As the corona-dust begins to settle, many investors are wondering how to know when it is the right time to begin acquiring real estate again. Concerns during this unprecedented time are, of course, well founded. While we know more about this disease and its economic impact now than we did several months ago, there are still many unknowns that make the prudent allocation of capital a more difficult proposition than under normal economic conditions. At Birgo Capital, we killed our pipeline of new acquisitions when we recognized the likely impact of the pandemic in early March and moved to a “wait and see'' posture that favored the preservation of cash over its deployment into new investments.
However, in our workforce housing portfolio, April collections fared better than anyone was expecting, and May collections were the best of any month this year so far. Despite a lack of an effective therapy or vaccine, the economy appears to be slowly opening for business, and consumer and investor sentiment alike seem to be ever-so-slightly brightening.
The question now becomes the following: When is it time to move money off the sidelines and back into the game?
While there are still many questions that remain unanswered, here is how we are thinking about acquisitions during a pandemic at Birgo Capital.
Valuations remain a challenge
With so many unknowns, correctly valuing assets is more challenging than it has been in any economic climate since the Great Recession. As many readers likely know, stabilized investment real estate is traditionally valued by applying a capitalization rate to the asset’s yearly net operating income (NOI). The current macroeconomic climate presents challenges in correctly determining both the numerator (net operating income) and denominator (cap rate) of that equation. Firstly, determining NOI on a go-forward basis is now a far more speculative exercise than it is under more traditional conditions. Now, more than ever, past performance is not indicative of future results. While April and May collections were promising in our own portfolio, the extent to which the virus and associated economic shutdown will disrupt future cash flows continues to be cause for debate among investors. On a bullish perspective, it’s entirely possible that the fiscal CPR implemented by the Federal government and the Federal Reserve did its job, the economy will start to reopen, a recovery will begin, and we’ll be on to brighter days. However, negative externalities such as a second viral wave followed by subsequent shutdowns could cause significant structural damage to various industries that would fundamentally alter demand, pricing, and affordability for residential real estate. Numerous variations of this scenario could prolong a recovery into a “many years” versus a “many months” scenario.
Additionally, the common use of a capitalization rate as a multiplier of NOI becomes a poor determinant of investment value in a climate where future cash flows are highly uncertain or variable. Like other asset classes, real estate investment value is equal to the discounted value of all future cash flows. If COVID-related reductions in rental income end up being a several month blip on an otherwise upward and to-the-right radar, investment value is barely affected. If, however, rents flatline for the next five years, asset values will be significantly depressed. Pre-COVID cap rates reflect pre-COVID sentiments regarding rent growth. Given this uncertainty regarding future cash flows, a risk premium is required today, and it’s difficult to determine for how long this uncertainty will impact pricing.
While macro questions about rent growth remain, it is important to note that our funds do not need to experience significant rent growth to achieve our target IRR. In coastal markets, asset valuations assume tremendous year-over-year growth rates. If rent growth is slowed or stagnates for a significant stretch of an asset’s investment lifespan, returns can be crushed. However, given the wider spread between cap rates and borrowing costs coupled with more modest rent growth assumptions, returns on investment real estate in Pittsburgh are primarily a result of current cash flow. As such, our assets are positioned to perform well even during a prolonged period of stagnant rents, and we feel marginally more comfortable beginning to deploy capital into a potentially slow-growth environment as a result of this unique market dynamic.
We are examining the data to develop an informed perspective on valuations
While there are both numerator and denominator questions that remain unresolved today, we are paying attention to several key indicators to inform our perspective on valuations.
First, we are looking to our own portfolio’s performance as an indicator of collections and vacancy rates in our region. With over 1,400 units under management within our target acquisition geography, if vacancy and collection losses become a systemic issue, we will observe it first in our own portfolio, and we can adjust our underwriting on new assets accordingly.
Additionally, our existing assets allow us to keep an eye on rent movements in the area. When rents and vacancies begin to stabilize and trend back in a positive direction, this will serve as an indicator that it may be time to move back into acquisitions mode.
Second, we are monitoring debt markets. While the Fed has taken decisive and historic action, the lending climate is still less favorable for borrowers than it was pre-COVID. While the risk-free rate has gone down, lender spreads have gone up, proceeds are being reduced, and onerous reserve requirements are being instituted. All of these factors combine to place downward pressure on asset prices. These dynamics are fast-moving, and we are already seeing improvement in lender sentiment. Going forward, we’ll continue to look to the lending community as a pulse for market consensus.
Third, we are monitoring public markets as a proxy for private valuations. REITs have experienced wild volatility during COVID-19 with a selloff beginning in mid-February and a mid-March bottom of nearly 40% off their yearly highs. At the time of writing, most REIT indices are hovering at about 20% down for the year. Given that most REITs are approximately 50% levered, this would indicate a discount to the underlying assets of something like 10%. While not a perfect proxy for private market values, the liquidity of REITs allows them to reprice much faster than private equity which can often take at least a full quarter to adjust due to the relative slow pace of transaction activity.
