Domestic Trends - Employment and Wages, Demographic and Retirement, and Student Loans

U.S. Employment and Wages

According to the Bipartisan Policy Center, since 2000, the majority of Americans have had real incomes flat-line or even decrease.  Many Americans are unable to save for short-term needs and are more likely to raid retirement savings in the event of an unexpected life event.  This is exacerbated by higher education and health insurance costs that hamper the ability of households to save for retirement and/or short-term needs.

According to the U.S. Department of Housing and Urban Development, "Families who pay more than 30 percent of their income for housing are considered cost-burdened and may have difficulty affording necessities such as food, clothing, transportation, and medical care. An estimated 12 million renter and homeowner households now pay more than 50 percent of their annual incomes for housing.  A family with one full-time worker earning the minimum wage cannot afford the local fair-market rent for a two-bedroom apartment anywhere in the United States."  Access to affordable housing is becoming an increasing concern for many Americans, and this trend continues to worsen.  Many Americans are being priced out of homeownership and may spend most or all their lives as renters.  The United States is growing as a renter nation.

Although the unemployment rate is currently around 4% and at the lowest level since 1976, this does not give a complete picture.  Many Americans are underemployed, a term that broadly refers to one of several circumstances:

• Skilled workers with lower-paying jobs

• Part-time workers that desire full-time jobs

• Highly skilled workers that can get only low-skilled jobs

Currently, measuring underemployment is difficult, and the Bureau of Labor Statistics does not officially track it, but the Economic Policy Institute (EPI) published a paper in May 2018 which found the underemployment rate to be 11.1%.  The possible reasons for the high level of underemployment are beyond the scope of this eBook, but there is clearly a growing segment of Americans facing barriers to income and wealth growth, who may never attain homeownership.

Demographic and Retirement Trends

One notable trend taking place in the U.S. is the retirement of the baby boomer generation (those born between 1946 and 1964) at a rate of approximately 10,000 per day.  In June 2019, the average social security retirement benefit was approximately $1,470 per month.  These benefits are extremely modest compared to the cost of living in many large cities such as Los Angeles and New York.  Approximately 35 percent of Americans rely entirely on Social Security.  It is estimated that by 2025, each retiree will be supported by only 2 working Americans. 

The retirement landscape has changed in the U.S. because of a series of profound events.  First, employers have been shifting from defined benefit pensions to defined contribution plans.  The previously unknown section of the tax code, 401(k), has become commonplace as the retirement vehicle for many U.S. workers.  The 401(k) has given people more control and responsibility for funding their retirement, but also exposed them to far more risk as many Americans lack "financial capability" or the basic knowledge to manage their own finances as concluded in a June 2016 report by the Bipartisan Policy Center. 

Americans own almost $13 trillion in home equity which is an important part of the potential retirement savings of older Americans who have minimal retirement savings.  Home equity can be monetized to cover retirement needs by downsizing to a smaller (less costly) home, using a reverse mortgage, or selling their home and renting.  According to the website RentCafé, by 2025, the number of renter households by someone 60 years and older is projected to increase to 13 million and, by 2035, it is forecasted to increase to 18.6 million, which is double the number in 2017.

In addition, many government agencies continue to offer defined benefits through pension plans that are heavily dependent on stock market returns.  The viability of these defined benefits has received much attention due to some of these pension plans being underfunded.  Some public pensions may be unable to sustain future retiree benefits if the general economy and stock market were to experience a prolonged period of little, if any, economic growth.  The result would lead to fiscal challenges to government agencies and possible reductions in retirement benefits.  Expert predictions for lower equity returns over the next decade will increase the difficulty in meeting pension fund liabilities.  This further highlights the need for investors to limit their personal and retirement exposure to stock market volatility and diversify into non-correlated assets like commercial real estate.

According to the Urban Institute, the renter rate is projected to increase until 2030.  Millions of new households will form over the next ten years, and new renters will outnumber new homeowners, especially among millennials, seniors, and minorities.  In fact, the homeownership rate is projected to decrease for all age groups except for those over age 75.

Millennials (those born between 1981 and 1996) will surpass the baby boomers as the largest adult generation in the U.S.  Many millennials are burdened with student debt, and this could be a contributing reason for the large number that continue to live with family.  Interestingly, according to the Pew Research Center (PRC), millennials are earning more than Baby Boomers did at the same age, but millennials have less wealth than Baby Boomers did at the same stage of life.  This is believed to be likely due to millennials having much higher amounts of student debt and increasing underemployment.  According to PRC, the number of adults in middle-class households is unchanged since 2011, but the wealth gaps between upper-income and both lower- and middle-income families in 2016 were at an all-time high.  This trend is representative of a long-term rise of income inequality in the U.S. and will further contribute to the increased likelihood of people renting.  The National Multifamily Housing Council has estimated that 4.6 million new apartment units will be needed in the U.S. by 2030 to meet the increased demand.

Student Loan Debt

In 2019, there are approximately 45 million borrowers of student loans who owe a total of $1.5 trillion.  Student loans are the second-highest consumer debt, behind only mortgage debt.  Unlike other debt, student loan debt is more difficult to discharge through bankruptcy, and this debt burden will remain tied to borrowers for many years.  Aggregate student debt that is more than 90 days delinquent or in default is almost 11%.  The number of Americans age 60 and older with student loan debt has more than doubled in the last decade. Since early 2010, total student loan debt has consistently outpaced other non-mortgage household debt

The average student loan borrower now graduates with an average of $37,000 in student loan debt, which is about the same as a 20% down payment on a $185,000 home or a 10% down payment on a $370,000 home.  Some college graduates have such massive student loan debt that it may be said they have a "mortgage" without actually having a home.  In 2017, the homeownership rate for households led by a 25-34-year-old was 38%, which was down from 55% in 1980.  According to research by the Federal Reserve Bank of New York, increasing student debt is an influential factor in the declining homeownership rates by younger Americans.  In addition, because home equity is a major contributor to retirement security, delays in homeownership will likely correlate with reductions in long-term wealth accumulation.

Mortgage Lending Standards

“United States is at risk of becoming a nation of renters because of the total unnecessary constraints that continue to present lenders from giving out mortgages.”

