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Real Estate - Apartment

A Bright Spot in the Sharing Economy

The benefits of integrating co-living into your apartment portfolio

The sharing economy, once the beneficiary of higher utilization of shared space and things, has been set back by the global pandemic as social distancing measures have put a damper on proximity. High profile start-ups that were yesterday’s VC darlings have come under pressure as their business models grapple with the de-densification of all things shared. Despite a challenging backdrop, co-living as a living alternative has been a bright spot within the sharing economy, demonstrating steady and even improved demand characteristics since the onset of the pandemic and economic unraveling.

Co-living: redux

Co-living as a concept has been legitimized and re-envisioned 5 years ago when institutional investors began to look into the space in earnest as an untapped asset class. The affordability offered to co-living renters plus the added flexibility in living arrangement and lease structure are seeing renewed appreciation due to the rapid physical and economic displacement over the last few months. This unanticipated demand wave provides traditional multifamily developers and owners an alternative operating strategy to address market risk within their portfolio as the broader economy secures its footing.

Since late February, unprecedented job losses as the result of nationwide lockdown measures incited by the Coronavirus have been matched with equal parts fiscal stimulus. The massive $2.2 trillion CARES act enacted in late March to tide over small businesses and families has delayed the full impact to household incomes and the flow-through effects to the broader economy. This is evidenced by the buoyancy, so far, of the apartment market.

According to a recent article published by Propmodo, multifamily rent collections have since proven resilient relative to retail and office. However, it feels a little premature to declare a victory for the sector. Even the Federal Reserve in mid-June’s market update gave such a wide range on the 2020 GDP growth outlook, from  down ten percent to down 4.2 percent, that it is anyone’s guess as to what unfolds for the economy. Whether you prescribe to the view that the worst is over, or that that we are in the early innings of a larger scale downturn, it is prudent to explore rent enhancement and lease protection options as property owners.

What goes up…

The apartment sector has benefitted from an impressive ten year run where rent growth, coupled with cap rate compression, resulted in sector leading returns. Now that we are in the later stages of the current real estate cycle where home ownership dropped to historical lows in favor of renting, how are apartment landlords and developers positioned to navigate an economic landscape where there is increased counterparty risk in the form of rent collection from tenants?

For multifamily developers and owners scheduled to deliver or lease-up into today’s market, one way to protect your exposure from economic uncertainty is to plan layouts with a co-living operator in mind for a portion of total units delivered. The value proposition to both renter and owner is clear. Taking an example put forth by one of the larger operators in the space, tenants can lock in a lease at a lower nominal rent versus a larger traditional unit at a fifteen to 30 percent savings, while owners benefit from a higher gross rent per square foot on more total units.

Co-living vs. traditional rental

To illustrate, an owner with a traditional two bedroom 1,200 square foot apartment in a gateway city may be able to comfortably fetch $4,000 per month in rent. Should this unit be converted to a 4-room co-living space at roughly 260 square feet per room, at $1,500 per bed, the unit would yield the owner $6,000 in monthly rent—50 percent higher than the traditional format (before fees paid to the operator). From the renter’s perspective, $1,500 monthly rent is a $500, or 25 percent, discount per month versus slightly larger comparable studios. With nationwide apartment affordability stretched as the rent-to-income ratio approaches the all-time high of 31.6 percent not seen since 2010, owners leasing units that are 25 percent below the competition gives meaningful runway to command relative pricing power even in a soft rental market.

Further, there is added benefit that’s especially relevant in today’s uncertain employment picture through the decreased counterparty risk from having a fractional lease structure within your project. Going back to the above example, instead of having $48,000 in annual rent invested with a single tenant, the co-living structure generates not only higher annual rent of $72,000, but is also diversified across four unique tenants. Even if the co-living arrangement were to yield the equivalent $48,000 in annual rent as the traditional apartment lease, there is greater embedded value to the compartmentalized lease structure, especially in today’s hazy employment picture, given the ease with which the landlord can re-lease the room should there be an unexpected tenant move-out.

Pandemic appeal?

One concern that is especially topical right now is the potential push-back from prospective tenants reluctant to live with roommates when we are still without a cure for COVID-19. While office co-working operators must deal with headcounts in large, unobstructed spaces, residential co-living is at an advantage given the only shared space is the living area. Further, co-living property management services typically have routine deep-cleaning options that are baked into the monthly rent. Additionally, the tech-enabled features of co-living operators allow renters to tour units and sign leases virtually, creating a completely contactless experience.

I’m not trying to sneak past the fact that co-living as a business model is swapping counterparty risk away from the tenant and onto the operator. In effect, the landlord is now subject to collecting rent from the co-living operator instead of the tenant, which exposes the landlord to the operator as an ongoing concern. As such, owners should think about what percentage of their portfolio ought to be allocated to co-living based on their individual assets and perform thorough due diligence on the long-term viability of each partner.

Much like how the government determined during the lockdown, tenants have picked their essential and non-essential businesses within the sharing economy. Vacation rentals have been canceled and co-working replaced with WFH. When where you live (and now, work) is the lowest and most essential common denominator, co-living comes into focus as the most affordable and flexible option for young working professionals. Landlords can take advantage of this tailwind and implement an alternative living strategy to navigate the uncertainty facing the rental market next year and beyond.

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