A respected industry analyst says those who succeed in picking, buying, financing and managing properties during a downturn will be set up to thrive when the economy improves.

While no one knows when the next recession will arrive, Ryan Severino, Chief Economist at JLL and an adjunct professor at Columbia and New York universities, is seeing signs that a downturn is getting closer.

“Growth will decline from ’18 to ’19 and ’19 to ’20, and we’re going to have to see if things hit the fan in 2021,” Severino said at NAA’s Maximize Conference, Sept. 23–24, in Atlanta.

Indeed, he’s already seeing some trouble on the horizon. “Objectively, [interest] rates are still low by historical standards,” Severino says. “Yet, investment is starting to pull back.”

When the recession does come, Severino thinks global political instability or unwise policy decisions will likely be the cause.

“We’ve entered a place where policy is starting to become a very big part of this economic outlook,” Severino says. “Most recessions are caused by policy errors.”

Specifically, Severino points to the trade war as a potential cause of the next recession. “[The trade war] isn’t doing very good things,” Severino says. “Trade is the linchpin on which a lot of this stuff hinges right now.”

In addition, political and economic tensions around the globe could spark a problem. “There’s no shortage of political risk in the world today, especially [regarding] policy,” Severino says.

When the next downturn does come, Severino isn’t sure there will be the political will to increase spending. “Spending is a lever that the government pulls to get the economy going. I’m not sure how many people are going to want to pull that lever next time,” he says.

Supply Concerns

The apartment industry is fairly well-positioned for the next downturn, though Severino does have some concerns about supply. 

“Supply will start ramping up again,” Severino says. “If the economy goes into a recession, absorption may be more difficult with more supply.”

While supply could cause problems in the Class A space, other locations and asset classes could thrive. Severino thinks suburbs to primary markets are poised to do well as millennials leave the urban core. He also likes older product. “I like B and lower product in a recession,” Severino says. “The demand there is incredibly stable, and supply has gone down.”

As a sector, Severino says, the apartment industry has some advantages going into a downturn. “There’s still a lot of demand out there, especially with for-sale housing being so expensive,” he says.

Even in a sector positioned to weather the downturn, there will be winners and losers. When the recession comes, the skill will be the most important factor in determining success, according to Severino. “Companies will rely on skill—picking, buying, financing and managing properties—to succeed,” Severino says.

The good news is that those who succeed in the worst of times are often set up for success when the economy improves. “The most successful people I know in real estate made their way in times of trouble,” Severino says.

Apartment deal volume set a record in the first half of 2019, but rent control poses valuation issues moving forward.

Driven by strong growth in secondary markets, apartment deal volume posted record highs and topped total commercial property sales growth statistics for the first half of 2019, according to Real Capital Analytics (RCA).

In all, $80.5 billion of apartments sold in the first half of 2019, beating the previous first-quarter record set in 2016. More than half of that volume, $43.2 billion, occurred in Q2, which posted a 19 percent year-over-year (YOY) increase and 7.3-percent YOY price change.

“Record highs this late in the economic expansion are all the more meaningful given how the market achieved this level of sales activity,” RCA said in its “US Capital Trends” report. “Back in 2016, the combination of portfolio and entity-level sales were [the foundation] behind 29 percent of all deal volume in the first half of the year. In 2019, only 23-percent of sales volume was tied up in megadeals.”

Only 2 percent of 2019 sales were entity-level deals (sales of entire companies), compared to 4 percent in 2016. Sales of individual assets, which RCA calls the “bedrock” of the market, struggled in Q1, but rose in Q2.

“It [the interest in single assets] is people making a decision one building at a time that, given all the other investment options; apartments are the place to be,” says Jim Costello, Senior Vice President at RCA.

The RCA CPPI, which tracks apartment value, increased 7.3 percent in Q2, compared to 11 percent a year earlier. Partially driving down prices was the performance in the six major metros: Boston, New York, Washington, Los Angeles, San Francisco and Seattle. The RCA CPPI only rose 4.5 percent YOY in those markets, versus an 8.3 percent gain in secondary and tertiary markets.

