary policy turned tailwinds into major head-aches, and we’re having to adjust to a more sobering reality. There is currently a sizable disconnect between buyers and sellers and we’re at a standoff to see who blinks first. So far, not many deals are trading hands but conditions are starting to favor buyers as some distressed sellers are having to go to market.
As a reminder we typically review 50+ deals and make offers on 2 or 3 and we are even more conservative today with valuations coming in. To illustrate, we are underwriting to above average exit cap rates (5 to 6%), no to low rent growth (below research projections), agency fixed debt at low leverage (5+ years, LTV < 65%), and with much higher cash reserves, which would naturally dampen expected returns but also reduce overall risk. In fact, investors should be cautious of syndicators still promising very high returns or doing a lot of deals in the current environment.
Even with lower expected returns (but at lower risk), investing in multifamily still projects favorable risk adjusted real returns, and especially when factoring in inflation and tax benefits. While there is the possibility of a return of cap rate compression or refinancing/adding supplemental loan to return capital to investors, none of these favorable outcomes are reflected in our underwriting.
We strongly believe in the long term success of investing in workforce housing and in particular Class B & C multifamily, and will continue to focus on our niche expertise. Some MF operators have pivoted into raising capital for oil and gas projects, ATM machines, car washes, RV parks, industrial flex, or whatever the latest shiny new object is. We are going to double down on what we do best and ride out the rough times and keep earning our stripes.
We appreciate your support and trust in Break of Day Capital to successfully navigate through obstacles, both anticipated and unexpected and be good stewards of our investor’s precious capital. Should you have any questions, please do not hesitate to reach out to Joe at email@example.com.