Landlords are making significant improvements to their properties in today’s hot real estate market. It’s all about curb appeal! But we see rental properties getting more than a face lift these days: longtime tenants are eased out under a provision of the rent stabilization ordinance that allows for major remodeling and then the remodeled units go to market at much higher rents. The real estate industry calls it ‘market repositioning.’
What is Market Repositioning?
Market repositioning is an industry term for wringing additional value from a residential rental property by putting the screws to existing tenants and even moving them out in favor of new, higher-paying tenants.
The aptly-named BiggerPockets real estate advisory service explains the market repositioning approach: “C properties located in a B market can be repositioned into a B property [which] attracts a better tenant class that will pay a higher rent.”
Cornell’s Baker Real Estate Program takes a more academic approach to market repositioning. It is presented as a three step process — buy in, boost net operating income, and then bail out — with a clear exit strategy. Pocketing the increased asset value is about pure speculation. It is a “value-added process” says the program, and leveraging multifamily residential real estate is called the “value-added multifamily play.”
Successful execution of a multifamily investment offers excellent risk-adjusted returns when compared to other classes of real estate. When augmented by a value-added strategy, the stable long-term cash flows typical in multifamily investments can be amplified to secure more attractive risk-adjusted returns by buying properties that have identifiable and fixable problems. — Cornell’s Baker Program
Market repositioning is where the value gets added.
Financing is the Key
The added value is the higher rent roll. The larger operating margin then allows for greater refinancing. And the greater debt allows for leveraging other properties (additional “multifamily plays”). And in today’s strong market there is no shortage of finance companies chasing that business.
Capital One observes how multifamily rental real estate looks like a good investment precisely because of the rental crisis we experience today. Here the market failure is actually a positive for the investor:
Demand remains very strong, with millennials entering the market in ever-larger numbers and expressing their intention—or recognizing the necessity—of continuing to rent far later in life than previous generations. On the supply side, there has been a persistent, shortage of multifamily housing, especially on the West Coast, that has lasted more than 20 years. — Greg Reed, Senior Vice President
Capital One also says that residential multifamily is good business when interest rates low:
Right now, the 7 to 8 percent preferred rate of return available from multifamily—in addition to the upside appreciation—sounds pretty good…. All the fundamentals point to continued growth in multifamily. — Brian Sykes, Senior Vice President for Multifamily Finance
So optimistic is the industry outlook that Capital One and other lenders are practically giving the financing away at low rates. Think about these numbers: operators of residential rental real estate enjoy operating margins on average of about 66%, our city consultant found. That means two-thirds of every rental dollar can be booked as profit after costs are paid. Contrast that with the cost of money at 4.75%. No wonder buyers are overpaying for rental properties in Beverly Hills. Who wouldn’t want to be in that business?
Moreover, a borrower can borrow money at an 87% loan-to-value ratio. That means putting just 13% down, according to advertisements. Lenders will happily finance a ‘portfolios’ of properties too. It’s just a matter of time before we see private equity or institutional investors forming vehicles specifically to scoop up multifamily properties. The Republican tax law has favored corporate ownership with a very low tax rate too.
Small Players are Welcome at The Gaming Table
Beverly Hills is a town of small- and medium-sized multifamily real estate. It has long been held in private hands as pass-through entities or family trusts. Corporate buyers with the deepest pockets may skim off the best of them, but there will always be duplexes, triplexes and other small properties that don’t fit the business model.
Multifamily rental properties have always attracted the small-capital investors that can’t get into retail or office commercial markets. They will continue to look for value in multifamily in Beverly Hills.
Today we see more LLC owners than ever in multifamily ownership (as opposed to individuals or family trusts).When we examine public records we can see how frequently two or three adjacent parcels are held by the same entity — a speculation strategy for sure. Cheap and accessible financing and leverage makes that possible.
Banks even offer multifamily financing to potential buyers with a credit score in the mid–600s. Here’s a real irony: it may be easier to qualify for financing a multifamily investment than it would be to make it past that landlord’s screening process!
The Upshot to ‘Upside’: Tenant Displacement
Market repositioning depends on wringing efficiency and revenue from an existing rental operation as well as adding value that can be cashed-out in an exit. There is no better way to add value than to make the property more appealing to higher-paying tenants. Of course that means displacing current tenants.
“We hope you never have to evict a tenant,” says BiggerPockets, but it does plug its own FREE Guide to Evicting Tenants. How helpful!
Rent control puts something of a brake on the worst market repositioning abuses. The cap on the allowed annual increase discourages opportunistic speculators while prohibiting no-just-cause termination in many cases takes eviction off the table. But our rent stabilization ordinance does allow for ‘major remodeling,’ which remains a huge loophole though which a landlord can end a tenancy.
Even rent control can’t stem all of the bad practices employed by a predatory, value-add-minded investor. Despite the cap on rent increases, rents can rise too quickly for longtime tenants; they can be priced out of housing in just a few years. For seniors this is a special worry as Social Security cost-of-living increases trail changing consumer costs in our region. Successive maximum allowed rent increases will put the rent out of reach for many of our seniors before long.
Other tenants may be vulnerable to a landlord’s cash-for-keys buyout offer. But often these are precisely the tenants who would most be harmed by signing away a tenancy: they could not easily afford to rent in our city again.
For those that manage to hold on to their housing, there is always the ‘disruptive’ multifamily management practices. Just as upending the boardroom apple cart is profitable for the activist investor, so is the introduction of strict or even punitive management policies. “Impose strict rules, regulations, and follow through with them,” urges ApartmentVestors.
Now is the time to train the tenants for how you are going to operate the property. Be prepared as you will have tenants leave, but that is a good thing. When you impose strict rules the good tenants will respect them and stay and you will weed out bad tenants faster. The quicker you get rid of problems, the faster you’ll turn around the property. — ApartmentVestors
BiggerPockets and ApartmentInvestors are only two of the many seemingly interchangeable real estate ‘advisors’ that stoke an ‘activist’ approach to multifamily rental real estate speculation, and tenant turnover is absolutely essential to that business model.
Marx Had It Right!
The buy, fix & sell pitch wasn’t around when Karl Marx made a crucial distinction between ‘use value’ and ‘exchange value.’ That was one hundred fifty years ago! But it remains so relevant when it comes to thinking about tenants and landlords in the speculative multifamily market.
Use value refers to how our home satisfies our needs; exchange value is the commodity value of rental housing. Indeed we can think of no better lens through which to view concepts like ‘market repositioning’ and ‘unlocking value.’ It simply cuts right to the heart of how landlords and tenants look differently at our home.
Tenants make an investment too; we forge friendships and partnerships and we build careers around our home. Many of us have raised a family in a rental apartment. But the landlords’ investment is more limited: it concerns asset values, margins, markets, and market repositioning.
How many times have we heard a landlord tell City Council they will consider simply razing their rent-stabilized property and building something new that would not be regulated by rent control?
In our view, the use value of housing is what should distinguish multifamily rental property from other commercial asset classes: it comes with a social obligation. An investor in it for the ‘multifamily play’ should know he has signed-on for something more than cash flow and asset appreciation.