Cap rates averaged 5 percent in the six major metros in Q2, which is a 20-basis point increase from a year ago, according to RCA. “The increased deal volume in Q219, along with the cap rate movement, suggests that owners have capitulated a bit on price expectations,” RCA said in the report.

RCA determined that cap rates were up in 11 out of the 15 submarkets that are within the six major metros but increased in only 15 out of 43 remaining markets in the non-major metros.

“People are looking at some of these [six major] metros and making the decision that, given rent control and a host of other factors, they are just stepping back from their [return] expectations,” Costello says. “There is a little bit of uncertainty around what’s going to happen to the rents and apartment income of these markets.”

Dallas led the way in deal volume for the first half of the year, followed by Phoenix, Los Angeles, Atlanta and Houston. Manhattan, which had held the top position for years, fell to No. 8 on the list.

“Again, cap rates are extremely low and a change in rent control regulations have chilled investor optimism [in New York],” RCA wrote in the report.

Apartment deal volume came in at $36.4 billion, which was only a 1 percent increase compared to Q1 2018, according to Real Capital Analytics (RCA).

While Q1 deal volume stalled compared to last year, the apartment market still posted the second most active first quarter ever (behind Q1 2016). RCA considers any growth at all a positive for the apartments.

“The paucity of growth for the apartment sector in Q1’19 was in some respects a positive sign,” RCA writes in its U.S. Capital Trends report for the apartment market. “Deal activity for commercial property overall fell in the face of turmoil in the financial markets. So, the limited growth for the apartment sector is a case of outperformance relative to other property types.”

Portfolio sales drove volume in the quarter while single-asset sales struggled. Portfolio sales in Texas represented 35 percent of deal volume.

Matt Ferrari, Co-Chief Investment Officer, Head of Acquisitions and East Coast Asset Management for TruAmerica Multifamily, says he has not seen as many portfolio sales as he saw last year. “The few portfolios that we have seen are certainly smaller and perhaps more regionally focused than a year ago,” he says.

Additionally, there were no entity-level deals (sales of entire organizations) in the quarter. While RCA says it is not unusual to get a quarter without these kinds of deals, they did represent 25 percent of all deal volume in 2018. Volume in the mid- and high-rise segment grew 7 percent, while sales in the garden segment fell 2 percent.

Prices continued to increase in Q1 as RCA CPPI for the apartment sector rose 7.3-percent YOY. As values rose, cap rates continued to decline, falling 20 basis points to 5.2 percent.

Competition for assets drives price increases. While Ferrari says competition for deals abated in Q4 and early in Q1, things soon heated up again.

“Since rates have dropped, it has been ultra-competitive to win deals, which seems to be a similar dynamic at the same time last year,” Ferrari says.

Others agree. “It is as competitive as ever,” says Doug Root, Co-Founder and Managing Partner of Blackfin Real Estate Investors.

Deals remain available if buyers know where to look.

“There are still good suburban value-add opportunities available in many of our target markets and we continue to be bullish on the space and our investment thesis,” Ferrari says. “There also continues to be a healthy amount of product in many of our markets and our goal is to still buy $900 million to $1 billion of apartments this year if we continue to find opportunities that we like.”

Ten years ago, the Great Recession walloped almost every sector of the economy. According to the U.S. National Bureau of Economic Research, which officially tracks the country’s recessions, it started in December 2007 and ended in June 2009, lasting 18 months. While many owners of apartments faced foreclosures and tighter lending regulations, demand for their product grew when homeowners lost their housing, couldn’t close or afford to buy.

Apartments became the belle of the ball, offering the best solution for a roof over residents’ heads and a good financial opportunity. Investment soared to $154 billion in 2017 from $104.6 billion in 2007, according to Real Capital Analytics. Owners and operators made their projects more appealing by debuting more downtown locations as urban living became hot and introducing new amenities, which helped fuel the current craze.

As the 10-year anniversary of the end of that meltdown has passed, many owners and operators look to a variety of strategies to preclude it from reoccurring, or at least on the same scale. For now, the market looks strong: Apartment absorption remains at its highest level in three years, according to the U.S. Census. Additionally, rental housing is becoming the favored choice for Gen Z, the cohort that follows the Millennials, says Andrew Gerringer, Managing Director of New Business Development at The Marketing Directors in New York, a real estate sales and marketing consultant.