-- Richard Kovacevich, Former Wells Fargo CEO

Since the Great Recession, tighter lending standards have substantially increased the paperwork and credit requirements to qualify for a mortgage.  The Consumer Finance Protection Bureau created by the Dodd-Frank Act now entails a lengthy and cumbersome process of appraisal, documents, certifying these documents, and so forth.  Anyone that has purchased property or refinanced an existing property since the passage of Dodd-Frank has experienced the frustrating effects of this process.  Per the Federal Reserve Bank of New York, 75% of mortgages taken out in the first quarter of 2019 were by Americans with a credit score above 700.  The median credit score in 2019 is 759.  These are reasonably robust credit scores.  It is good that lending standards are being upheld, but those with lesser credit scores will continue to be at a disadvantage while trying to qualify for a mortgage.

Take Away for Investors

Most of the developed world is on the path to ever-increasing deficits and debt, little or slow economic growth, and interest rates.  Furthermore, Americans are facing a future filled with financial hurdles, and the economic picture in the U.S. is undergoing changes to retirement, increasing debt (consumer, corporate, and government), persistent underemployment, stagnant wage growth, and demographic shifts among others.  Once informed investors understand these economic challenges, the next step is to identify real estate opportunities that will benefit from these conditions and trends. 

Global Debt and Interest Rates

“In other words, QE certainly benefits investors/savers (i.e., those who own financial assets) much more than people who don’t, thus widening the wealth gap.”

― Ray Dalio (Founder of the hedge fund, Bridgewater Associates)

Interest rates are the most critical economic driver, and their movements (up or down) can have ripple effects through the global financial markets.  Stocks, bonds, commodities, and currencies are all directly affected by the actual and anticipated directional move in interest rates, but not always in a linear manner.  The cost of borrowing money, as determined by interest rates, can have a profound effect on the economy as leverage (debt) is the basis for the majority of worldwide economic growth.

The U.S., Europe, and other developed countries continue to increase deficits (the annual difference between how much the government spends and what it receives in revenue).  The U.S. federal budget deficit for the fiscal year of 2020 is $1.10 trillion.  Each year's deficit adds to the national debt.  U.S. government spending at 17 percent of total GDP has become a sizable component of the economy.  Therefore, politicians of both political parties are incentivized to increase spending as this artificially creates jobs and grows the economy. 

Total global debt continues to increase, and by the end of 2019 is projected to surpass and make a new record level of $255 trillion but, more importantly, this trend is not expected to slow down any time soon.  The global debt translates to approximately $34,000 for each person on earth.  These record debt levels are occurring at the same time as a zero interest-rate policy (ZIRP), or a negative interest rate policy (NIRP) is being implemented by the central banks of many developed countries.  Approximately 30 percent of the developed world's government debt is yielding negative rates, and almost 100 percent of the debt is zero or negative-yielding when factoring for inflation.  The stated goal of these central bank policies is to increase economic activity by encouraging both businesses and consumers to spend rather than save. The phenomenon of negative-yielding government debt might be another "subprime" bubble, but this time it would be in "subprime governments."

In addition to policies like ZIRP and NIRP, some central banks have engaged in several rounds of quantitative easing (QE).  When interest rates are near zero, central banks are limited in affecting interest rates even lower so they may implement QE to increase the money supply by purchasing from banks securities such as government bonds.  These purchases provide banks with liquidity and effectively increase the money supply.  QE is done to promote lending and investment, but eventually, it loses its effectiveness.  As monetary policies like QE, ZIRP, and NIRP become ineffective, governments feel compelled to further expand the monetary supply via fiscal policy (i.e., more government spending), thus, increasing government deficits and the cost of servicing this debt. 

 In the next economic slowdown or recession, the Federal Reserve and other central banks will likely engage in more aggressive QE, ZIRP or NIRP to promote spending and economic growth, especially given these statements:

•  Former U.S. Federal Reserve Chair, Janet Yellen, stated, "If it were possible to take interest rates into negative territory, I would be voting for that."

•  U.S. President Donald Trump tweeted on September 11, 2019, that "The Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt."

 But what do central bank policies like ZIRP or NIRP mean for real estate investors?

• Today's historically low interest-rates have reduced the cost of servicing the enormous debt accumulated by Subprime Governments and makes it fairly difficult for central banks to substantially raise interest rates given governments need these low rates to fund increasing debt.  Low rates may likely be commonplace for many years to come.  This means real estate investors may have access to low borrowing rates to fund fruitful opportunities.

• The U.S. status as the preferred safe haven means that foreign capital will continue to flow into assets like the highly desirable commercial real estate market.

• Declining yields worldwide mean that investors will continue to invest in opportunities with favorable cash flow and price appreciation.  This will further spur appreciation of commercial real estate assets.

It is important to note that interest rates cannot be considered in isolation because interest rates affect various markets and asset classes.  It is conceivable that the anticipated positive effect of falling interest rates may be partially or completely negated by how other markets react to falling rates in the near and intermediate terms, but over the long-term, ZIRP and NIRP will be extremely bullish for commercial real estate assets and other income-producing assets.  Also, it should be noted that central banks have embarked on policies that have never been implemented.  Regardless of the corresponding uncertainty, commercial real estate, especially multifamily assets, will continue to experience superior investment returns as compared to other assets.

Portfolio Diversification and Real Estate Returns

“Real estate investing, even on a very small scale, remains a tried and true means of building an individual’s cash flow and wealth.”

— Robert T. Kiyosaki

Every investor has, or at least should have, the goal of building a portfolio that has the highest return with the lowest amount of volatility.  Between 2009 and 2017, the Russell 3000 has increased over 250%, but all this has occurred during a time when several economic conditions and trends present challenges (discussed in the next chapter) for equity returns over the next decade or so.  Equities, bonds, and other investment classes tend to be cyclical and can experience extended periods of underperformance.  For instance, during the Great Recession, the S&P 500 dropped more than 50% from its peak and did not fully recover until 5 years later in 2013.  Therefore, many institutional and savvy investors look to diversify their portfolios with asset classes that are as uncorrelated to each other as much as possible. 

The NCREIF Real Estate Index is a metric of privately held (i.e., direct investment) commercial real estate as measured by the National Council of Real Estate Investment Fiduciaries (NCREIF) property index (NPI).  The following table is a comparison of the correlation coefficients of the NCREIF Index to the following markets: Russell 3000 Index (equities market), Barclays U.S. Aggregate Bond Index (U.S. bond market), and the NAREIT Index (publicly traded U.S. real estate companies).  A correlation coefficient value of “1” indicates a perfect positive correlation, a value of “-1” indicates a perfect negative correlation, and a value of “0” indicates no correlation.  Private commercial real estate has low or negative correlations to stocks and bonds because real estate is relatively illiquid, trade infrequently, and not prone to speculation.  This makes private commercial real estate a strong diversifier that dampens portfolio volatility.  In the case of a publicly-traded real estate investment trust (REIT), the share price will fluctuate similarly to equities as it is subjected to the same market dynamics.  A REIT may trade higher or lower than the value of its underlying assets.  Therefore, a publicly-traded REIT will be more highly correlated to equities than to direct ownership of commercial real estate.

