Arcan Capital Multifamily Update: The New Normal
Much to the dismay of all Americans, the COVID-19 pandemic has continued throughout the summer months. The case count in the United States has climbed to over 5 million before the end of summer and the ongoing nature of the disease is beginning to make the crisis feel more like a new normal than a temporary crisis. This new normal is also being felt in the multifamily business. Social distancing remains in place and nearly all properties have adopted a new way to operate which minimizes in-person interaction where possible and includes new signage and rules for amenities and common areas. While property operations have successfully made the ”COVID” adjustment, the capital markets have not. An enormous amount of capital remains on the sidelines as sellers and buyers are waiting for signs that jumping back in and transacting are the right move. While there is no consensus on exactly where we are and where we go from here, things are beginning to take shape.
Transactions
Transaction volume across the country collapsed in the second quarter of 2020. By way of example, the Atlanta market had $2.6 billion in transactions in the fourth quarter of 2019. There were less than $500 million in transactions in the second quarter of 2020[1]. This represents the lowest transaction volume since the first quarter of 2012. Transaction volume bounced back in August of 2020 but Q3 volume is still on pace to be the slowest third quarter since 2014. Much of this was anticipated as the pandemic forced shutdowns across the country. In many respects, it is not possible to acquire apartments when shut down. There is simply no way to adequately perform physical diligence on a real estate asset without physically inspecting the property and that was almost impossible in the second quarter of 2020. A complex single question remains: how will the pandemic affect multifamily?
Valuation
The primary question Arcan is contemplating is: what are assets worth in today’s environment? In a normal market there are scores of sales one can use as competitive points for reference (“comps”). These sales essentially inform the value of other, similar properties. While every investor has a proprietary financial model they use to analyze a property, the basis for valuation, appraisal, and lending is competitive sales. When there are no comps, most people, investors, appraisers, and brokers included, are guessing. For professional investors, it is an educated guess based on lending rates and returns, but it is a guess, nonetheless. Thus far, investors are still willing to be aggressive but there is a tangible gap between what sellers want to receive and what buyers want to pay.
Collections
Another key component of valuation is collections. If properties cannot collect rents and other charges, valuations will suffer as underwriting gets more conservative. Thus far, collections at apartment assets have been very good, all things considered. Nationally, collections increased in June and July (95.9% and 95.7%) from April and May (94.6% and 95.1%). The April to June 2020 average of 95.3% is below the 2019 figure of 96.7%[2], however. While the pandemic is the cause, the eviction moratorium is just as likely to blame and will likely has been extended beyond the initial August end date through the end of 2020. The Arcan portfolio remains approximately 95% collected throughout the pandemic, though the rates on certain properties are falling slightly each month. Non-paying tenants cannot be removed via eviction and there is now a backlog. Every month you have a few more tenants who are unwilling to pay rent and they now cannot be removed. In prior years, the non-paying tenants would be replaced by another with a far better likelihood of payment.
The Market
There are other metrics to consider in determining valuations, such as market factors that can dramatically change valuations. The first is rent growth. In the Atlanta market, rents fell dramatically in the initial stages of the pandemic. Arcan believes this was a mix of panic and lower traffic as properties fearfully tried to stay full during the uncertainty. While growth has been slow, market rents have recovered to pre-pandemic levels. Annual rent growth now stands at 3.3% in Atlanta since March and other markets have showed strength as well. Rents in Birmingham, Charlotte, Raleigh-Durham and almost every other major market in the Southeast that Arcan tracks are above those of one year ago[3]. That is an enormously powerful statistic, if it holds. Lenders are also back in the game even if less aggressive. While bridge loans are still slowly coming back, the agencies are very much helping the market with substantially lower rates. In many instances, Agency pricing is 100 Bps below rates from 1 year ago, often coming in at well below 3%. Even if prices remain the same, initial yields on investments will go up. This is a major factor in investors ability to keep paying all-time high prices.
The Way Forward
The final results of the pandemic are simply not in. The federal government is pumping money into the system via multiple rescue packages, so it is hard to know what will happen when the flow of free money stops. To date, renters have been paying (even if less than in prior years) and performance of multifamily assets has been good. It may turn out that multifamily assets are the ideal asset to hold given the current environment. Unlike other real estate like retail, hotel and office assets, people still need a place to sleep every night and apartments fill that need. However, cracks are beginning to form in collections. In markets Arcan tracks closely, a clear distinction can be made between properties that collect nearly all their revenue and others that struggle.
Investors are now jumping back in and new transactions are beginning to take shape. This will inform pricing as we move towards the end of 2020. As deals come to market, pricing expectations are all over the board. We do see some good opportunities, but others seem shockingly overpriced. For Arcan, the key to success is underwriting and experience. Some forget that the definition of value is not only what a buyer will pay, but also the present value of all future cash flows. Those whose expectations of rent and expenses are aggressive will ultimately pay the price with cash flow and an asset worth less than they planned. The days of underwriting a blanket collection loss for all assets are over for now as delinquency should be a key component of every acquisition. Arcan is very cautiously approaching investments as it does not feel as though the pain of the pandemic has been fully felt. While there are good investments out there, we feel more are coming and only time will reveal them to us.
[1] Multi-Family Capital Markets Report, Atlanta - GA - CoStar
[2] National Multifamily Housing Council, NMHC Rent Payment Tracker
[3] CoStar Market Analytics