Lastly, we are, of course, monitoring trades in our target market, as these will be the best indicator of value in our region. As referenced above, data points from illiquid private markets take longer to trickle in than their public counterparts. Additionally, we were not alone in our conservative posture regarding new acquisitions; Costar has reported that April was down 70% from March sales volumes. Many investors are walking away from hand money and adopting a similarly conservative approach while the world collectively waits for more clarity. Given that it can often take upwards of 90 days for new transactions to consummate, we could be without meaningful data points from private transactions until July or August. Since these are the best determinants of local investment value, we will feel more comfortable pursuing new acquisitions as we begin to see Pittsburgh investment sales data matriculate.
We are refocusing on our local geographical sandbox
Since the inception of our first fund, we have believed that, while not a sexy, high-growth coastal market, Pittsburgh enjoys a sticky and varied economic base that is well positioned to weather a multitude of economic storms. From the oft-touted “meds and eds” bastions of UPMC, Highmark, the University of Pittsburgh, and Carnegie Mellon University, to stable corporate employers like Heinz, PPG, and Alcoa; from ancient financial behemoths like PNC and BNY Mellon to a burgeoning technology employment scene with the likes of Facebook and Zoom, Pittsburgh is far from a company town. This provides significant insulation from the large swings in property value experienced by major markets. As such, we are abandoning exploratory deals in other regional markets to focus on deploying capital in our own backyard for the foreseeable future.
We are a long-term buyer
Near to medium-term COVID-19 implications aside, it is important to remember that real estate as an asset class has never lost money over a ten-year period, and each of our funds has a ten-year time horizon. This provides structural protection against capital stack pressures and the flexibility to make prudent long-term decisions on behalf of our funds.
Given our long-term business plan, we are somewhat more immune to near-term turbulence than investors with shorter time horizons. Resultantly, we can be somewhat more opportunistic with new acquisitions than can other fund managers who may be staring down the barrel of a forced liquidity event in the near to medium term. Since we plan to buy and hold our deals and add value over the long-term, we can demonstrate the patience necessary to weather storms that others simply cannot. As Blackstone President Jonathan Gray has stated, an unassailable capital stack is an absolute must in generating strong returns. This has been a core component of our investment strategy since our inception, and it serves us particularly well during turbulent times such as these.
We plan to patiently seek to acquire quality assets at rational valuations
With all of this said, we believe that there will be unique buying opportunities over the coming months and years, and we plan to be patient and cautious while we wait for the right opportunities to be decisively aggressive.
According to Costar, distressed sales in 2021 and 2022 could be in excess of $146 billion and “could increase to $565 billion under Oxford [Economics]’s more severe ‘moderate downside’ forecast scenario based on higher unemployment due to the pandemic.”
As a point of reference, distressed sales totaled just $176 billion during the eight years following the Great Recession.
However, these distressed sales are likely months away, and they may be few and far between in the multifamily sector given the asset type’s stability relative to more volatile product types. For the time being, multifamily collections are not as broadly challenging as forecasted, lenders are being helpful and cooperative, and very few assets are trading. Price discovery is difficult, and sellers are reluctant to sell as they likely assume better pricing can be obtained once we’re “out of the woods.” But velocity won’t stay low forever. Whether due to partnership issues, end of a fund life, an owner retiring, an inability to refinance at favorable terms, or just a preference to generate liquidity and take risk off the table, there are sellers in every market, and difficult times tend to exacerbate these types of issues.
Interestingly, Costar reports that the assets that are trading post-COVID are “generally the better quality, cash-flowing ones,” further noting that, while velocity is down, the multifamily that sold did so at a 3% premium to year-end 2019 pricing. This speaks to the resilience of the asset class, and presents the case for a counterargument to the general sentiment of “everything is worth less now than it was a few months ago.” What if multifamily is actually more valuable because of the pandemic and associated recession?
Whether to our benefit or our detriment, one of the factors in consideration for Birgo is that perhaps the flood of liquidity in the marketplace today will lead to increased appetite for alternative investments. If so, we believe real estate allocations will likely skew heavier towards multifamily, storage, and industrial as a result of broad, well-founded concerns for retail and office. As a result, we believe it’s possible that it will remain a seller’s market for multifamily, particularly in the absence of acute distress in the industry. Our nimble approach to acquiring assets that are generally too small to generate interest from professional investors will serve us well in this regard, as we believe a preference to sell is more likely to be observed in smaller owner-operators who simply want to remove the complexity and risk that comes with real estate ownership as a result of the pandemic.
It’s difficult to evaluate with any degree of certainty what’s to come in the investment real estate transaction market, but we are committed to a cautious, data-driven approach. We believe it’s critical to be conservative in valuation but decisive in our execution in order to protect our reputation as a preferred buyer in what may persist to be a seller’s market. We look forward to continuing to monitor these trends and sharing insights as they become clearer.