Publicly traded assets offer better liquidity than private investments, however, private investments have the advantage of offering lower volatility.  Most investors are heavily weighted in stock, bonds, and mutual funds through their personal and retirement holdings and could substantially benefit from diversifying into privately held commercial real estate assets.

An absolute return is a measurement that includes all the money generated from an investment; specifically, asset appreciation, depreciation (benefit), and cash flow.  According to the research firm Preqin, a $100,000 investment on January 1, 2001, would yield $380,000 and $255,000 in commercial real estate and the S&P 500, respectively, on March 1, 2017.  Private commercial real estate generates higher absolute returns than equities.

The figure below is a comparison of the investment returns and volatility of commercial real estate, equities, and bonds.  Investments in commercial real estate have produced two notable benefits.  These investments have generated returns higher than equities and bonds, and the returns came with a volatility lower than equities and scarcely higher than bonds.  On a risk-adjusted basis, that means that commercial real estate is a more favorable investment than both equities and bonds.

20-Year Period Ending December 31, 2018

Source: ©2019 Black Creek Capital Markets, LLC

Value-Add Investment Strategy

Investment Strategy

The sponsor is the most critical element of any investment opportunity because the sponsor is creating the opportunity, obtaining financing, managing the property, and attracting investor capital. But what is the potential “opportunity?” The opportunity is the multitude of multifamily properties that are poorly managed, have deferred maintenance, no business systems in place, have higher vacancy rates than the market, rents below market value, or fees not assessed. The significant number of these underperforming and inefficiently operated properties in the U.S. are prime opportunities for the sponsor to implement a value-add strategy to maximize income and deliver returns to investors.

Because commercial real estate is valued based on the amount of income generated, the asset becomes more valuable with income growth. Each asset should be thought of as a functioning business, and the goal is to make each asset into a better business that will be highly valued by investors. Therefore, the sponsor will take a poorly run operation and turn it into a well-run company, which is also backed by real estate (what a nice bonus!).

Improving the appearance of an older property should be a high priority. The outside appearance of the property is influential to prospective tenants who will be drawn to a positive first impression. Simple items of work such as painting the facade, improving the landscaping, and the common areas are very beneficial. These improvements add to the curb appeal and help to increase the occupancy rate and the bottom line of the business.

A well-planned renovation will typically start from the exterior of the property and progress to the interior of any vacant units. Occupied units will be renovated when existing leases expire. Only renovations that add value that renters will pay for should be utilized. In the case of assets like multifamily and senior living facilities, these could include updating the following: kitchen cabinets and countertops, carpeting and flooring, light fixtures, and window coverings. The extent of the renovation will be partially dependent on the existing condition of the property and the degree of the intended repositioning (e.g., moving from Class “C” to Class “B” will be different than moving from Class “B” to Class “A”). It is crucial to carry out only work that will produce the highest return.

Multifamily Value-Add

Many older properties are not individually metered, and inefficiently managed properties may not have a system of billing back any owner paid utility costs to the tenant. A new owner should look to shift the responsibility of these expenses to the tenant. One method is to implement a ratio utility billing system (RUBS) formula that estimates the amount of tenant consumption based on variables such as the number of occupants and square footage of the unit. Depending on the number of units and the current cap rate, an additional $30/month recouped by the owner could add tens of thousands of dollars to the property value.

Laundry service is sometimes an overlooked component of a value-add strategy despite there being several options that can be executed. For instance, the owner may contract with a laundry service company that furnishes and maintains the washing and drying machines and splits the revenue with the owner. Another option would be for the owner to remove any on-site laundry facilities and install a washer and dryer set in each unit if the property classification would justify this (e.g., Class “B” and higher). Washer and dryer installations would be performed as part of each unit’s renovation. Also, the former laundry building could be partitioned into individual storage units and rented to tenants, becoming a perpetual income generating on-site self-storage facility.

Depending on the specific circumstances of the property, owners should look to implement fees such as the following: prospective tenant application fees, pet fee, month-to-month fee, lease termination fee, use of additional storage room fee, additional assigned parking or use of carport/garage, and nonsufficient funds (NSF) fee. The supplemental income from these ancillary fees can add tremendous value to a multifamily asset.

These value-add components are intended to be an overview and not comprehensive of the ways to add value. Innovative sponsors will find ways of increasing efficiency and making constant improvements to the asset.

Value-Add Process

Once the asset is repositioned and turned into an efficient cash flow machine, investors will pay more for this asset because of its higher cash flow. A typical value-add strategy consists of the steps shown in the figure below. The sponsor will thoroughly underwrite and acquire the asset, then the specific value-add strategy will be implemented to reposition the asset so it may operate close to its original operational state. The sponsor will work with a third-party management company to bring in tenants at market value and gradually raise rents of the existing tenants. Investors will receive distributions (cash flow) as appropriate from the operations. The property will be stabilized and held in accordance with the exit strategy outlined in the business plan.

In cases of long-term asset holds, the property may be refinanced to extract equity from the forced appreciation and any market appreciation. One of the renowned wealth-building mechanisms is the ability to refinance and allow investors to receive some or all their invested capital back. Also, the refinance is a non-taxable liquidity event because investors are being paid with borrowed money. Investors will continue to receive passive income from the operation of the asset. Eventually, the sale of the asset will occur, and profits will be split between the sponsor and investors. The process will continue again as the sponsor looks to further build wealth by applying the strategy to one or more other properties.

Crowdfunding vs. Syndicating

Investing in commercial real estate has become more accessible to investors through the use of crowdfunding and syndications.  These terms are sometimes used interchangeably, but they are not the same.  Crowdfunding is a tactic of using mass advertising in the hopes of raising capital from a "crowd" outside of one's network; it is the means to attract and engage potential investors to syndicate a real estate opportunity.  While crowdfunding advertisements are typically conducted online, it is not necessary to use this method.  Crowdfunding has applications that extend beyond securities (think of a donation-based application like GoFundMe), and its use in syndications has grown since the JOBS Act of 2012 legalized publicly advertised offerings.

