You don’t have to spend very much time talking shop with a real estate investor to hear the time-honored dictum: “location, location, location.” Indeed, real estate in general — and Class B multifamily in particular — is an attractive investment because of its remarkable valuation resilience: the tendency to, whatever market conditions may be, move steadily up and to the right. However, where one acquires multifamily property is a significant factor in the level of risk adjusted returns one can expect to generate. At Birgo, we believe that multifamily assets in the Heartland represent an opportunity to achieve superior returns while incurring risk well below that of investments in traditional coastal markets.
Nevertheless, the basic “buy trough; sell peak” principle is a pertinent consideration for any investor. Fortunately, arbitrage opportunities abound for the savvy real estate investor. We believe that the absolute affordability of the American Heartland makes it a geography that provides superior risk adjusted returns — especially in the fast-growing metros that will increasingly be financial and industrial hubs of tomorrow. Let’s take a look at three reasons we believe this to be the case.
Multifamily real estate investment tends to post consistent returns because housing is intrinsically valuable - everybody, regardless of their career, financial, or family situation, needs shelter. Consequently, housing demand tends to be proportional to population density: more people means stronger demand. Over the last decade, economic and demographic shifts have precipitated noteworthy changes in the Heartland that we expect will substantially increase regional demand for affordable housing.
The national GDP is strongly reliant on capital goods and manufacturing supplies exports; at the same time, almost 90% of the food Americans eat is grown and produced domestically. The Heartland encompasses a wealth of infrastructure and natural resources that have historically made the Midwest and Plains regions powerhouses of industry and agriculture. While those sectors may not be as dominant as they once were, it is important to recognize that the Heartland of 2020 is not the Heartland of yesteryear: regional monoliths propelled by a few core industries have given way to increasingly diverse economic landscapes, and emerging structural trends have only accelerated the region’s diversification. This fact pattern notwithstanding, some areas of the Heartland suffered more than others at the hands of the steel and industrial crises of the late 20th century; property values and living costs in these areas hover well below national medians.
These forces have culminated in a few trends worth watching.
First, large national corporations have begun opening satellite offices — or, in some cases, relocating their primary offices — to the Midwest and South. Over the past few years, traditional urban centers like San Francisco and Boston have increasing barriers to entry, as inflated living costs and inhospitable tax rates drive business into other states. Their employees frequently follow suit, which is part of the reason Austin and Nashville have witnessed meteoric growth over the same period. Cities like Milwaukee, Columbus, Dayton, and — yes — Pittsburgh are catching on to the trend, and deploying incentives like tax breaks to lure in new firms by the dozen. When business moves into town, employees come with. The result? Capital floods the region, kick-starting economic performance; strong economic performance attracts yet more migrants; and housing demand rises.
Second, Big Tech — facing increasingly saturated coastal markets — is watching Midwestern markets carefully. The Midwest is already home to more than a quarter of America’s computer science professionals; digital natives who can work comfortably from anywhere with Wi-Fi may be paid less in Des Moines than L.A., but real purchasing power is significantly higher due to low food, rent, and fuel costs. For some cash-strapped start-ups, the Midwest is a “Silicon Prairie” that affords the chance to get off the ground without breaking the bank.
These trends converge to paint a new picture of the Heartland: a vibrant band of attractive, affordable, economically-diverse cities which will soon play host to an increasingly large chunk of America’s people and corporations, and see correspondingly elevated housing demand.
“If professionals and corporations are drawn to the Heartland because of below-average costs,” you may be wondering, “surely investors can use the same forces to expand their margins too?”
This is a pertinent observation. Compressed living costs and expanded real buying power in the Heartland present investors with significant opportunity. Low asset prices in the region tend to accompany lower operating costs. Among other considerations, labor is cheaper in a high-buying-power city. Costs associated with property management, repairs, and improvements are all lower in such an environment.
Correspondingly higher cap rates, on the other hand, leave a margin for cap rate compression at sale, which improves investors’ exit outlook. Multifamily real estate in the Heartland is promising from a cash-on-cash perspective, because locales in which every dollar spent goes further eat less capital — making the prospect of improvements less capital-intensive.
