Value-Add Deals On Hold As Investors Weigh Rental Income Risk

The swift economic impact of the coronavirus pandemic pulled the brakes on a wide range of real estate transactions around the country. Value-add acquisitions, which have been a hot target for investors in the multifamily and office sectors for years, have tapered off, reflecting investor uncertainty around property values, projected rental income and leasing activity.

Houston, which is dealing with the double blow of the pandemic and falling crude oil prices, could become a ripe market for value-add deals. But those opportunities could be as far as two years away, depending on how long economic recovery will take and when assets become distressed enough to be a good deal.

Value-add investment typically involves purchasing a property with some maintenance needs or that hasn't been updated in a while, and investing in upgrades. The buyer can then charge higher rents, appeal to more tenants to boost occupancy or even raise the property up a class.

CBRE Americas Head of Multifamily Research Jeanette Rice told Bisnow value-add investment is tougher in the multifamily sector right now. Though there is still plenty of interest, the uncertainty around achieving the needed increases in rental income has taken most deals off the table for the moment.

“The big short-term question — for the U.S. or Houston — is: Can an owner get the rent growth needed to justify the upgrade to the product? The answer is probably not. That uncertainly leads to difficulty in pricing an asset by the buyer or lender,” she said.

Most buyers and lenders will also need to see an increase in multifamily demand. That demand has taken a substantial hit from the pandemic, as millions of people have lost jobs, which may drive renters to get roommates, move down a class or move back in with family.

Beyond the immediate effects of the pandemic, Rice said value-add activity will return. But in order for that to happen, both the U.S. and Houston will need to see more market recovery, which will provide a clear sightline on future rents.

Houston’s multifamily performance over the past two months has been in line with national trends. CBRE Econometric Advisors is projecting an 8.1% drop in rents nationally and 8.4% in Houston in 2020. Vacancy rates are also expected to rise 2.9% nationally and 2.8% in Houston. Property revenues are also impacted by rent delinquency and credit loss, Rice said.

Widespread job losses have dampened renter mobility, and Houston is among several U.S. metros expected to see a significant drop-off in migration for at least the next year, according to research from CoStar. That slowdown could mean fewer multifamily projects in the pipeline or construction timelines extended as a reaction to weaker demand.

Value-add acquisitions in the U.S. office sector have also seen a significant drop-off over the last two months. Chad Phillips, head of the office sector and portfolio manager for the Americas at Nuveen, told Bisnow transaction volumes have clearly fallen.

“Most of the deals that were on the market pre-COVID or kind of in the middle or beginning parts of COVID were probably pulled from the market,” Phillips said.

“You're starting to see some signs of life now. There are starting to be some new deals coming into the market, and I think that the first wave of the deals are probably going to be core in nature, with security of cash flow.”

Phillips said in this environment, it’s harder for investors to predict lease-up timing and how rents are going to react, which could mean they take a hit on value. That could lead to some long-term opportunities for buyers.

Houston’s office market has a vacancy rate of 21.9%, according to NAI Partners’ monthly snapshot report for May. That is expected to rise as the energy downturn continues to force oil and gas companies to cut costs.

Houston’s older stock of 1980s vintage office buildings have frequently been targets of value-add acquisitions, providing an opportunity for investors to buy well-located buildings and upgrade them with better amenities to boost rental rates.

“Prior to the COVID-19 pandemic, many active landlords were involved in an amenitization war with their projects and were in the process of reimagining existing, very well-located assets to unlock value and meet the demands of today’s tenancy,” Nuveen Senior Director and Southeast regional head Charlie Russo said.

“Examples include food and beverage options, health and wellness offerings, collaboration areas and other ancillary services such as day care, all done in an effort to create a sense of place for tenants and enhance efficiencies. I see this trend to continue when things return to a new normal and beyond.”

Though there may be a pause in acquisitions, experts believe Houston will stay on investment radars and value-add buys will resume — eventually.

“There is a strong talent base and many well-capitalized organizations with a significant footprint in Houston that make it an attractive place to invest, depending upon an investor’s particular investment parameters,” Russo said.

Rice said that multifamily recovery should begin in Q1 2021, and then continue steadily through the rest of the year. However, full recovery is not likely until early 2022.

“Once the recovery process has begun, it will be a safer environment to underwrite value-add acquisitions for both buyers and lenders,” Rice said.

Longer term, the U.S. and Houston will need more moderately priced housing and preservation of older stock apartments, which value-add activity can provide, she added.

For office, the best time to buy may still be yet to come. Collections on most office portfolios are still at 90% of scheduled revenue, so there isn’t enough distress in the system yet. There is also the challenge of travel restrictions, which is a barrier for investors looking to make opportunistic purchases.

“It's hard to travel to the buildings and things like that and actually do all the ground diligence,” Phillips said. “Until that comes back in full force, you won't see too many transactions, but you're starting to see some, and the world's starting to open up.”

Russo said it could take another year or more for value-add opportunities to become apparent in Houston’s oil market as the dynamics of the pandemic and the oil downturn continue to play out.

“We may not see the real influx of value-add investment opportunities here until the next 12 to 18 months as deals reprice and workout discussions between borrowers and lenders run their course,” Russo said.