Crowdfunding is a method of finding investors or funders, whereas syndication is the grouping of these investors into a (real estate) transaction.  In a syndicated real estate transaction, the syndicator (hereinafter referred to as "sponsor") sells to investors membership interest in a special purpose entity, typically an LLC, that will own and manage the asset.  The sponsor may consist of multiple partners working as the management team and pooling capital from investors.  The sponsor contributes the "intellectual capital" and is responsible for all the decision making and work involved with delivering the forecasted investment return to the investors.  Because the investors have no responsibility to manage the details of the investment, the investors' involvement is "passive."  Investing in a syndication can provide passive investors with several benefits:

• Benefit from the sponsor's efforts to produce the investment opportunity

• Ability to invest with others and pool capital to invest in more significant transactions

• Pursue greater investment returns due to larger transaction size

• Benefit from having a passive role in the opportunity

The membership interests that are sold to passive investors are classified as securities and subject to regulations governed by the U.S. Securities and Exchange Commission (SEC).  Sponsors can legally sell their securities without having a broker-dealer license (also known as the "owner exemption").  Registration is a lengthy and expensive process that is utilized only when taking the offering to the general public.  Otherwise, most sponsors choose to qualify their offering under one of two primary SEC exemptions under Regulation D, Rule 506(b) and Rule 506(c).*

• Rule 506(b) allows up to 35 "sophisticated" investors, but public advertisement of the opportunity is not permitted; the sponsor must have a substantive, pre-existing relationship with the investor prior to the deal.  There is no limit on the number of "accredited" investors that may invest.

• Rule 506(c), created under the JOBS Act of 2012, allows public advertisement of the opportunity, but all the investors must meet the income or wealth requirements of being "accredited."

Even with the addition of 506(c) to spur capital formation, it is estimated that over 90% of new real estate syndications are done under 506(b).  This demonstrates the strong relationship and trust-based environment of these opportunities.

*This is a simplified overview of crowdfunding and syndications and is neither intended to be comprehensive nor legal advice.  Check with www.sec.gov for specific criteria of accredited and sophisticated investors.  Please consult with a securities attorney prior to engaging in a syndicated opportunity either as a sponsor or passive investor.

Forced vs. Market Appreciation

Real estate appreciation is the most profound way to create long-term wealth.  Appreciation can take the form of market or forced appreciation.  Market appreciation is driven by market forces such as job and population growth, the economy (think of what happened during the Great Recession), and other factors covered in Chapter 3 (Macro-Economic Trends and Conditions) of our eBook - More Doors, More Profits - which can be found here.  These forces are controlled by the market and are outside the control of the sponsor.

Forced appreciation is within the control of the sponsor and occurs when the value is "forced" higher by increasing the income it produces via a value-add strategy.  Forced appreciation provides benefits in all market conditions.  For instance, if the market goes down, then the value of the asset would likely continue to stay flat.  If the market is flat, then the value of the asset would still increase.  If the market goes up, the value of the asset would increase more than other comparable assets.

It is necessary to highlight that the more investment returns are based on market appreciation, the less dependable the projected returns.  Investment returns that are entirely or primarily based on forced appreciation, the more dependable the returns.  Investment returns that are dependent on market appreciation occurring are relying on cap rate compression to transpire.  For instance, if investors are willing to pay more in the future for the same stream of income, then the cap rate has compressed.  In numeric form, this would look like:

If an asset's NOI of $500,000 remains unchanged, but the cap rate has moved from 8% to 7%, then the value of the asset has increased from $6,250,000 to $7,142,857.  Because the NOI is unchanged, this appreciation was due to market appreciation.  This investment yielded a 14% return on investment (ROI).

Passive investors should be careful when investing in a value-add strategy that is underwritten using a lower or compressed cap rate.  Sponsors that are using conservative assumptions should be assuming a higher cap rate at the end of the projected hold period.

If the asset in the previous example is to undergo a proposed value-add strategy that is projected to increase the NOI from $500,000 to $600,000 with a cap rate of 8% AND cap rate expansion of 0.10% per year for a 5-year hold, then the value of the asset is projected to increase from $6,250,000 to $7,058,824.  This yields a projected 13% ROI that is based entirely on forced appreciation and, therefore, this return is more dependable because it does not rely on any market appreciation to occur.  In this scenario, the sponsor is in a position to over-deliver to the investors.

Basics of Investor Due Diligence

As passive investors have realized the tremendous benefits of investing in real estate syndications, the accessibility of these opportunities has grown.  Investors need to be knowledgeable to scrutinize and evaluate the slew of opportunities and determine what is a "worthwhile" deal based on their risk-to-reward profile.  Due diligence is essential because some of the best deals are the ones to be avoided.  Ultimately it is the responsibility of investors to ask the right questions and determine whether an opportunity meets their investment objectives.

There are four general areas that a passive investor should consider in every potential investment, the management, financials, asset, and legal documents.  The most important is the management consisting of the sponsor and property management teams.  Listed below is a potential checklist that a passive investor may review or ask the sponsor.  The checklist is not meant to be comprehensive, but merely a starting point.

Management

Sponsor Team

• Experience and background

• Local market knowledge

• Transparent and relationship-drive

• Understand their role as a fiduciary to their investors

• Properly incentivized in the deal ("skin in the game") via co-invest, personal guarantor on loan, and so forth

• Structure fair deals for everyone involved

• Highly value their investors and work relentlessly on their behalf

Property Management Team

• Local market presence and experience

• Number of similar properties in the same market under same management

• Relationships with contractors, repairmen and other outside services

Financials

Pro Forma and Financial Performance Metrics

• Purchase Price/NOI/Cap Rate consistent with comparable sales

• Breakdown of budgeted capital expenditures and contingency amount

• Pro-forma assumptions and comparison of Year 1 pro-forma to T12 financials

• Sale Price (exit cap rate should be higher than the entry cap rate)

• Projected expense and income growth rates and comparison to market growth rate

• Internal Rate of Return

• Cash-on-cash

• Equity Multiple

• Preferred return (if applicable)

• Sensitivity analysis of assumptions on performance metrics

Debt and Financing

• Loan-to-Value and Loan-to-Cost

• Repayment schedule

• Fixed or floating rate

• DSCR

• Interest-only period

• Loan prepayment penalties

• Projected refinance timeline (if applicable)

