Months after the first U.S. coronavirus (COVID-19) case was announced in January, financial markets across the entire country have been upended. The long-term impacts on the real estate industry, however, are still unknown.
As the saying goes, real estate is all about location, location, location. While it’s always important to identify macroeconomic factors, which are items that affect the entire real estate industry, it is also critical to understand the microeconomic dynamics of specific markets when underwriting real estate investments. These microeconomic factors will drive the formation of underwriting assumptions and subsequent sensitivity analyses, as we will explain.
For example, at ArborCrowd we are paying close attention to the weekly nationwide unemployment insurance claims, which details the number of people who have lost their jobs and filed for public assistance. However, we are also tracking these claims at the individual market level to understand which markets have been less economically impacted by the virus.
Additionally, we’re examining the historical performance of specific markets during and after downturns compared to the nation as a whole while considering how each market has subsequently changed since those downturns.
We then utilize this macro and microeconomic data to inform the development of our underwriting assumptions when analyzing potential real estate investments. Of course, despite all the historical and real-time information we have, it is impossible to accurately predict the future. That is why, as part of our underwriting and due diligence process, we perform sensitivity analyses to understand how vulnerable a real estate investment’s yield is to changing economic circumstances.
A sensitivity analysis is when you change a variable to account for a range of potential outcomes to determine how the investment may perform. While we always perform sensitivity analyses as part of our regular due diligence, they are even more critical in the current economic environment.
Here are a few examples of what a sensitivity analysis may look like in the current economic climate when applied to our underwriting assumptions.
Rent & Rent Growth
The majority of a multifamily investment’s return is driven by rents. During due diligence, experienced underwriters estimate a property’s potential market rents by analyzing comparable properties in the marketplace and taking into account other micro and macroeconomic data. For instance, the amount a unit at a comparable property leased for this past January may be materially different than what it may lease for in June due to the pandemic.
The rate at which market rents will grow during the hold period must also be considered. It is anticipated that rents nationwide will remain stagnant or possibly contract in the near term due to COVID-19. Therefore, rents in a market that was experiencing robust rent growth prior to the crisis may remain flat or grow at a much lower rate than what was anticipated before the crisis. However, it is expected that rent growth will normalize as the economy stabilizes.
For example, if an assumption is that a 1-bedroom apartment will rent for $1,500 per month, a sensitivity analysis may include running the same financial analysis, but instead assuming that the unit will only rent for $1,350, $1,400 or $1,450 per month. The same idea can be applied to the rent growth rate. If a market was achieving 3% annual rent growth, a sensitivity analysis may include modeling 0%, 1%, and 2% rent growth for at least the next few years, in the event rents don’t grow until the economy recovers.
As part of our underwriting, we factor in the number of tenants who choose to not renew and move out at the maturity of their lease, which is referred to as turnover. The COVID-19 crisis presents unique circumstances for multifamily owners and real estate investors as “stay-at-home” policies are forcing people to remain in their homes to slow the spread of COVID-19.
This could lead to an increase in renewals as prospective tenants cannot tour new apartments or homes and may choose to renew their current lease, decreasing turnover.
Even after the stay-at-home orders across the country are lifted, economic uncertainty may lead people to stay put until they have a better sense of their own financial security. A decrease in turnover will impact revenue generated from certain onboarding fees, while conversely reducing certain costs incurred to prepare vacated units for new tenants.
Given the uncertainly of when people may resume normal social activity, it is difficult to determine turnover rates and associated costs. A prudent underwriter will run through various scenarios in their financial model to account for different outcomes, including a quick return to normalcy, and prolonged stay-at-home orders and social distancing.
The vacancy rate is the ratio between the unoccupied units and the total apartments in a property. In usual circumstances, a market with decreased demand could potentially experience increased vacancy. However, due to government policies, such as eviction moratoriums, and the reduced turnover of existing tenants, vacancy rates may stay unaffected in the short term. As these policies come to an end, some multifamily properties and markets could see a rise in vacancy as demand for their units change. Such changes will depend on a multitude of factors including how heavily COVID-19 impacted the local market, and the property’s quality, such as Class A, B, or C.
Typically, one can determine the average vacancy rate of a market by performing research, including contacting owners or managers of comparable properties. This information along with other factors would help inform the underwritten vacancy rate. Given the current uncertainty, it is prudent to run a sensitivity analysis that shows the impact of potentially higher vacancy rates on the investment’s return.
Markets will always experience ups and downs, whether caused by a pandemic or by a financial bubble. Therefore, sophisticated underwriters always perform sensitivity analyses during due diligence to quantify the impact such events, both predictable and unpredictable, could have on a property’s financial performance and corresponding yield.
While sudden macro and microeconomic shocks can bring uncertainty, they can also offer historic buying opportunities for those investors with the ability to capitalize on them. The key is to properly account for multiple potential scenarios as part of a sensitivity analysis to test whether the deal still makes economic sense if certain adverse circumstances occur, but also to determine whether there is potential upside if positive outcomes are achieved.