In a volatile market, investors recognize the importance of diversification to generate income that is supplemental, and can offer lower risk than found in the capital markets. Many turn to commercial real estate, which offers non-correlated potential income and historically has served as a hedge against inflation.
During the first half of 2022, the multifamily sector experienced continued strong demand, driven by demographic shifts, a strong labor market with continued growth, and increased renter household formations. While this strength is expected to carry on in the second half of 2022, there are indications that there is a slowing of the economy, with recession forecast on the horizon. A “flight-to-quality” has been occurring in the multifamily sector with investors flocking toward Class A properties, which they believe are a safer investment in uncertain times.
Stagflation and loan-to-cost factors are expected to narrow the return gap between Class A and Class B assets in certain areas, -while widening in others. Local occupancy levels, new supply in the market and affordability are factors to consider in each region.
While purchasing top shelf properties may seem like a solid strategy, it may not adequately account for all the risks inherent in this asset class. An investor might want to take a second look at those investments that are less attractive, at first glance. Class B and specifically Class B, value-add assets located in secondary markets, have the potential to generate better returns and add accretive value, over time, to a diversified portfolio.
A lesser-known risk factor to consider is that better returns over time can also lower capital loss risk. Many investors may assume that Class A core assets pose less risk than Class B, which are often older properties that may need refreshing, offering more basic amenities. Sometimes this may prove to be true, however, more often it is not. At today’s low cap rates, Class A assets often have little room for error and less room for cap rates to compress further. Over the long-term, many Class B assets have outperformed, producing higher cashflow and capturing greater cap rate compression. Examining the data over a half decade or more, Class B, and specifically Class B value-add, have performed better, generating higher returns and less risk. While value-add investing does require more work on the front-end (and there is always the possible risk of execution in performing the rehab work), the reward payoff and return can potentially be much higher.
A smart multifamily investor is advised to assess each market independently and adopt a localized strategy. Don’t assume that a dataset translates seamlessly across regions. It is vital to conduct a thorough due diligence for each market. While California is home to two expensive coastal cities, San Francisco and Los Angeles, the state is expansive and offers multifamily investment opportunities that can provide value and lower risk. Understanding your goals, and considering your capacity to invest capital, time and work in a property, can help determine the best strategy to build a multihousing real estate portfolio on a solid foundation.
Streit Lending offers short-term construction and bridge loans in Southern California, from $500,000 to $10,000,000 at a loan-to-cost up to 70 percent, to build and rehabilitate commercial residential properties. Streit can tailor a loan to meet borrowers’ needs and offers quick, transparent and stress-free closings that help clients complete construction projects faster.