Asset

Investment Strategy

• Strategy consistent with the market and submarket

• Targeted hold period

• Time to complete renovations and stabilize asset

• Strategy confirmed with post-renovated asset in the same market

Market

• Projected job, population and wage growth over the next three to five years

• Median income and alignment with projected rents

• Landlord friendly rental laws

• Diversification of the employment base

• Market rental rate and vacancy rate

• Comparable properties within 3-miles (these are the competitors)

• Quality of the school district

• Crime rate

Property

• Age of the property

• Property classification and general condition of the property

• Market type

• Economic and physical occupancy rates

• Capital expenditure history

• Visibility of the property

• Daily traveled vehicles

Legal Documents

• Documents prepared by a securities attorney

• Document package includes a private placement memorandum

• Documents consistent with executive summary, business plan and conversations with sponsor

• Capital call provision (ideal if not present)

• Source and uses in the operating agreement

• Distribution waterfall

• Reporting requirements to passive investors

• Incentive alignment of syndication team and investors

• Transferability of shares

Commercial Real Estate Financials

Capital Stack

Passive investors should understand the basics of how an investment is funded as capital from different sources is brought together to finance a real estate opportunity.  Not all capital invested in an opportunity is equal in terms of the risks and returns.  The graphic depiction of the full capital stack on a real estate investment is shown below.  The stack represents an inverse hierarchy of risk and priority to receive payment.  The higher the position on the stack, the higher the risk and expected returns, but the lower priority to collect profits and income generated by the asset.

Typical Capital Stack

Senior debt occupies the bottom position because its interests are secured by the asset, which serves as collateral for the loan.  Senior debt is considered to have the lowest risk because of its secured position. In addition, due to its "senior" position, it receives a predetermined return before the higher positions in the stack.  In the event of default, the senior debt holders have the right to foreclose, assume ownership, and liquidate the asset to recover capital owed. 

Mezzanine debt is subordinate to senior debt but ordinate to all equity positions.  This debt is unsecured, but if the debt payments are not made, the lender may assume the ownership

interest of the sponsor.  This debt demands a higher return than senior debt and is a "hybrid" position in that it may share in some of the profits.

The senior lender and mezzanine lender will usually enter into an agreement, called an inter-creditor agreement, where the lenders outline how they will proceed if debt payments are not carried out.

Preferred equity is subordinate to mezzanine debt and ordinate to common equity positions.  This equity position is paid ahead of common equity but has lower risk and expected returns than common equity.  Similar to mezzanine debt, this position is a "hybrid" in that it may have limited potential for additional compensation.

Common equity is at the top of the stack and has the most risk of all the positions because these equity holders are paid only after all the others are paid.  These holders are not guaranteed to receive either income or invested capital but have the potential to make the highest return of all the positions to compensate for their investment risk.  Each position carries a distinct risk-to-reward profile, and all these positions come together to finance an opportunity. 

Most passive investors that invest in a syndicated real estate opportunity will be in the common equity position.  For equity holders, their return will be variable and dependent on the success of the project.  Distributions from operations and profits from liquidity events (refinance or sale) are "split" among the equity holders (i.e., the sponsor and the passive investors).  A common split is 70/75% to the passive investors and 30/25% to the sponsor, but the exact percentage split varies among opportunities.  Furthermore, there may be one or more hurdles (or waterfall) whereby the split may increase in favor of the sponsor if a pre-determined performance metric is achieved.  For instance, the split may change from a 70/30 to a 60/40 split once the project achieves a specified return.

Financial Performance Metrics

Many financial performance metrics are used to evaluate an investment and derived from a property pro forma.  The pro forma is a simplified and combined income and cash flow statement of the property projected into the future.  The pro forma accounts for financials such as revenue, operating expenses, capital expenditures, and debt service, which allow financial metrics to be determined.  Passive investors should keep in mind that the projections in the pro forma are based on assumptions made by the sponsor. 

These assumptions should be based on a combination of past market performance, existing market characteristics, and future trends.  The conservative or aggressive nature of these assumptions reveals the credibility of the metrics.  Recall that for a value-add strategy, the goal is to reposition or force appreciation on the asset.  Appreciation may be forced either by increasing income, decreasing expenses, or both, with the ultimate goal of increasing the NOI.

Take Away for Investors

Financial metrics and their underlying assumptions are necessary to know, but investors should consider that not all returns are created equally.  A "higher" quality return is primarily based on passive income with associated passive losses to reduce tax liability.  A "lower" quality return is based primarily on appreciation and principal pay down.  With a stabilized income-generating asset, the passive income is generally very consistent, whereas appreciation and principal pay down can be realized only upon a liquidity event.  Appreciation generally bears the bulk of investor returns but is the least predictable.

Active vs. Passive Investing

“Financial freedom is available to those who learn about it and work for it.”

— Robert T. Kiyosaki

Investing in commercial real estate can be done via two main strategies - active and passive - that are fundamentally at opposite ends of the investor spectrum.  Each strategy represents a different mindset and level of effort to be successful.  Depending on the perspective of the investor, each strategy may be viewed as having its advantages and disadvantages.

Active Investing

Active investing is a hands-on approach whereby the active investors are expending time and effort ("sweat equity") and making crucial decisions affecting the investment, and therefore, the performance of the asset.  In a syndicated real estate opportunity, the sponsors are the active investors or partners who make various contributions to the success of the deal such as identifying and packaging the deal, obtaining financing, managing the property, and attracting investor capital to the opportunity.  In exchange for their efforts, sponsors are compensated with partial ownership of the opportunity.  The importance of the sponsors cannot be overstated as being the most critical element of any syndicated investment.

Passive Investing

Passive investing is a hands-off approach whereby the passive investors are expending minimal time and effort while benefiting from the performance of the sponsor to produce returns and distributions (i.e., passive income or cash flow).  Passive investors need to meet the relevant investor qualifications depending on whether the sponsors have chosen the offering to be exempt under Rule 506(b) or 506(c).

Passive investing is an astounding way to become financially free as motivated investors can build portfolios that eventually produce enough passive income to cover all their living expenses and more.  In a syndicated real estate opportunity, there can be a varied number of passive investors that invest capital to acquire a percentage of the equity ownership and corresponding portion of the cash flow and appreciation.  When investing with an experienced sponsor, passive investors can leverage this relationship to obtain the following benefits: 

• Portfolio Diversification - passive investors are investing in asset-specific opportunities and have the ability to assemble their own diversified portfolio by carefully selecting opportunities across a range of asset classes and geographic locations.  Furthermore, investors that shift their holdings from stocks, bonds, and mutual funds into commercial real estate to reduce volatility and increase returns.

