Multifamily investment transaction volume had an unprecedented year in 2021, and the first six months of 2022 were quite robust. Now, economic uncertainty in the form of rising interest rates and a cooling economy has created some hesitancy on the part of investors.
“Some normalization is occurring in the market now, in addition to a pullback because of what is going on in the capital markets and economy,” says Paul Darrow, a managing director of Walker & Dunlop’s investment sales team based out of Los Angeles. Walker & Dunlop is one of the largest providers of capital to commercial real estate industry in the United States.
Darrow sat down with REBusinessOnline to talk about multifamily investment sales trends in the Los Angeles area and the opportunities he sees for investors down the road.
REBusiness: Investor interests have shifted in the past few months. What kinds of properties are investors most interested in now?
Darrow: It’s a mixed bag when it comes to investor appetite. Those who raised money to buy specific types of buildings are obviously guided by what they’ve promised their investors in the form of return profiles and risk. Core funds, for example, can’t just switch to value-add or ground-up depending on the mood of the market, so they will chase what their mandates require.
There is also a greater level of sophistication. Investors aren’t limited to one area or business plan. Information is available, zoning codes are online and best practices are shared everywhere. Other investors such as family offices, can pick and choose freely as opportunities surface.
In general, 1980s and newer vintage in semi-urban locations like the San Gabriel Valley, the 605 Corridor and the South Bay have incredible interest for investors.
Recently, there has been increased appetite in ground-up development as developers are charged with anticipating market conditions two-to-four years from now. That future seems promising when you think about slowing construction starts that will trigger fewer deliveries in 2024 and beyond. The changing landscape of technology, and shifting renter preferences post-COVID, is driving demand for sites.
This is particularly true when considering that Los Angeles’ building boom was accelerating in 2014-2016, and those buildings will be ten-years old over the development period. Many lack the technology, amenities and common area space that today’s renter wants.
Everyone still loves adding value to a property by upgrading its interior and common areas to meet renter demand, but it’s been a challenge with buildings in Los Angeles County subject to the eviction moratorium and rent freeze. Irrespective of your position on those issues, it’s not an easy to keep the revenue side of the equation static while we experience historic levels of inflation.
Where we are uniquely positioned to help our clients as advisors is the ability to step back and point to the Los Angeles big picture/trajectory. We help investors look beyond immediate cash flow and focus on market appreciation opportunities.
On a macro level, there are numerous projects that were talked about prior to COVID that haven’t been discussed. All of a sudden, the World Cup is in four years and the Olympics are in six. The first section of the Purple line, a train line from Downtown to Rodeo Drive, Century City and Westwood — is opening in less than 24 months. This took 40-plus years of planning. This is a big deal, and it’s almost done.
Taking a more nuanced approach and (dare I say) “post-COVID” view is key. For, example, work-from-home/office requirements will become increasingly important, as will full funding of projects.
With investors being increasingly sophisticated and more open minded about different geographic markets and business plans, we are helping share best practices to accelerate their learning. For those getting into ground-up development or moving from ground-up to value-add, there’s a wealth of knowledge we can share.
REBusiness: Beyond institutional and individual buyers, what groups are strongest in terms of acquisitions? What attitudes are you seeing in the market?
Darrow: Some family offices are entering the market with fresh capital and are less concerned about near-term cash-on-cash returns or negative leverage. Those groups are selective but able to win when they really like a property. Many times they are less return driven and are working from intuition rooted in decades of watching the market go and up down. Their purchasing power has signficnalty increased to the point of competing with institutions on $75 million, $100 million or more.
Also, a 1031 exchange buyer, for example, would be able to outcompete because of the tax consequences of not buying. Once you get to the bigger spaces, a lot of the institutions are still winning those deals.
However, there’s been some pullback lately. Companies have switched from participant to observer, and there’s a bit of a thinner buyer pool, at least for the moment.
Some people feel like next year there will better buying opportunities or the market will snap back into gear and prices will be higher. In the conversations I have had, there isn’t a consistent theme other than agreement that there’s some uncertainty out there.
