At the beginning of the pandemic, we at Birgo Capital, like many other real estate private equity firms, pressed the pause button on our acquisitions pipeline while we waited for some semblance of certainty or normalcy to return. With stay-at-home orders spreading across the country, owners of workforce housing assets collectively held their breath as they waited to see whether tenants who couldn’t work from home would pay April rent. Investors across the country – Birgo Capital included – shifted from a posture of aggressive acquisitions to one of hoarding cash and halting new deals. Shortly thereafter, we provided our perspective on what indicators we would be monitoring to determine when it was time to put our foot back on the gas pedal and go back into acquisitions mode. While we are a far cry from back to normal, some patterns have emerged that inform our perspective about continuing to acquire stabilized but underutilized multifamily housing in the Heartland.
Existing Portfolio Performance
With over 1,500 units under management in the greater Pittsburgh region, any market shifts – either positive or negative – will be felt in the Birgo Capital portfolio, making it a proxy for the performance of the region in general. At the beginning of the COVID-19 pandemic, we, like many multifamily investors, assumed that we would likely experience a period of plummeting collections and rising vacancies. When these trends began to stabilize and eventually reverse, it stood to reason, we would be in the clear to begin pursuing acquisitions once again.
However, as March turned to April and April into May, the effects of the virus were still yet to affect the multifamily sector. Much to our surprise and delight, rather than collections falling off of a cliff, Birgo Capital’s collections in Q2 were actually 2.2% higher than they were in Q1.
We, like many industry experts, were concerned that Q2 performance was artificially bolstered by the enormous economic stimulus provided by the CARES Act, and that when said provisions expired, we would be in for the devastation we all feared.
This, too, was not the case. Collections continued to remain strong through Q3, and, shockingly, they even continue to outperform Q1 collections. Similarly, occupancy within the Birgo Capital portfolio has held steady, and leasing demand, while naturally experiencing a dip during widespread lockdowns, has picked up once again.
“But Josh,” you protest, “Birgo Capital is a vertically integrated private equity real estate firm. We all know how critically important vertically integrated property management is in generating strong workforce housing investment outcomes. Does success in your remarkably well-managed portfolio necessarily translate to a similar experience in the broader sector?”
A lucid and well-reasoned objection, my astute friend!
Yes, we are a vertically integrated firm. Yes, our property managers have personal relationships with the tenants that they serve. Yes, vertically integrated firms perform better than their peers that outsource property management, particularly during a downturn. Yes, these factors combine to generate outsized returns in our portfolio relative to the properties in their competitive set. Yes, Fund II still has a little bit of room left for additional investment (but act quickly, because it’s almost fully subscribed).
However, as we consider how these factors affect our posture as a buyer, we must keep a few considerations in mind. Firstly, on an absolute basis, Pittsburgh is a remarkably affordable major metro. Our average rent for a one-bedroom apartment in our first fund is $672 per month. We founded our firm based in large part on the thesis that there is never an economy so bad that a renter can’t find a way to pay us $672 a month for a one-bedroom apartment within commuting distance to downtown Pittsburgh. Even in the midst of a pandemic that disproportionately affects the workforce, that thesis has held true, and the absolute affordability of renting an apartment in a Heartland-metro like Pittsburgh relative to a coastal hub shines through as an incredible downside protector.
Secondly, when evaluating a new acquisition, even if a particular property is suffering as a result of the pandemic, experience tells us that it will fare better under our management. Indeed, our sweet spot as a buyer – and a core component of our unique selling proposition as an investment manager – is the acquisition of “stabilized but underutilized” workforce housing. In this climate, we can substitute “undermanaged” for “underutilized,” and recognize that this creates a compelling opportunity for us to buy and reposition through better management practices.