• Tax Benefits - depreciation (also known as passive loss) could be used to reduce the tax consequence of passive income.  Professional investors may utilize this strategy to pay little, if any, tax.

• Financing - passive investors utilize the financing capabilities of sponsors to obtain favorable loan terms and conditions.

• Expertise - passive investors utilize the years of experience and knowledge of sponsors; passive investors can carefully select the best in class sponsors with whom to invest.

• Time - passive investors have very little responsibility and time committed to the investment.  The lack of commitments to the investment gives investors a chance to pursue other endeavors such as identifying other passive investment opportunities.

Investment Strategies

There are several real estate investment strategies that are differentiated by their risk-to-return characteristics.  As the risk profile of each strategy is based on the amount of leverage used to acquire the asset and the characteristics of the asset such as tenant credit worthiness, length of the lease, location, and physical condition of the asset.  A higher leveraged asset will increase investment returns and, all things being equal, a higher leveraged asset will also increase the risk associated with the asset due to increased likelihood of a default and foreclosure if the asset value declines during a market cycle downturn.  There are four main types of strategies:

• Core

• Core Plus

• Value-Add

• Opportunistic

The Core Strategy has the lowest risk of all the real estate strategies.  Core real estate assets are located in the high demand areas of major cities like Los Angeles and New York.  Core assets are typically on long-term leases and tied to "credit tenants," which have been deemed by a major credit agency (like Moody's or Standard and Poor's) to have the financial strength of being rated as investment grade.  These assets generate consistent cash flow, and their values tend to be the least volatile of all real estate assets.  For instance, a core asset would be a CVS or Walgreens store on a long-term lease.

The Core Plus Strategy has a higher return than Core but with a slightly higher risk profile.  Core Plus real estate assets are similar to the ones found in Core, but the quality is not as high.  These assets may be in secondary markets or asset types, such as medical offices and student housing.  These assets generate less predictable cash flow than Core assets but it may be possible to increase the cash flow by improving the property, quality of tenant, or the management.

The Value-Add Strategy has a higher return and a slightly higher risk profile than Core Plus.  The higher risk profile is, for the most part, due to the use of higher leverage of up to 80%.  Value-add assets may be in safer primary markets or riskier secondary markets.  These assets may suffer from one or more deficiencies, such as poor management, deferred maintenance, and occupancy issues that will be addressed as part of the value-add strategy.  There is the potential to greatly improve upon the existing amount of cash flow of these assets once the value-add strategy has been implemented.

The Opportunistic Strategy has the highest risk of all the real estate strategies.  Opportunistic assets involve the most complicated real estate projects.  These opportunities may include repositioning an asset from one use type to another, renovating a highly distressed property, or developing raw land into residential or commercial properties.  Investors in these deals may not obtain a return on their investments for several years, but the resulting cash flow may be very high.

The Value-Add investment strategy has a very favorable risk-to-reward profile when properly implemented on assets that have in-place cash flow with potential for forced appreciation.  It should be noted that this strategy becomes more difficult to apply in the latter stages of the real estate cycle when price valuations reach "premium" levels. 

For more information on the application of the value-add strategy as it specifically relates to multifamily assets, please check out our eBook - More Doors, More Profits - by clicking here.

Property Classifications and Market Types

PROPERTY CLASSIFICATIONS

Within multifamily, there are four property classifications.  Each classification has distinct property and tenant qualities and investment potential and risk.  Investors and lenders will utilize this information when making decisions about the viability of an investment.  Disparate pools of buyers will be attracted to each classification, and lenders will formulate this potential when considering financing terms.  The risk profile and investment objectives of an investor will determine the property classification to which they are most drawn.

Although Class "D" is included for completeness, most investors will avoid these properties because they tend to be located in high-crime, problematic areas and are very management intensive.  These properties are often purchased for cash flow rather than for appreciation potential.  The risk profile for these properties is not favorable for most investors.

MARKET TYPES

In the U.S., there are three main types of real estate markets: linear, cyclical, and hybrid.  Linear markets are characterized by property prices that are generally the "slow and steady" markets (i.e., little volatility), meaning that they experience gradual price increases without significant fluctuations either up or down.  Many of the linear markets tend to be away from the West and East Coasts and toward the middle of the country.  Birmingham, Huntsville, Kansas City, and St. Louis are some examples of linear markets.  Cyclical markets are generally more expensive markets and are characterized by prices that can experience significant fluctuations up or down.  Coastal cities like Los Angeles, San Francisco, Seattle, New York, and New Jersey are examples of cyclical markets.   Investors in cyclical markets are susceptible to substantial losses during economic downturns and sharp corrections.  Hybrid markets are demonstrating characteristics of an in-between market; the price volatility has increased substantially over a linear market but not to the extent of a cyclical market.  Charlotte, Denver, and Phoenix are examples of once linear markets that are now hybrid markets.  A once hybrid market, Austin appears to now be a cyclical market given its sizeable appreciation in real estate prices over the last decade.

Also, an area's market type may change over time.  For instance, a once linear market may become a hybrid market and even become a cyclical market.  A region that experiences continued job and population growth (capital inflows) may eventually transition from a linear market to a hybrid market, then potentially to a cyclical market.  These transitions occur as an increase in capital flows into a market and pushes up real estate prices.  If these transitions occur, they do so over a period of many years of continuous capital flowing into that market. 

Linear markets tend to have the highest cap rates and highest cash flow potential.  On the contrary, cyclical markets tend to have the lowest cap rates and the lowest cash flow potential.  The hybrid market is the intermediary and tends to have cap rates in between the other two market types.  Hybrid markets tend to have marginal cash flow, if any. 

Class A, B, C, and D properties exist in all market types.

Real Estate Tax Benefits

“The government grants tax and legal loopholes to real estate investors to encourage them to do a job that the government can’t.”

― Garrett Sutton

Since a syndicated investment holds real estate in a special purpose entity (SPE) such as an LLC, which is a pass-through-entity, the entity does not get taxed.  All the income, expenses, and tax benefits are passed through to investors and their respective tax returns as a result of being members (owners) in the LLC.  These benefits are summarized on a year-end tax document called a Schedule K-1, which is prepared by the LLC's accountant.  Each passive investor gets a share of these benefits in proportion to their ownership.  It is not uncommon for the passive investors to have little or no tax liability due to tax efficiencies or benefits like depreciation, cost segregation, business expense deductions, refinance, supplemental loan, 1031 exchanges, and self-directed IRAs.