On the flip side, many sellers are waiting until fall to put properties on the market. In June and July, we saw some uncertainty and advised sellers to pause for a minute. That advice paid off. Many sellers are hitting a fork in the road where they either need to sell an asset right away if it’s not ideal or they are in for a longer haul, perhaps three to five years.
REBusiness: How have interest rates impacted the availability of capital?
Darrow: Given factors like the fluctuation in the ten-year Treasury note, it’s clear there’s a lot of volatility at the moment, disrupting the mindset of anyone who thought there might be a slow increase in interest rate movements.
But historically, the market has proven that it can absorb interest rate hikes without meaningful pressure on pricing. Look at single-family home data from July 2015 to July 2019. The Fed raised interest rates nine times and values rose more than 25 percent.
But the question you ask also ties to prices. What is the availability of capital at the current price points of the market? The answer is much less than in 2021, perhaps 50 percent less. But if you lowered prices 10 to 15 percent, you’d hit an inflection point where all the capital on the sidelines jumps back in. That’s a different story.
It’s hard to quantify the amount of liquidity private capital has, but I am reminded of a client who said he’s refinanced two to three buildings every month for the last ten years, and he’s not unique. The run up from 2009 to the present has created a lot of liquidity.
REBusiness: What issues specific to Southern California and Los Angeles are of concern to those investing in multifamily right now?
Darrow: There’s a transfer of tax increase that’s on the ballot in November that creates the potential for a ten times increase of transfer taxes during the sale. Anyone thinking about a sale in the next few years is wondering if they should accelerate their decision.
The regulatory landscape is also a major area of focus because there are 88 cities in Los Angeles County, each with their own mayor and housing laws. In July, Santa Monica announced an effort to update their existing rent control laws and Pomona just implemented their first rent control ordinance on Aug. 1.
This level of change requires constant vigilance, so we monitor these cities on behalf of our clients who may located in New York or Chicago. Those city community plans and zoning codes are also changing. Opportunity can arise or disappear depending on the realtime zoning of a 1960s shopping center in a trade area of the city.
REBusiness: What kind of rent growth are you seeing in the markets?
Darrow: On average, we are seeing 10 percent. But this answer really requires a block-by-block analysis of the greater Los Angeles area. Everyone agrees that rent growth is pretty promising. Now the question is, what vehicle can we find to capitalize on rent growth? Other area-specific issues complicate this question: the difficulty of building ground-up, high construction costs, a cumbersome approval process, NIMBYism, etc. Everyone agrees there will be considerable rent growth and are trying to place their bets appropriately.
With certain restrictions on zoning and SB330 and SB8, which make tearing down buildings extremely difficult or financially unfeasible, there is going to be a real challenge over the next couple of years to find viable sites, even before one considers whether or not those sites have motivated sellers.
REBusiness: Looking ahead to the rest of 2022 and into 2023, what kind of opportunities are you seeing for investors?
Darrow: Owners we never thought would sell are selling, including an unusual number of larger buildings, owned and inherited for years by generations of families. The REITs are clearly shedding many of their California assets, so there is a clear opportunity to acquire best-in-class properties that haven’t been for sale in 20, 30 or even 40 years. On the ground-up side, we are taking middle-market-sized assignments in Hollywood and Pasadena where the sellers have decided they won’t go vertical. Instead they want to redeploy the capital elsewhere, so there is opportunity there.
The types of buying opportunities out there are exciting. Figuring out the pricing is a whole other dimension. Understanding collection losses and working with our debt teams is critical. Banks need help understanding what is happening at the property level. We just can’t send a few reports and hope they understand the NOI.
We also bring a long-term view having seen multiple cylces in Los Angeles. The interest rates people got used to over the last two years were not normal, nor were a lot of unlevered yields, so we are trying to helping buyers recalibate their investors expectations as well. It’s all about perspective and using hard data and insights to give investors direction.
It’s funny, but a client recently reached out in a 1031 trade and said “we have a big trade but to be honest, we don’t even know where and what we want to buy right now.” That’s truly indicative of the market and I think helping them answer that question, with unbiased insights, is the direction our team takes.
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