Elevated Pricing, Shaky Fundamentals Have Some Investors Shying Away From D.C.

D.C.'s investment sales market started off hot in 2018, but amid an environment with falling multifamily rents and tepid office leasing, some investors think deals are being overpriced and are shying away from buying in the District. 

Crowdfunding platform Fundrise in August 2016 had announced plans to invest $200M annually in D.C. multifamily properties, as part of a JV with Insight Property Group, but Fundrise CEO Ben Miller said he has since become less bullish on D.C.

"The market has gotten very pricey, and there is a lot of new supply of multifamily," Miller said. "It's very challenging to invest, especially in D.C., with that dynamic. We've ended up investing more actively elsewhere and not being as active in D.C."

The last D.C. multifamily deal Fundrise closed was an investment in Elysium Fourteen, a 56-unit apartment building on the U Street corridor. It made the initial investment in November 2016, but Miller said it recapitalized the deal in January. Miller said Fundrise has shifted to doing multifamily deals in other cities and focused on smaller, single-family and row house deals in D.C., because he does not like what he sees in the District's multifamily market.  

The District's Class-A apartment rents fell 3.9% in 2017, according to Delta Associates, coinciding with the delivery of 4,789 units, 45% more than hit the market the prior year. That supply growth is expected to increase even more this year, and Delta predicts rents will decline another 2% in 2018. Given these fundamentals, Miller said it does not make sense for investors and developers to keep putting money into new projects. 

"Every cycle you build an industry; this cycle they built an industry around multifamily. A lot of multifamily real estate companies have to stay active, so they're going to continue to do deals even when they shouldn't," Miller said. "If you look at the supply of multifamily coming in this year and next year, and Class-A multifamily rents went down last year and probably will this year and the following year, why do they keep building? Why are they still supplying the market?" 

Federal Capital Partners Senior Vice President Erik Weinberg has similar concerns about Downtown D.C.'s office market. The investor has recently done deals on the Dulles Toll Road, where it last year landed Amazon Web Services to fill a 400K SF Herndon building it acquired in 2015. But Weinberg said FCP has not been active in D.C.'s central business district. 

"We've found it to be a challenging leasing environment, and it's not priced well in the capital markets," Weinberg said. "We have not done a lot in downtown. We'd like to, if we could find something, we just haven't gotten there." 

The year began with a rapid string of office sales in the CBD, with a large portion of the investment coming from overseas. Spanish investor Masaveu Real Estate acquired 900 G St. NW for a record-breaking price of $1,278/SF. But given that the District has seen relatively slow office leasing in recent years, Weinberg thinks foreign investment is contributing to an overpriced market.  

"We always see foreign investment in D.C., and when you have someone looking for long-term ownership in a D.C. asset, it tends to drive up pricing," Weinberg said. 

FCP is currently working to raise money for what it hopes to be a $700M real estate fund. Weinberg said it remains bullish on the Dulles Toll Road corridor, and also has become more active in the Raleigh-Durham market. 

As Fundrise and FCP grow hesitant about making big D.C. acquisitions, both investors have begun providing more mezzanine financing and preferred equity.

With banks becoming more conservative and only lending for 55% to 60% of a project's cost, both investors have seen an opportunity to bridge the gap in a developer's capital stack to help deals get completed. Given the escalation of construction costs making deals tougher to pencil, Weinberg said FCP has been more comfortable taking a mezzanine financing position.

"A lot of this is driven by the banks either not investing or investing at a lower percentage of the deal, so it creates a void in the capital raise for these deals," Weinberg said. "You’ve seen a lot of alternate lenders in this space over the last couple years."

Miller said the majority of recent deals he's done in D.C. has been providing preferred mezzanine equity, entering the capital stack between the equity investor and the bank and offering 10% to 12% rates of return. 

"I like it because it's generally safer than equity, it may not have as much upside but it has less downside," Miller said. "Our strategy has been from the beginning to take on more risk than a traditional senior bank, but less risky and expensive than a private equity fund." 

Miller and Weinberg will discuss their investment strategies Wednesday at Bisnow's Capital Markets and Real Estate Finance event at the Washington Marriott Marquis.