The concept of depreciation is based on the idea that an asset will experience “wear and tear,” so the IRS allows the asset to be written off or depreciated over a period of time.  Depending on the real estate asset, this depreciation schedule is 27.5 or 39 years, and it can be used for the entire asset except for the land component.  In reality, real estate assets do not become obsolete like computers or vehicles, which do have a limited service life and are depreciated in a typical business.  This is why depreciation is also known as a “phantom” loss (the terms “paper” or “passive loss” are also commonly used) as this loss can be taken even when the asset is appreciating and producing income.  Passive losses will offset the annual cash flow (passive income) from an asset.

Furthermore, real estate depreciation can be accelerated through a cost segregation analysis.  This entails a study performed by a trained professional to identify property components that can be accelerated to a 5, 7, or 15-year period.  The cost segregation accelerates the passive losses and front-loads them in the earlier years of ownership, reducing the tax liability on any income.  The time value of money created by this benefit can be substantial.

As in any business, in real estate, all operating expenses such as property taxes, insurance, mortgage interest, repairs, and maintenance are tax-deductible.  These expenses are deducted from the asset's gross income before the taxable income is determined.  A W-2 employee should ask himself how many expenses can he deduct before receiving his paycheck?   

Refinances and supplemental loans are typically used to pull equity from an appreciated asset.  The pulled equity is passed along to the investors, and this money is non-taxable as this is borrowed money.  Harvesting equity in this manner can be used to invest in another real estate opportunity and the process can be repeated. Savvy investors will not allow real estate equity to sit idly, but will always look to refinance when practical and increase the velocity of their money.

If an asset is to be sold, a 1031 Exchange can be used to defer any taxes on the asset.  A 1031 Exchange allows the asset to be exchanged for a like-kind asset, which can be any type of domestic real estate such as raw land, multifamily, residential, retail, office, and so forth.  It is important to clarify that this is a tax deferral strategy, not a tax reduction strategy.  If a 1031 Exchange is implemented correctly, it can be repeatedly done until the owner passes away.  At that point, the owner's heirs inherit the property and get a stepped-up basis that resets the cost basis to the market value at the time of inheritance.  This wealth transfer is used by astute investor families to transfer legacy wealth from one generation to the next.  It is important to note that many real estate syndications are not set up to accommodate a 1031 exchange either into or out of the opportunity. 

Passive investors should first check with the sponsor if interested in using a 1031 Exchange.  There are rules for a 1031 Exchange that are beyond the scope of this article, and it is advisable to consult a tax professional or qualified exchange company for more information.

Self-directed IRAs can be used to invest in real estate syndications.  Most retirement accounts are typically held by a custodian that allows access to pre-selected stocks, mutual funds, and bonds; however, a self-directed IRA is much broader and can be used to invest in assets such as raw land, residential homes, commercial properties, notes, businesses, and also syndicated investments.

The tax benefits available to the real estate investor are tremendous.  There are more advanced tax strategies that are complex and require a more meticulous delineation than this article provides.  A motivated passive investor may construct a diversified portfolio of real estate assets to generate passive income and utilize tax benefits such as passive losses to offset as much passive income as possible.

Syndication Structure and Offering Documents

In a syndication investment, the sponsor will form a special purpose entity (SPE), which will hold title to the property and be the borrower on the loan.  The SPE is a legal entity typically structured as a Limited Liability Company (LLC) or a Limited Partnership (LP) and managed by the sponsor in the form of a Manager LLC or General Partner, respectively.  Passive investors become "members" of the LLC or become "limited partners" of the LP.  Lenders will want a newly created, property-specific SPE to make sure that this new entity has not engaged in prior business and potentially incurred liabilities.  In addition, the SPE protects passive investors from potential liability due to investor ownership of the property in the event of a lawsuit.

Prior to accepting investor funds, the sponsor is required to provide prospective investors with offering documents.  A securities attorney should prepare these documents.  The offering package consists of the following:

• Private Placement Memorandum

• Operating (or Limited Partnership) Agreement

• Subscription Agreement

• Business Plan/Investor Pitch Deck/Investment Summary

The Private Placement Memorandum (PPM) is the disclosure document that describes things such as the structure of the company, how the company will be operated and managed, risks of the investment, projected distributions to investors, fees, conflicts of interest, and liquidity of the investment.  Although real estate syndications can be great investments, these opportunities generally have a lack of liquidity, and investors should be prepared to hold interest for at least the entire project hold period.  The use of a PPM in a syndicated opportunity functions similarly to a prospectus for public offerings of stocks, bonds, and mutual funds.

The Operating Agreement in the case of an LLC entity or Limited Partnership Agreement in the case of an LP entity is the contractual agreement between the sponsor and the passive investors.  The agreement describes the duties and rights of the parties involved in the transaction, such as investor distributions, bylaws, voting rights, and fees collected by the sponsor.  

The Subscription Agreement is for investors to certify that they meet the qualifications and suitability to invest in the offering.  In this agreement, the investor will indicate the amount of money to be invested.

The business plan or pitch deck is the "marketing" piece that details the investment opportunity and its financial projections.  This document may be accompanied by other related documents such as the purchase and sale agreement, asset appraisal, and inspection report.

In a properly structured and aligned opportunity, the bulk of the sponsor's profits should be based on the performance of the asset, but there may be several non-performance-based fees:

• Acquisition Fee - for finding the asset, conducting due diligence, and structuring the opportunity; typically 1-3% based on the purchase price and is paid to the sponsor at closing

• Asset Management Fee - for ensuring execution of the business plan (i.e., oversight of the property management company and investors); typically 1-3% of monthly revenues 

• Refinance Fee - for refinancing the asset

• Loan Guarantor Fee - for loans that require a personal guarantee by the guarantor

• Disposition Fee - one-time fee for selling the asset

Not all these fees will be present on every opportunity, and, if present, their amounts will vary.  The most common fees in syndicated deals include acquisition and asset management fees.  These fees are not paid by the investors but are business expenses and accounted for before projected investor returns.  Fees merely compensate the sponsor to perform work that the business would otherwise have to hire and pay a third party to perform.

