How do different property classes perform in a downturn?

Question

Looking for input from those who have actually owned multifamily property during a downturn in the market. I've heard a lot of theories about how different classes are affected by changes in the market. We typically buy C class stuff, and I constantly hear discussions about how C class won't be affected by all the new construction, because "they're not building anymore of those," or "where do you think everyone has to move when jobs go away," and any number of other conversations. The flip side is that as A class overbuilds, they drop their rents, and B tenants are able to move up a class, and the trickle down effect hurts everyone.

I'm in the DFW area, and even though we didn't get hurt as badly as other areas, when I look at the data, there was definitely a drop in rent growth and occupancy during 08 and 09. It wasn't terrible, but it was there. As a result, I always stress test my numbers for a drop in performance. I'm looking at a deal that is in an A or maybe even A+ area, and wonder if it needs to be stressed to a greater degree than the usual C class deals, or stressed less because its such a good location. To be more specific, this is NOT a new construction, super nice, $2000/month property like we have popping up on EVERY corner in DFW. It is an old, but desirable property in a great area. Its rents are significantly below the newer stuff, so I think we have a cushion there. I do know that the property will always have a lot of people wanting to lease, I just don't know how hard to stress the rents in this situation.

I know there's no concrete answer to this question, but hoping someone with a lot of experience (hello @Brian Burke!) can provide some direct experience.

Brian Burke · Answer

@Tom Lafferty don't believe the hype that class C is where everybody moves to when jobs go away. If they have no job, would you want them as a tenant? Would they pay the rent if you did? When there is an economic downturn class C gets hit the hardest. It might be the last to get hit, but the wound runs deep.

Folks who lose their job don't move to class C, they move in with friends or family. Looking at the data you correctly found a drop in rent growth (for all practical purposes it went to zero) and a drop in occupancy in 08 and 09. But that doesn't tell the whole story. What you don't see in the data (because it isn't reported) is the delinquency rate. The joke was that class C had half of their units vacant and the other half weren't paying. That is an exaggeration but it wasn't uncommon to see 20% to 30% vacancy and 10% delinquency (almost all of which was unrecoverable). Some properties had lower vacancy because they severely cut their screening standards to put heads in beds, but their units were full of concession surfers who would take the one month free deal, never pay, wait to be evicted, then repeat at the next property.

Meanwhile, A properties get hit with negative rent growth and concessions but don't suffer as bad in terms of turnover, delinquency and evictions because they can attract the good tenants that still have jobs just by lowering the rent and undercutting inferior properties. That's why I'm sticking to a notch up in quality when making my acquisitions at this point in the cycle. And, as you astutely mentioned, underwriting to stress in the market.

Tom Lafferty · Answer

Great information @Brian Burke, thanks. I definitely remember the conversation we had regarding one of your deals here. I think about that every time I'm looking at one!

Paul B. · Answer

@Luke Grogan I think another good question to ask when considering a Class A property is who are the tenants? Is this their primary residence, with good jobs nearby, or is it a second home for them, because they like to spend time in this "premier location?" The former would give the crash protection you mention, not sure about the latter.

Mike Dymski · Answer

Tom, this is not spot on with your question (because it relates to duplexes rather than apartments) but it's directionally correct. I had C class units in a B class area and they held up fine...rents actually went up some during the recession. Incidentally, they have been rehabbed and are now B class in a A class area. You will also find variations in how different people and markets classify properties. Many investors and brokers want to think all of their properties are B class.

My point is that performance will be more market and location specific. Risk can be mitigated in markets that are stable or have modest growth during dips or in sub-market locations that are desirable. Many of the big boys shy away from all C class and that creates an opportunity for others to purchase the right C class properties.

Tom Lafferty · Answer

I mainly just run different scenarios on the analysis spreadsheet I use. I will model decreasing or stagnant rents, decreasing occupancy, and increasing cap rates. I also play with projected expenses to see what the returns look like if expenses come in higher than expected. In addition to cash in cash returns and capital gains at sale, I also look at the debt coverage ratio to see if the property can support its debt service in these scenarios.

Jenifer Levini · Answer

@Tom Lafferty How do you "stress test" your numbers?

Mike R. · Answer

what a great question!!

We actually started buying during the down turn but have made purchases with this question in mind. Here they way we think: our A/B properties are in areas with soild income/professionals that have good schools. Everyone wants good schools so hopefully the current tenants stay tenants or they are easily replaced even in hard times. Our breakeven rent is nearly 30% lower than current rent so we have plenty of room to cut rent if needed. Our C area properties are near military bases (navy) and nearly every renter is navy or works on the base. Even if Hilary wins the WH and cuts military spending, you can't easily move a port so we feel somewhat protected in a downturn. Our breakeven rent is 20% lower than current so again we can cut rent if needed

How do different property classes perform in a downturn?

How do different property classes perform in a downturn?

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