But because demand can quickly shift, owners and operators should know which strategies industry survivors find most useful. While shoring up their balance sheet with the right financing is important, other strategies, such as finding the right location, utilizing technology and data, hitting the right affordability sweet spot and using superior design can help apartment professionals weather the next storm.

Financing: Secure longer-term fixed and floating rates and non-recourse debt.

The excessive short-term debt that many developers and owners took on is frequently cited as one of the prime causes of the crash. But so, too, is the fluctuating nature of interest rates, especially in an industry where projects take years to complete.

“Interest rates shot up, people couldn’t pay, homeowners moved out and projects failed,” says Stuart Saft, Head of The Real Estate Practice at the law firm Holland & Knight. More lessons were learned if projects took longer than expected, says Gerringer. “They found interest rates were not their friend and could make a difference as to whether they made a profit,” he says.

Another financial lesson learned was remembering the cyclical nature of the industry and that adjustments must be made. Commercial mortgage broker Charles Foschini’s recommendation now is for apartment owners to take advantage of the current “exceptional time” and lock down long-term, non-recourse debt or financing for 15 or 20 years. It’s also important for owners to recognize that the market is now mature, says Foschini, Senior Managing Director and Co-Leader for Florida Productions in Berkadia’s South Florida office. “Growth will continue but not at the same pace,” he says.

Many owners are already doing so. Waterton in Chicago, which has long focused on investing and managing workforce apartments, has used a combination of long-term debt with a 50/50 mix of fixed and floating rates that are non-recourse and matched the term to the asset’s expected holding period. “The goal has been to have plenty of liquidity for good opportunities,” says David R. Schwartz, CEO, Chairman and Co-Founder of Waterton.

At the time of the Great Recession, Waterton had accumulated significant capital, and sat tight until banks came calling for it to help rescue other firms’ assets. “It became a fun time with great opportunities for us,” says Schwartz. “Rents were down 3 percent because of job loss but that was much less than the overall housing downturn of 25 percent,” he says.

King of Prussia, Penn.-based Morgan Properties, the nation’s 20th largest multifamily apartment owner with more than 46,000 units in 11 states, takes a different approach with its class B rental housing. During the past few years, the company has remained active in acquisitions, but has changed its financing strategy toward debt versus floating-rate financing.

“Today, 90 percent of our portfolio has long-term, fixed-rate financing, which makes us extremely well positioned for success toward the later innings of the cycle,” says Jason Morgan, Senior Vice President of Acquisitions and Investment Management for Morgan.

Morgan has also launched a multifamily debt platform during the past 14 months that focuses on Freddie Mac K-Series B-pieces (Freddie loans with various terms). “We are able to leverage off our vertically integrated platform, diversify in the capital stack and make attractive risk-adjusted returns,” Morgan says.

LumaCorp., in Dallas, another workforce apartment leader, has found that holding investments for the long term helped it survive throughout its 35 years. Because it, too, believes the cycle is at or near the market peak, it is harvesting capital gains from existing assets and reinvesting them through 1031 Exchanges.

“We want to sell strategically and reposition existing assets for long-term holds since we anticipate doing fewer deals,” says Ian Mattingly, President.

Some companies are willing to use a combination of construction loans and mortgage debt, but do so carefully. Steve Fifield, Founder and CEO of Fifield Cos. in Chicago, which focuses on urban infill apartments, keeps debt to 60 percent to 65 percent of the value in case rents drop or vacancies increase if a recession occurs. But Fifield says he learned this lesson longer ago. “It came from the 1990-91 recession when most of us developers had easy access to 80 percent to 100 percent of cost financing. Ten years ago, I had already embraced using 60 percent to 70 percent debt levels and partnering on virtually all development projects with large institutional investors or family offices,” he says.