Commercial Real Estate Basics

Commercial Real Estate Basics

Investing in any type of real estate is a great way to build wealth, especially generational wealth, and offers five benefits:

• Tax Advantages - real estate offers several tax benefits

• Cash Flow - "profit" after paying the property expenses

• Inflation Hedge - unlike other investments, real estate in terms of both rents and property values move proportionately to inflation

• Leverage - the ability to tap into other's capital (typically from a bank) and then spread one's available investment capital across multiple opportunities

• Principal Pay down - portion of each loan payment is used to pay down the loan principal and build equity into the property

Many investors that invest in real estate, do so in residential assets like condominiums, townhouses, single-family homes, and complexes up to four units.  Commercial property is defined by five or more residential units within the same structure.  Commercial real estate is a fairly diverse asset class:

• Multifamily

• Senior Housing

• Hotel/Hospitality

• Industrial

• Retail

• Office

• Self-Storage

• Mobile Home Parks

Many investors are either unaware or under the belief that commercial real estate assets like multifamily are outside their reach or reserved for institutional and wealthy investors.  While for many years these players dominated the commercial real estate space, this is no longer the case.  The growth of online crowdfunding platforms and private equity companies raising investor capital via syndications in the last several years now make it readily accessible for motivated investors to become involved in commercial real estate.

Investing in commercial real estate provides investors with several potential benefits, including:

• Relatively consistent cash flow

• Lower vacancy risks as properties tend to have multiple units, and this mitigates for inevitable vacancies

• Higher income and appreciation with an annual income up to 2-3 times higher than residential real estate

• Higher availability of tenants

• Less competition (perceived barrier to investment entry in this asset class means that it tends to be less saturated with other investors)

For more information on commercial real estate and passive investing in multifamily assets, please check out our eBook - More Doors, More Profits - by clicking here.

The Confluence of Factors Favoring Multifamily Real Estate

Commercial multifamily real estate has historically been a proven asset class as it fulfills the human desire for safe, clean, and functioning housing.  Multifamily has performed very well in the last decade, and in spite of its extended price appreciation, the outlook for this asset class remains favorable.  Even with several fundamental drivers still in-place, investors should be mindful of current dynamics when evaluating multifamily investment opportunities.   

1. Decreasing Homeownership - Increasing rental households due to several factors such as increasing underemployment, stagnating wage growth, increasing consumer debt, changing lifestyle preferences in favor of renting, and tightening of mortgage lending standards.  The hurdles to homeownership continue to increase for many people in the U.S.

• Despite having an unemployment rate of around 4% at the lowest rate since 1976, this is not a complete picture as many Americans are "underemployed."  For instance, highly skilled workers who can get only low-skilled/lower-paying jobs would be classified as underemployed. Underemployment is challenging to measure and is not officially tracked by the U.S. Bureau of Labor Statistics, but the Economic Policy Institute published a paper in May 2018, which found the rate to be 11.1%. 

• Many Americans have had real incomes flat-line or decrease since 2000, according to the Bipartisan Policy Center's Report of the Commission on Retirement Security and Personal Savings.  An increasing number of Americans are facing barriers to income and wealth growth and also homeownership. 

2. Demographic Shifts - Major demographic shifts have been taking place. U.S. population growth continues to increase with approximately half of the total population consisting of two groups: Baby Boomers (born between 1946 and 1964) and Millennials (born between 1981 and 1996).  Millennials now comprise the largest share of the U.S. population and labor force. This group is expected to create up to 25 million new households between 2015 and 2025 and have a strong preference in favor of renting. Baby Boomers and Millennials are significant to multifamily demand because the largest group of renters is those age 20 to 34, and the fastest-growing group of renters is those age 55 and older.  Also, immigration is expected to account for approximately half of the new population growth in the U.S.  Immigrants have historically shown a much higher likelihood to rent than own and to do so for longer periods of time.

Projected Total U.S. Population - 2020 to 2060

Source: U.S. Census Bureau, 2017 National Population Projections

Projected U.S. Population of Predominant Renter Age Groups - 2020 to 2060

Source: U.S. Census Bureau, 2017 National Population Projections

3. Constrained Supply - It is estimated that construction of 4,600,0000 multifamily units will be needed by 2030 to keep pace with demand.  Meeting the demand is being hampered by factors such as unnecessary government regulations, increasing construction-related costs, rent control, and concentration of new supply.

• According to a research study conducted by the National Multifamily Housing Council and the National Association of Home Builders, an average of 32% of multifamily development costs were due to regulations imposed by all levels of government.  This is a staggering component of the total cost of multifamily development projects and serves as a sizeable hurdle to development and, particularly, with regard to affordable housing units. 

• Multifamily housing development is increasingly expensive due to the costs of vacant commercial land and construction (labor, materials, and contractor fees), according to the Joint Center for Housing Studies of Harvard University.  Between 2012 and 2017, the inflation rate was only 7%, but land and construction-related costs increased by 62% and 25%, respectively.

• In 2019, California, Oregon, and New York passed rent control laws with the most stringent taking place in New York.  Since 2017, more than a dozen other states have either considered legislation and/or ballot initiatives to limit rent growth.  Based on these developments, the continued push for more rent control is likely. Unfortunately, these laws disincentivize continued development of new units and investment in existing units.

• Based on a 2018 fact sheet from the National Multifamily Housing Council and National Apartment Association, supply has been further constrained due to the loss of up to 125,000 multifamily units every year due to destruction, demolition, and deterioration.  Also, the loss of multifamily units tends to be concentrated in lower-end workforce housing, which has been decreasing in supply. 

• Construction of new units has concentrated geographically and/or mainly in higher-end Class "A" properties. According to the March 2017 report by Fannie Mae, approximately 25% of multifamily construction occurred in five cities: Boston, Los Angeles, New York, San Francisco, and Washington D.C.  Developers will construct based on the project's (investment) yield, and this does not necessarily correspond to what unit type is most needed.  The construction of mid to lower-end multifamily units is financially challenging or nonviable in high-cost markets/areas as these same areas would highly favor the development of higher-end units.  However, these higher-end units fail to address the growing demand for affordable units.

Take Away for Investors

The constrained supply and growing demand for multifamily may take one or more decades to balance out as it requires almost 350,000 units per year.  The increase in rental households due to factors such as underemployment and stagnant wage growth means that a sizable portion of the demand is for workforce housing units.  In high-cost markets, the construction of higher-end units is heavily favored, but these units fail to adequately address the increasing demand for affordable units.

Given the multiyear price appreciation in multifamily real estate, it is likely that valuations in some markets are at or near the top of the current real estate cycle.  The fundamentals continue to favor multifamily investments, but investors will need to be highly selective when reviewing potential opportunities. Investors looking for lower-risk opportunities may want to focus on vetted secondary and tertiary markets that serve moderate and low-income households.