“Everything’s worth 20% less overnight.” At Birgo Capital, we heard that countless times within the first few weeks of economic shutdowns as COVID-19 began to spread throughout the United States in mid-March. On the one hand, the sentiment made sense to us, and we at least partially agreed with it. The investment landscape was fundamentally altered in a very short period of time, throwing supply and demand into a helter skelter state in which investors didn’t know left from right. All we could be sure of was that the arrival of a global pandemic was accompanied by the potential for gut-wrenching financial challenges. The perception of risk increased, so the most reasonable knee jerk reaction was to assume that values deteriorated.
On the other hand, though, we weren’t so convinced. Experienced real estate investors know that a capitalization rate, or “cap rate,” is a primary determinant of value in real estate markets, and cap rates don’t tend to move quickly. The cap rate is the unlevered (debt free) cash-on-cash return that an investor expects to receive on a real estate investment. There is an inverse relationship between cap rates and property values: if cap rates go up, investors require a higher rate of return, so values go down. If cap rates go down, investors require less of a return for the same asset, so market value increases. Consensus within the investment community has been that cap rates will rise; there’s more risk today than there was prior to COVID-19, so investors will presumably need to achieve a higher rate of return to part with cash. But what if other factors actually point to a different conclusion in the marketplace?
While a heightened sense of risk was clearly present for multifamily investors in late March, the fast-moving dynamics of coronavirus response have contributed to a quick shift towards a different sentiment. We’d be foolish to think we are anything close to out of the woods yet: permanent job losses are on the rise; the disease is spreading and we don’t have a vaccine; bipartisan cooperation for further government stimulus will likely be a necessity at a time when political divisiveness is only worsening. These considerations notwithstanding, there are hints of optimism today. At least as it relates to assets that align with Birgo’s investment thesis -- that is, workforce housing in Pittsburgh and other similarly-sized rust belt cities -- we think it’s worth sharing a few observations as to why demand for multifamily properties -- and not cap rates -- might actually increase in the near term.
01. The (early) data don’t lie
From our own investment activities at Birgo Capital, we have both anecdotal and deal-specific evidence of positive trends. With respect to real transactions, the two most recent acquisitions within the Birgo portfolio prior to the onset of COVID-19 were valued by appraisers at cap rates of 7.00% and 7.25%, respectively. We entered into a contract to purchase one similar property since the economic shutdown, and to our surprise, the cap rate applied by the appraiser was 6.75%. In our extensive discussions with lenders, the years-long trend of declining cap rates seems to be persisting from real buyer/seller transactions that are taking place today.
Additionally, we’ve had a disproportionately high amount of unsolicited inbound outreach from buyers that are interested in acquiring segments of our portfolio, and have seen other local transactions close at values that are in excess of broker’s Q1 value estimates. In short, an objective look at trends reveals that we haven’t seen a single instance of material downward shift in valuation, but we have plenty of data that point to the contrary.
02. We’re still hungry, but the menu shrunk
Asset and liquidity levels remain very high. The Q2 runup in the stock market has investors sitting on balance sheets that are still very healthy, and high levels of pre-pandemic liquidity have only increased as participants have clamored to hoard cash. These lofty levels of cash and assets place investors in a position of again focusing on risk management through yield generation. However, whereas six months ago the generally accepted options for private capital to gain exposure to real estate included multifamily, office, retail, industrial, hospitality, and storage, among others, about half of this list is now off the table for most investors. The liquidity in the marketplace today wants to find a home in safety and yield, and it is actively reallocating away from hospitality, retail, and office, and towards multifamily, industrial, and storage. Simply put, investor demand is again on the rise for multifamily assets.
03. The core hasn’t changed
The core thesis of multifamily property investing is based on the conviction that people will always need a place to live. One trend that can clearly be observed as a result of the pandemic is that society is doubling down on its prioritization of shelter as a basic need. In most markets nationwide, housing prices are booming. Multifamily collections are (still) holding up in July, as renters prioritize making timely payments to ensure stability in an otherwise tumultuous time. Further, the nationwide shortage of affordable housing stock has only been exacerbated as affordable properties become more attractive to cost-conscious consumers. As we scour the market for discounted opportunities, we have yet to come across one single distressed multifamily situation. Human behavior has validated the core assumption that we will prioritize shelter, and markets are responding rationally to this observation. As a result, it seems that the risk premium that investors require to purchase residential investment property is actually falling, not rising; again, demand for multifamily is increasing.
04. The government won’t let us fail
While it’s still early in the story of how COVID-19 will play out, it seems increasingly likely that pain won’t be felt in the multifamily sector like most feared it might. It’s undeniable that this is owing in large part to central bank intervention. Actions associated with the CARES Act imply that there is structural support for the workforce housing sector from governments. It’s a societal priority and the extent to which governing bodies have made that clear cannot be overstated. Markets respond to this. Federally sponsored extensive forbearance programs, aggressive stimulus support for the vulnerable working class, state and local governments prioritizing rent relief programs that benefit both tenant and landlord -- these measures can and do set a precedent for how investors think about risk assessment going forward. “If I buy a multifamily property and something goes terribly wrong in society, the government will probably step in to help me.” That means there’s less risk for the asset class, and therefore a lower cap rate.
05. Low interest rates matter
This is a much larger topic than can be adequately addressed in a few brief sentences, but a change in interest rates is one leading indicator for a change in cap rates. The cap rate is calculated by adding together the risk free rate of return plus a risk premium. If the 10-year treasury is the risk free rate, and it drops substantially, and the risk premium does not rise to offset the lower risk free rate, then eventually a reduction in cap rates will come after the lower interest rates. This is a trend that we can clearly observe when looking at cap rate movements in other countries after their respective central banks moved interest rates to at or below zero. While we can’t expect the pace or degree of a change in cap rates to correlate 1:1 with changes in interest rates, it’s reasonable to expect that the two will directionally migrate together. This inevitably means that property values should increase.
We’ll underscore again that these trends are moving rapidly: the July 31 expiration of extended unemployment benefits looms on the horizon, and perhaps August collections will be indicative of scarring that was previously invisible. Surely as long-term structural shifts in the economy become more evident, multifamily assets in certain hard-hit geographies will experience acute pain and some targeted distress will emerge. This isn’t lost on Birgo Capital, and we’re eyes wide open for what will come in the months and years ahead. The duty of investment analysis is to react honestly to new data, and we plan to do just that -- just as we are today with this current viewpoint.
Naturally, as an organization whose economic success or failure rides on the value of multifamily real estate, we’re rooting for property values to increase over time. We’ll be the first to admit that we have a dog in this fight. But we believe that we’re being rational, and this isn’t just wishful thinking. We’re very sure that property values will appreciate over time, and we have the luxury of being a patient investor with long investment horizons. That said, as an active buyer who is seeking to develop conviction about near-term pricing, we can’t help but observe the trends noted above. As of today, it seems as though multifamily is clearly shining through as a haven of safety.
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