Also worth noting is that the multifamily lending environment in the Heartland is relatively favorable: agency lenders offer discounts for affordability, and the Heartland is a disproportionate home to naturally-occurring affordable properties because of their low cost of living. While inflation may impel rent increases and loftier property valuations in coastal metropolises, lack of affordability can result in relatively higher interest rates: a larger mortgage payment means a lower cash-on-cash return.
Meanwhile, from a renter’s perspective, the region with the highest buying power is — all else equal — the best place to live. Globalization, digital freelancing, and the normalization of remote work afford today’s professionals more independence than ever; if the current trends continue, professionals able to do so face an incentive to move where their regular paycheck compares favorably against their variable expenses.
Demographic shifts, too, will likely accelerate housing demand in dollar-efficient cities. By 2040, over 80 million Americans will be 65 or older; as America becomes proportionally older and Social Security reserves dwindle, more retired Americans will look to live where their dollars reach the furthest.
Finally, COVID-19 will likely expedite these secular shifts long after we can get state-sponsored shots at our local pharmacies and put the pandemic firmly in the rear-view mirror. Numerous firms (including industry giants like Google) have recognized the flexibility and cost advantages afforded by remote-work arrangements, and we’ll likely see this option wax in popularity even when it is safe to return to an office. From a corporation's perspective, the option to keep employees at home decreases overhead outlays, especially for organizations which have historically maintained large offices. The less-closely work is tethered to expensive geographies, the more migration we expect to see, as employees granted this novel independence may opt to relocate to areas in which cost-of-living is lower.
Of course, a generalized increase in demand for housing is not necessarily helpful to a portfolio predominantly composed of workforce housing assets. However, the demographics that stand to benefit most from a migratory expansion of buying power are the very same young, mobile professionals (and retired parents following their kids?) that commonly rent Class B and C multifamily spaces.
The bottom line for investors: low operating costs plus high demand means better cash-on-cash returns, and lower asset values mean higher cap rates, which creates a margin for better performance on exit.
Finally, investment in the Heartland doubles down on the generally low-risk features afforded by multifamily properties.
First, lower rent strengthens tenants’ financial resilience in the face of downturns, preserving occupancy rates (read: investor cash flows) during recessions.
Second, the Heartland’s economic diversification is a significant boon to landowners. Real estate values in diverse markets are less susceptible to the collapse of a single industry's bubble. Our home city is an instructive example. Throughout much of its history, Pittsburgh was economically reliant on steel. When the steel industry crashed, property values tanked. Four decades later, Pittsburgh plays host to a constellation of industries: health, technology, education, manufacturing, and more. Consequently, the city’s economy — and therefore its housing market — are more resilient to perturbations in any given industry. This was seen clearly during the last economic downturn - Pittsburgh was the only major metro in the nation in which housing values actually increased during the Great Recession.
This principle is great news for a real estate investor because, in general, downturns tend to be targeted, not systemic. Interest rate expansion, bad loans, overvaluations, and more can capsize virtually any particular sector, but truly system-wide recessions are often the result of national or global black swans (think 9/11, or COVID-19). Diversification protects against all but the most dramatic recessions, and perpetuates the cycle of migration. In Pittsburgh’s case, the health sector expanded with the city’s population, big tech moved in because of lower costs and the need for business expansion away from already-saturated coastal markets, those developments attracted migrants, and the cycle perpetuated itself.
Because of these features, real estate exposure in the Heartland situates investors to benefit from black swans. Crashes, pandemics, and unrest are associated with Heartland population growth and economic diversification — and the persistent values of Heartland assets will yield positions comparatively stronger than the alternatives during periods of crisis.
The multifamily space is intrinsically lower-risk than many other investment classes. It doesn’t hurt that workforce housing is effectively backed by the full faith and credit of the U.S. government. Nevertheless, your investment will be more secure in a region with lower costs, diverse economic structures, and growing populations. The development of platforms like RealCrowd empowers more investors than ever to benefit from this financial regionalism — a stance that private equity firms, as opposed to slow-moving national REITs, are well-positioned to take.
If you are interested in learning more about Heartland real estate, or discussing an investment with Birgo, schedule a call with us today.