Fifield’s other financial strategies are to get to know his bank and equity investors well, track supply and demand, keep rents in line with fluctuations in each market and hold down head-count costs by not replacing staff lost through attrition. “Numbers [headcount] fell about 20 percent over the last two years. We’re now right-sized,” he says.

Location: Know your market.

Location, location, location may still be the mantra, but the definition of what’s a prime apartment site varies by the cost of developing and operating it for different demographics that may congregate there. In uber-expensive New York City, properties are rising farther afield, says Gerringer. For many clients that has meant buildings in the Hudson Yards area along the Far West Side, in Long Island City in Queens where Amazon will locate a HQ2 headquarters and parts of New Jersey beyond gentrifying Hoboken and Jersey City, he says. 

Harrison, N.J., a suburb of Newark, once had little to attract residents, but developers saw the wisdom of constructing apartments because of the low cost of land and proximity to a Path rail stop into Manhattan. “It was a good place for renters looking for the best value rather than mixed-use amenities their more affluent counterparts want,” says Gerringer. 

Waterton’s favorite sites are typically in urban and suburban areas near public transportation, a highway or major road. But it has found that its renters also seek a variety of retail and employment opportunities. Currently, it sees strong demand in suburbs of Dallas, Raleigh and Charlotte. 

RKW Residential, based in Charlotte, is interested in suburban markets, too, but which have a downtown-type center to attract a mix of demographics. Proof that its strategy works is its The Lowrie in suburban Charlotte, which leased up soon after opening, says President Marcie Williams.

Some owners prefer to focus on a single region that it knows well. For LumaCorp. That place is Texas. There, it finds viable opportunities as companies relocate, and desires apartment buildings close to jobs. Unlike counterparts elsewhere, walkability to mass transit isn’t a factor since it’s still in its infancy in Texas, Mattingly says. “Renters have to have a car to have a job,” he says.

London-based Balfour Beatty Communities, with its U.S. headquarters outside Philadelphia, also considers knowing its markets well part of its success, though its locations are spread apart in 17 U.S. cities and six states. Its 1,500-plus staff helps it tap into the local dynamics and adjust strategies, says Mike Price, Senior Vice President of Residential Transactions. “We feel deep local market knowledge is still key to weathering the tougher investment cycles and taking advantage of the upturns,” he says.

Avoiding losses also involves knowing when to leave a market or not enter. While LumaCorp hunts for new locations, it also trims its portfolio where growth forecasts are low, or other companies have a robust pipeline of new inventory, Mattingly says. Fifield steered clear of his South Loop Chicago backyard because of a lack of restaurants and shopping. As they were added so was apartment inventory, and now, he says, it will be three to four years before the submarket is back in equilibrium.

Technology: Harness knowledge.

Before 2008, few predicted a recession and of such magnitude. Ten years later most of the industry waits for the next downturn, though the prediction is for one far less severe. The difference, says Alfredo Munoz, CEO at ABIBIOO Studio in New York, a design and construction management firm, is the quantity of data available.

“With all the data out there, it’s much easier to track markets, opportunities and zero in where we can build and when,” Fifield says. All the data also helps companies save money since it eliminates their need for as much advertising, says Gerringer.

Some large companies, such as Waterton, have an in-house technology staff and use proprietary algorithms to track data. It also outsources research. The goal is to stay on top of 1,000 submarkets across the country and rank the best ones to invest in, Schwartz says. Recently, it added new markets to its U.S. target list, such as Nashville, Salt Lake City and Louisville.

“Nashville, for example is seeing significant growth as 100 people move there each day, some from companies relocating like asset manager Alliance/Bernstein from New York, which will provide a better labor pool and more renters,” Schwartz says. Smaller companies see the wisdom of outsourcing technology, leasing and marketing and investing in systems, so they can stick to their knitting and not support staff during slower periods, says Gerringer.
Firms use the technology for more than choosing locations. Mattingly has found data helpful to know when to pare labor costs, one of its biggest challenges.
“Last year, these costs increased at double the pace of our typical five-year trend,” he says. The result: More video conferencing and less reliance on road warriors, he says. At the same time, it won’t give up on the important human touch, which it considers critical to attract and retain renters and staff. Such steps help secure positive online reviews and maximize occupancy.
“Renters look for buildings with the best reviews. Essentially, more good reviews leads to more renters,” says David Scherer, Founder and Co-Head of Origin Investments in Chicago, a private equity real estate firm that owns and operates multifamily buildings nationally.
Williams’ RKW Residential concurs with this approach. Though her company offers virtual reality tours to generate leases, it also depends on a live team.
“One thing we are doing is adjusting hours,” she says. “This way, a team member is available for residents or prospective residents who work during the day and need service when they are off work in the evening. 