When we examined the question of lender sentiment in April, the Fed had taken decisive and historic action, slashing rates to zero and buying corporate debt by the fistful in an attempt to act as a backstop for the U.S. economy. In spite of these actions, the lending climate was considerably less favorable than it had been pre-COVID. While the risk-free rate went down, lenders viewed every loan as riskier overnight, so spreads increased, and effective borrowing rates largely stayed constant despite the reduction in the risk-free rate. Additionally, historically aggressive agency lenders slashed proceeds and instituted large reserve requirements in an effort to mitigate projected pandemic-induced cash flow issues, effectively neutralizing any advantage of agency borrowing relative to local balance sheet lenders. However, at the time of writing our last acquisitions update, we were already seeing an improvement in lender sentiment. It has continued to brighten in the ensuing months, albeit cautiously. Spreads have decreased in some instances, and investors are generally able to borrow at rates that are lower than pre-pandemic levels. However, reserve requirements are still in the six to nine-month range, and lenders remain more cautious than they were before the pandemic. Overall, lenders remain cautious, but the term sheets we are receiving on prospective acquisitions are very attractive, and debt markets are resultantly placing upward pressure on multifamily valuations.
Public markets as a proxy for private valuations
Given that private real estate deals can take upwards of 60-90 days to consummate, we initially looked to the faster-adjusting public markets as a proxy for private valuations. After a period of wild volatility during the early weeks of the pandemic, we saw multifamily REIT prices settle in at about 20% lower than pre-COVID pricing. With an average of 50% leverage, this would indicate a 10% discount to the underlying assets.
While collections have remained strong, apartment REITs are still down just over 22% this year. Now that we have post-COVID transaction data, there is a clear disparity between REIT valuations and those of their private market counterparts, which remain strong.
In terms of the trend’s impact on our position as a buyer, we believe that the underwhelming performance of REITs through the pandemic is not a proxy for asset values within our target geographies. Most multifamily REITs own class-A apartments in coastal growth markets, and even if these assets were experiencing value erosion, that would not necessarily translate to decreased values for workforce housing in the Heartland. Resultantly, while we continue to monitor trends in the public markets, we are not placing much weight on REIT pricing in our own underwriting.
Pittsburgh is historically one of the lowest-volume markets in the country in terms of multifamily transactions, and COVID has slowed new deals from a crawl to near full-halt. In the last six months, CoStar reports only nine completed multifamily transactions over $1m in the MSA, and most of those deals were either very small apartment buildings or mobile home parks – neither of which provide helpful data points for our acquisition thesis.
Still, we are in regular dialogue with the brokerage and ownership communities, and our interactions have been revealing. Far from the promised fire-sale of distressed assets that had many opportunistic investors salivating at the beginning of the pandemic, multifamily investor sentiment has remained strong, and few multifamily landlords are feeling the level of property-level pain that would force a distressed sale.
While the future of retail and office assets remains uncertain in the face of an as-yet-to-be-under-control virus, the multifamily and industrial sectors have emerged as havens of safety.
Core and core-plus dollars that were previously in search of a full spectrum of commercial property are now focused largely on those product types. Far from the 10-20% asset discounts that we and many investors expected to see in the multifamily sector, our experience thus far supports a thesis of multifamily actually being worth more as a result of the pandemic. As we’ve discussed, rent collection and occupancy rates remain strong, and there is still plenty of dry powder on the sidelines in search of attractive risk adjusted returns. For investors with a low risk tolerance, the menu of available options has effectively been halved, and the offerings that remain on said menu are naturally enjoying increased demand and the resulting price increase that goes with it.
Much remains unknown about the future of the economy in the face of an ongoing pandemic. Some argue that the shoe has to drop at some point. After all, unemployment remains at historic highs and GDP at historic lows. There are rumblings of a second wave of the virus and the possibility of future lockdowns as a result. But remember – not all multifamily is created equal, and pain will not be evenly felt across all major metros. After all, it is easier for renters to come up with $1000 to pay for a median one-bedroom apartment in Pittsburgh than it is for them to come up with $2000 to pay for the same in Miami. Further, we believe that the government simply will not let the workforce fail, and that government stimulus goes farther to cover the cost of living in the Heartland than it does on the coasts. Combine these with the fact that, as a long-term buyer with an unassailable capital stack, Birgo Capital’s returns are more immune to near-term shocks than those with upcoming loan maturation or are nearing the end of a fund life, and we have returned to our posture as a cautious but active buyer.
Interested in learning more? Schedule a call with one of our principals today.