Fear of US unemployment reportedly nearing 20 percent due to the economic fallout of the covid-19 public health crisis has brought the spotlight back onto housing unaffordability, especially for moderate income earners like the healthcare workers on the front line.
According to estimates by the Furman Center for Real Estate and Urban Policy at New York University in June, as many as 451,300 renter households in New York state – one of the worst affected regions globally – have experienced job losses and filed unemployment benefits claims. These are effectively households with annual incomes below 80 percent of their local area median income. The amount of monthly rent owed by this income demographic who have lost wages in the past three months is around 17 percent of all rent across the state.
Housing for such middle-income earners – generally defined in the US as households earning between 60 and 120 percent of the area median income – has become a key target area for multifamily investment managers over the past few years. Covid-19 will only further exacerbate the demand for such housing, even though existing underwriting of such assets would need to be revised just like all other real estate sectors.
Preferred investment routes
Popularly referred to as workforce housing, the strategy includes both unregulated, non-rent-controlled properties and regulated housing wherein managers are contractually restricted to keep their rents to a certain AMI level. A Q3 2019 CBRE report estimated the total regulated workforce housing stock was 1.4 million units while unregulated housing – so-called naturally occurring affordable housing – was 5.3 million units across the US.
There are a further 23 million rental units in properties with fewer than five units, where CBRE notes it is reasonable to assume that many have rents low enough to be counted as naturally occurring affordable housing.
In January, for example, former Ares Management partner James Simmons set up a private real estate investment firm specializing in middle-income housing, among other sectors. Asland Capital Partners was launched through a concurrent recapitalization process by StepStone Group Real Estate and went on to acquire two mixed-income multifamily assets – including both subsidized and market-rate rental units – in New York and Virginia worth approximately $85 million. PERE understands the firm plans to acquire approximately $500 million-worth of assets over 24 months.
Considering how covid-19 changed the original underwriting for the two value-add investments, Simmons says: “We have sensitized our collections and we have increased our potential delinquency and our legal fees. So, as we project forward over the next six months, we have sensitized revenues based upon that. [However], our collections have been better than what we might have expected back in March.”
Going forward, the firm intends to focus on a few core markets, including Austin, Chicago, Dallas, San Francisco and Los Angeles, where Simmons believes there is dire need for high-quality affordable housing. These value-add investments will typically target mid-teens IRRs.
Particularly for rent-stabilized workforce housing investments, however, Simmons says managers would need to lower their return expectations to 10-12 percent gross returns, more akin to a core-plus strategy, and partner with long-term capital that can invest for a 10-15 year duration.
These underwriting revisions are a consequence of not just covid-19 but tightening regulations. Last summer, New York City passed sweeping rent laws allowing more protections for tenants in its one million-plus rent-stabilized apartments.
On the commercial real estate debt side, firms are betting largely on mezzanine construction loans or first mortgage acquisition loans. For instance, Pembrook Capital Management, a New York-based debt manager focused on impact investing and affordable housing deals, targets housing in high-cost areas for a strongly employed lower middle class to enable them to live closer to where they work. The firm closed a $10.6 million financing deal for the acquisition and rehabilitation of five Los Angeles properties in January.
Stuart Boesky, chief executive of Pembrook, believes the opportunity for construction financing by private lenders lies in filling out the capital stack between the pre-GFC advance rates and what they are today. He notes that before 2009, it was typical for banks to offer construction financing between 80-85 percent loan-to-cost, but that number has now dropped to 50-65 percent.
Over a year ago, for example, the firm made a similar construction financing deal in Los Angeles County for a housing complex being built for hospital workers, policemen and teachers working in surrounding areas. Pembrook made approximately a $20 million investment in the deal valued at $90 million overall. A local bank provided financing at a 50 percent advance rate; Pembrook came in at the preferred equity stage to fill the space between 50-75 percent, and the remaining 25 percent was committed by the developer of the project.
“The construction loan opportunities for workforce housing are really mezzanine or preferred equity,” Boesky says. “A bank should be doing the first, and if it is not then there is probably something wrong with the deal. The only construction lending that should be getting done privately is spec office or hotels, where the risk is high enough that somebody will pay the price. But in multifamily rental housing, that is just not the case.”
The firm has also been active in the first mortgage loan space. “Pre-covid-19 we would have probably priced a first mortgage acquisition loan between 400-600 basis points over LIBOR,” Boesky notes. “Then we would go to our bank and borrow against that at anywhere between 175-225 basis points over LIBOR, which ended up getting us low double-digit returns. The pricing has changed because covid-19 has destroyed a lot of competition, especially the mortgage REITs.”
In general, pricing across the debt capital stack has been revised to factor in the current disruption. Boesky says Pembrook has made its pricing at least 200 basis points lighter.
For a lot of multifamily operators in workforce housing and the broader affordable housing sector, the US government stimulus measures – a $1,200 coronavirus stimulus check for US residents below a certain income threshold and other incentives for small businesses – have so far helped tenants pay their rents, thereby avoiding a catastrophic disruption to the landlord’s operating cashflows.
“If the stimulus checks keep going through November until the elections and businesses end up re-opening by November, we feel like it will be a happy ending for affordable housing,” says Boesky.