The demand for this kind of quality of service stems from owners and operators knowing that many residents measure what they do against the hospitality industry. “We are seeing greater convergence between apartments and hospitality, and we expect this to continue,” says Fred Cooper, Sr., Vice President, Corporate Finance, Toll Brothers, a luxury home and apartment builder in Horsham, Penn., outside Philadelphia.

Affordability: Fill a void.

From 2010 and 2016, the number of apartments deemed affordable for very low-income families fell by more than 60 percent, according to a report from Freddie Mac. New York-based Jonathan Rose Companies has long recognized the void because of its core belief in impact investment. Doing so helped it weather the Great Recession without vacancies, says CFO Mike Arman. And President Jonathan Rose remains optimistic for any upcoming downturns. “We think we’ll continue to be pretty recession proof,” he says.

Rose plans to acquire more assets from acquisitions rather than building them, which is riskier.
“Our goal is to preserve this sector by buying and holding onto units acquired through the life of the funds we use—about 10 years—or if we sell, going to a buyer with the same philosophy,” Arman says.

Most of Rose’s 70 properties also represent project-based Section 8 housing rather than riskier voucher-based housing and are operated by the company’s own property management company rather than turned over to a third party, Arman says. Yet another reason Arman thinks that his company’s 15,000 units have become so desirable is its practice of creating “Communities of Opportunity” to bring health, social services, education and recreational programming into the community centers it constructs. A coordinator works with local organizations to strengthen residents’ lives, which, in turn, enhances neighborhood fabric. For example, residents without health insurance might receive free flu shots from a local hospital.

At Waterton, Schwartz and his team also focus on older buildings with lower rents, so it makes economic sense to add value inside the apartments and amenities, such as a fitness room, outdoor space and 24/7 accessible package room and develop underutilized features, such as racquetball and tennis courts. “We raise rents but still keep them affordable and significantly less than new counterparts,” he says.

Design: Cater to a target’s psychographics.

These days good design isn’t just about looks but inspiring the right experience. Doing so doesn’t require greater spending but better research and planning on paper before construction gets bid, says Mary Cook, a Commercial Interior Designer and Founder of Mary Cook Associates in Chicago. “What’s also important is weighing the competition’s offerings against the values and interests of the target market and differentiating projects,” she says. 

Nowadays the newest recession-proof tool is psychographics research that factors in customized lifestyle choices, Cook says. “If you improve their quality of life and make it easier, they will come and stay—and encourage friends and acquaintances to join them,” she says. But it’s essential to use information to get choices right the first time rather than spend to correct problems, she says. “Fifteen percent of our work each year is ‘fixing’ projects completed by someone else who did not adequately consider the potential residents,” Cook says. 

Gerringer advocates for this approach, as well as building in flexibility, particularly with an amenities program that can adapt to changing resident preferences. “Rather than have theaters with stadium seating that limit use, we suggest a screen in a room that can be converted to other purposes,” he says. 

RKW Residential is converting business offices to co-working spaces, and dog parks to fitness centers so canines can do more than walk but work out on agility courses, treadmills and with tennis-ball launchers. Because of technology tools residents can be polled frequently about choices, from their fitness preferences to sponsored group events that foster community, Cook says.

Bottom line.

Owners and operators who remember the Great Recession’s lessons and monitor what’s happening seem optimistic. “If we go into an economic downturn in 2020 as some prognosticators suggest, the rental housing industry is on solid footing and may see nominal revenue declines, but will still be supported with strong capital flows,” said Schwartz of Waterton.
Barbara Ballinger is a freelance reporter.