HQ Capital Real Estate Update: COVID-19

2.4.2020

Dear HQCRE Investors,

As HQCRE enters its third week of working remotely, we would like to start by expressing our gratitude to all our investors who have been extremely supportive during these times. The health and safety of our team, investors and our surrounding communities remain a priority for us.

Over HQCRE’s 30-year history, we have made it through multiple crises. Open communication with our investors has always been of great importance to us, and this is even more true during these difficult times. For those investors who would like more detail or have questions, we invite you to reach out to us with your concerns. We are also happy to set up one-on-one calls to address any questions you might have.

U.S. markets remain very volatile

Last week, the Dow posted its biggest weekly gain since 1938 as market sentiment improved with the Fed’s announcement of an unlimited Treasury purchase program and most importantly the passage of an unprecedented $2 trillion U.S. stimulus package. Both were instituted to offset the fallout from the coronavirus pandemic. Despite the optimism, jobless claims showed that a record 3.28 million U.S. workers applied for unemployment benefits in a single week, nearly five times the previous high, and consumer sentiment plummeted in March by the widest margin since October 2008. GDP is now projected to be negative into the double digits for 2Q20, and most economists now consider the U.S. to be in a recession. While all this is quite negative, the general expectation remains for this to be a “V”-shaped recovery given the overall healthy fundamentals prior to entering this externally-induced downturn.

Real estate market outlook

In particular, the real estate market entered this period with solid supply / demand balance in most asset classes and with much lower leverage levels than the 2008 recession. Real estate is expected to feel the pain in the short term with lower effective rents and increased bad debt but rebound in the medium term. Cap rates could experience some upward pressure in the short term. HQCRE’s underwriting has always included a cushion of 75 to 100 bps on exit cap rates when compared to prevailing cap rates at the time of underwriting.

At this time, approximately 80% of the U.S. population is under a “shelter-in-place” order, affecting commerce, profits, jobs, and ultimately real estate, as nearly all non-essential workers are staying home. Construction is deemed essential in most of the markets in which we have investments, and construction – while slower than under normal circumstances – continues in most of our development projects. The duration of the downturn will be the key determinant of how long and in what ways the real estate markets will be affected.

Multifamily rentals also expected to be impacted in the short term

The next ten days will provide early indications for the pandemic’s effect on the real estate markets. Rents are due on April 1st. The stimulus package approved by the U.S. government (CARES Act) likely will have the greatest direct impact on multifamily with the direct monetary support to individuals. There are also guidelines freezing all evictions for non-payment and expectations for owners to work with residential tenants on payment terms. Borrowers who financed multifamily properties through government-affiliated agencies (Fannie Mae and Freddie Mac) will also receive relief in the form of suspension of loan payments for 90 to 120 days and will in turn be required to provide relief for tenants. This is not a waiver of rent or mortgage payments, but rather a deferral plan for tenants and owners with hardships. Our RECAP fund investments are usually financed through LIBOR-based floating-rate loans and do not qualify for this relief. However, we expect lenders to work with their borrowers and accommodate extensions and soften covenants for their good relationships.

Given the high number of unemployed people, we do expect rental revenue to be affected beginning in April and probably more severely in May as more people lose their jobs. In addition, projects in the initial lease-up phase could see very slow lease-ups as people will be unlikely to move during this time, but renewal percentages are expected to increase. As previously stated, HQCRE investments that are in the initial stages of lease-up should be able to sustain this temporary slower lease-up pace with the support of the interest reserves that are capitalized upfront in the original development budget. Low LIBOR rates (vs higher underwritten LIBOR rates in the initial reserve) should provide a cushion to carry the projects through these delays.

While we expect to see downward pressure on effective rents in the next few months, the same fundamentals that existed going into this pandemic – a growing population with strong rental demand from young professionals and suppressed homeownership rates – are expected to emerge again. Crises often produce above-average numbers of divorces, marriages and births – all of which also create demand for housing.

HQCRE’s actions

We are in the process of completing our “stress test” analyses for each of our investments and – together with our partners – expect to engage in dialogues with the individual lenders on a proactive basis on any project that is deemed to have an upcoming covenant test or is approaching maturity.

Over the last week, the sales market has come to an almost complete halt as lenders are finding it difficult to quote loans and buyers and sellers assess the future with regards to projections for rental rates, cap rates and occupancy impacts. HQCRE funds had four projects in various stages of the sales process, and all these potential sales have been temporarily halted or delayed. Buyers have asked for extensions as they and their lenders reassess the market and the terms of the potential capital structure.

RECAP Opportunity Fund III had two approved new investments. At this time, we have decided to not pursue the Sacramento State student housing development project, and we have negotiated a 120-day extension on the acquisition of the land for the Alexan Stapleton (Denver) project, at which time we will reassess this investment.

While the current environment seems uncertain and volatile, multifamily real estate remains a relatively stable investment over the long term. When examining investment returns from an international perspective, the United States should continue to provide the safest and best market for capital appreciation. We have weathered these storms before and have found great opportunities on the other side.

Again, we encourage you to reach out to us with any questions and please let us know if you would like to set up a time to talk about your individual investments.

Stay well!

The HQ Capital Real Estate team