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COVID-19 affects multihousing pricing, underwriting

The one topic that seems to be of most interest to buyers and sellers alike is: What does underwriting and pricing look like during this COVID-19 environment?

Pam Koster
Managing director,
capital markets, JLL

Like so many real estate professionals, my days during this COVID-19 pandemic have been filled with more conference calls than I’m even able to count. Understandably, everyone is searching for real-time information – from current rent collection data and consensus about employment/market conditions, to agency lending options and up-to-the-minute status on deals in the market. At the same time, all of this information is changing seemingly daily – so quickly that it was stressful thinking of a topic for this article, knowing that by the time this goes to press, the world will look completely different again.

The one topic that seems to be of most interest to buyers and sellers alike is: What does underwriting and pricing look like during this COVID-19 environment? Undoubtedly, both have been impacted. Our Denver multifamily team did complete one transaction that was marketed on a limited basis in April and closed in June. There were three conclusions that we were able to draw from this particular deal.

One, buyers still are underwriting to pre-COVID-19 yield requirements. For example, if a buyer was targeting, say, a 13% levered internal rate of return on a core-plus deal prior to the pandemic, they still are targeting the same 13% levered IRR today. What has changed is how buyers are underwriting assets, most notably in years one and two of their hold period. Buyers are increasing physical vacancy slightly, increasing bad debt, underwriting two to four weeks of concessions, and assuming zero market rent growth for the first two years. Also, if there is any potential to upgrade the property’s common area amenities or unit interiors, buyers aren’t undertaking these capital expenditures until year two or three.

Second, these changes to underwriting while keeping yield requirements the same is resulting in a pricing decrease of roughly 4% in metro Denver compared to six months ago. However, it’s important to keep this decrease in perspective. Deals that were trading in fourth-quarter 2019 and first-quarter 2020 were seeing some of the most aggressive cap rates we’ve ever seen in metro Denver. Several of the deals that we sold during this time were trading in the 4.25% to 4.5% cap rate range on in-place rents and stabilized expenses. The deal that we closed in June during COVID-19 was closer to a 4.7% cap rate, which was more in line with the cap rates we saw as recently as June/July of 2019, but would have undoubtedly traded closer to a 4.5% cap rate even three to four months ago.

What is keeping the changes to underwriting and subsequent price decreases somewhat minimal is the third conclusion, which is the fact that agencies have been lending throughout this pandemic. This has been instrumental in keeping the multifamily sector on somewhat steady ground the past several months. Even though lending terms are very fluid and changing daily, the simple fact is that debt is just as advantageous today as it was prepandemic. In April, Freddie Mac’s 10-year, fixed-rate debt was closer to a 3.51% coupon. Today that coupon is as low as 2.87%. Interest-only loans for seven- and 10-year terms still are available. Although an increase to a 1.45 debt service coverage ratio is impacting proceeds somewhat from 65% loan to value prior to closer to 60% LTV today, in some cases, because the government-sponsored enterprises are not close to hitting their 2019 lending caps, they are actively and aggressively lending on new transactions.

All this said, what the world looks like in three to six months, or even one month, is anyone’s guess. However, in terms of what investment activity might look like in metro Denver, there are a number of factors that bode well for looking at the glass as “half full” going forward. Industry research groups such as RealPage and Yardi note that multifamily markets performing the best during this pandemic tend to be tertiary, tech-centric markets such as Denver, Phoenix, Austin, Texas, and Charlotte, North Carolina.

Another positive factor has been rent collection data. The National Multifamily Housing Council, which is tracking rent collection data for circa 11.5 million apartment units nationwide, found that in April, May and June, 94%, 95% and 95%, respectively, of apartment households make a full or partial payment by the end of the month. Metro Denver data is showing this number to be closer to 97%, so metro Denver has been outperforming the nation. Another factor that bodes well for metro Denver is the political climate during this pandemic. While states such as California, Washington, Oregon and New York have grappled with legislation pertaining to rent control and evictions specific to the pandemic climate, metro Denver has not seen the political volatility that has accompanied some of these debates in other states. Since capital typically doesn’t like instability and uncertainty, it will continue to seek markets like Denver where political risk is mitigated, comparatively.

Although the future still holds much uncertainty, like every economic downturn we’ve seen, opportunities will and do arise. Most investors still hold a positive, longer-term outlook, and maintain that we still will see more of a V-shaped recovery at some point. Some markets will fare better than others, no question. But based on current discussions with investors, most remain favorable on multifamily investments in metro Denver today and in the foreseeable future.

Featured in CREJ’s August 2020 Multifamily Properties Quarterly

Edited by the Colorado Real Estate Journal staff.