Vertical Integration: The Key to Successful Workforce Housing Investments

Post by 
Josh Fischer

A real estate investor lives and dies by his collections number.  An excel model can look as pretty as you’d like, but at the end of the day, the performance of the building is determined by real world factors: Keeping expenses in line with a budget and, by building relationships with real people, ensuring that tenants are paying rent.  

In light of this, many multifamily investors focus on acquiring Class A product.  Their reasoning is certainly understandable. Class A apartments are undeniably easier to manage from an operations perspective.  Buildings are newer and therefore less prone to surprise maintenance expenses, and rent collections tend to be simple, predictable, and consistent. 

However,  Birgo Capital is focused almost exclusively on acquiring workforce housing rather than trophy properties.  We believe that workforce housing has stellar stress test characteristics in a downturn, which has proven to be true in our portfolio’s performance through COVID thus far.  We also like the relatively higher yields afforded by the asset class -- as you move down the spectrum of building age, condition, and location, cap rates tend to go up.  

But workforce housing investors have to honestly ask themselves this question: will we actually experience those higher returns?  If you underwrite vacancy and collection losses to 5%, but your actual experience is 15%, a property can quickly go from a cash cow to a money pit, particularly if the business model involves the use of leverage. 

For this reason, Class B and C apartments can often get a bad rap in the institutional investment community.  REITs focus almost entirely on Class A apartments, and understandably so.  I’ve heard a senior executive at a fund explain that they don’t invest in Class B or C apartments explicitly because collections can be a challenge, particularly during an economic downturn. 

So why does Birgo Capital dive right into an asset class that others shy away from?

And what’s our secret that’s led us to be able to collect 99.5% of our budgeted top line through a pandemic? 

The secret is vertical integration, and it is one of the most important and often overlooked questions to consider in investment real estate. 

How much of the investment and management process you control in-house versus how much you contract out to a third party has a significant impact on your operations, and ultimately, on your financial performance.  I personally know several boutique funds that only employ two people – every function except asset management is carried out by a third party.  Other companies, like ours, control every aspect of the investment process in-house.  

So why did Birgo Capital determine that building a vertically integrated firm was a critical component in the successful execution of our investment thesis? 

Let’s examine a hypothetical scenario.  An asset manager is considering acquiring a workforce housing property for $1m.  Gross Potential Rent is $150k, and the asset manager has underwritten vacancy and collection losses at 5%, bringing modeled Net Rental Income to $143,880.  If we further assume $65,000 a year in expenses, we arrive at a going in cap rate of 7.9% and a year one levered yield of 11.8% with standard mortgage assumptions.  

“A healthy return!” our fictional landlord exclaims.  He decides to acquire the asset.  

However, this is where things take a dark turn. 

Let’s dig a little deeper into the economics of this scenario to find out why. 

Based on the above model, a property manager paid a standard fee of 6% of Net Rental Income makes roughly $8,600 for managing the building.  This is obviously insufficient to pay a full-time onsite manager, so you’re getting someone’s divided attention as they manage properties for many other landlords. 

As time goes on, the property manager gets lax with leasing and doesn’t prioritize collections, so vacancy and collection losses go from 5% to 15%. 

In this entirely realistic scenario, the property management company still makes $7,700 for managing the asset – a mere few hundred dollars less than their initially expected fee. 

What about the investor?  The healthy going-in cap rate of 7.9% is now less than 6.4%, and year one yield-on-cost plummets to 6.5%.  For an investor with limited partners, this difference over the life of an investment is a make-or-break difference to total performance.  

We have just witnessed a classic example of what Harvard economist Michael Jensen called the “Principal-Agent Problem,” in which there is a mismatch in priorities between a person or group and the representative authorized to act on their behalf.  The incentives for third party property managers to do the hard work necessary to keep a building full and tenants happy simply are not strong enough.  They lose a little bit of income, but certainly don’t take enough of a beating to go the extra mile.  To quote from the immortal wisdom of Office Space, “That’ll only make someone work hard enough to not get fired.” 

For the investor, however, the above drop in collections is devastating.  If they are directly managing the property within their organization, you had better believe that they are going to do everything possible to reverse the trend and bring the property back to budgeted performance. 

So why does anyone use a third-party property management company?

The answer is connected to the above distinctions between Class A buildings versus workforce apartments.  When you own a brand new building in an in-demand location that basically runs itself, the principal-agent problem is far less of an issue.  However, bringing property management in-house allows an investor to reap the rewards of workforce housing investments – namely, higher yields and less cyclical variation in performance – without the drawbacks of third-party property management. 

Third party property management is fine for Class A investments. With workforce housing, it’s a vastly different experience.  Deals aren’t plug and play, and every asset requires an appropriate allocation of targeted human capital in order to generated the intended outcome.  They have a business plan that requires executional follow through, hands-on involvement, experience, and the right temperament.  For workforce housing investments, vertically integrated operations makes all the difference.   

Learn more about investing with Birgo Capital, a vertically integrated private equity real estate firm in Pittsburgh.


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