Mitch Siegler of Pathfinder Partners joined us on the podcast to explain the Class B multifamily market.
In this episode you will learn:
- What makes a great Class B multifamily market
- How housing trends are impacting multifamily
- 6 markets Mitch is bullish on and why
- Where we are in the market cycle
Mitch focuses on sourcing prospective transactions, developing financial structures, and business and financial strategies. Prior to co-founding Pathfinder, he founded and served as CEO of several companies and was a partner in LENSER, a national management consulting firm.
Earlier in his career Mitch was a partner in Sorrento Associates, an investment banking firm, where he advised clients on more than 40 financings, mergers, acquisitions and financial restructurings involving both private and public companies and Sorrento Ventures, a private equity firm, where he invested in scores of private financing exceeding one-half billion dollars.
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RealCrowd – All opinions expressed by Adam, Tyler, and podcast guests are solely their own opinions, and do not reflect the opinion of RealCrowd. This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing please consult your advisors.
Tyler Stewart – Hey, listeners, Tyler here. Before we start today’s episode, I wanted to quickly remind you to head to realcrowduniversity.com to enroll into our free six-week course on the fundamentals behind commercial real estate investing. That’s realcrowduniversity.com.
Adam Hooper – Hey, Tyler.
Tyler Stewart – Hey, Adam how are you today?
Adam Hooper – Tyler, I’m good, but we’re breaking the streak of sunny days here in Portland.
Tyler Stewart – We had six podcasts in a row where it was sunny outside.
Adam Hooper – Portland rears its head. It’s kind of cloudy out today.
Tyler Stewart – Yeah, a little bit cloudy. Well, good thing we have good coffee here.
Adam Hooper – Yep, and we have a guest from a sunnier clime.
Tyler Stewart – We do. We brought on Mitch Siegler from Pathfinder Partners from down in San Diego.
Adam Hooper – Sunny San Diego. Mitch has been in the business for a long time. We talked about kind of how we got into this space, identifying some of the challenges to the market in the last cycle, how they took advantage of that, and how that’s informed their investment thesis and strategy here going forward.
Tyler Stewart – He dropped the big three on us, the big three keys he looks for in a market, which is population growth, job growth, and housing decline.
Adam Hooper – That was actually really interesting. Some stats around the decline in homeownership rate. He said baby boomers’ homeownership rate is about 70%, and millennials…cut that in half, or less, 30%.
Tyler Stewart – Yeah, whoo.
Adam Hooper – There’s some interesting trends there. You know, this kind of echoes what we talked about with Pat Poling and the Class B multi-family space, and that just very fundamental supply-demand imbalance where there’s a lot of demand for this more affordable housing in these Class B units, but you just can’t produce new supply, so there’s a very constrained opportunity, which creates for opportunity.
Tyler Stewart – It does, and speaking of opportunity, Mitch broke down seven markets they like, and what they like about those markets.
Adam Hooper – A lot of good information for listeners there: questions to ask of sponsors about debt strategies, maybe about those markets, how to identify some of those key things. Should be another really good episode for listeners out there. Get the pen, take some notes, and let us know what you think.
Tyler Stewart – Send us your feedback.
Adam Hooper – You can either send us emails to email@example.com or we always appreciate ratings, reviews, comments, iTunes, Google Play, SoundCloud. All right, well with that, let’s get to it.
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Adam Hooper – Mitch, thanks for joining us today from sunny San Diego. How are things down in California today?
Mitch Siegler – It’s another perfect day in paradise. We’re enjoying the first few days of nice, sunny summer weather, so excited to have another beautiful summer here.
Adam Hooper – Perfect. What are your favorite spoils of the weather? What do you enjoy doing down there?
Mitch Siegler – I like to do a lot of outdoor things: biking, and hiking, and surfing, and paddleboarding, and when time permits a little fishing here and there.
Adam Hooper – And surfing, that was a Tyler tells me that was a later-in-life thing you picked up. That wasn’t a lifetime lifelong thing.
Mitch Siegler – I didn’t grow up in California, so I took up longboard surfing at the age of 40, so a little while ago, and I lived in a neighborhood near a famous surf break that many of my neighbors had been surfing since they were seven and eight years old. I had a little catching up to do.
Adam Hooper – How has that been? Any parallels between real estate world and longboard surfing?
Mitch Siegler – Careful wave selection is important, and safety first, probably a couple good life lessons learned out on a surfboard.
Adam Hooper – Good, well why don’t we take why don’t you take us back a little bit into kind of early days of your career in real estate. What got you into the space? What did you like about this industry? Kind of take us up to where you’re at now with Pathfinder.
Mitch Siegler – Adam, I’ve been investing in real estate for decades. I got involved with Pathfinder when my cofounder, Lorne Polger and I, were talking, in about 2005, and we identified what we considered frothiness in the lending environment, both for residential and commercial real estate, and a deterioration in loan underwriting standards, and kind of second and third-tier projects being financed, and we felt that those were the signs of a bubble. We’d seen those signs previously in other bubbles, in the ’87 equity market crash, and the 2000 dot-com crash, and other California real estate corrections in the ’80s, and felt that this was just another one that was bound to happen. We started a company in 2006 and began building databases of banks and certain projects in the western US, and started calling on the banks. It was a little slow going. We were early. We raised our first fund in 2007 and really didn’t start deploying the money for almost a year until pricing got a little more sensible, but that was our entree into the real estate business, and the start of Pathfinder 12 years ago.
Adam Hooper – Well, and I’m curious, in 2005 when you started seeing these things, obviously one of the things on everybody’s mind is, we’re pretty late in the cycle: are we starting to see some of those early indicators that we saw back then, 13, 14 years ago? I’m assuming you guys have been tracking similar metrics, and with Lorne going out and starting a bank, he must feel fairly comfortable about the environment, lending environment right now, but is there any parallel between what we’re seeing today? Is this more strict underwriting that we’re seeing banks sticking to now? Or how does that environment look, compared to when you guys saw these signs back in ’05?
Mitch Siegler – History doesn’t repeat, it does rhyme, as the old saying goes. I don’t think we have the same backdrop in 2018, by any way, stretch, or form that we had in 2005 and ’06. Back then, there was a lot of financial engineering. There were securitizations and CMBS financings. There were subprime lenders who were lending to home buyers on the basis of weak or no credit checks. Banks were being pulled into deals that had probably 80 and 90% leverage in one form or another, including mezzanine and preferred, and in some cases it was worse than that. The banks definitely learned their lessons. The regulators are much more mindful and watchful of the banks, particularly as related to higher-risk lending and real estate lending. Good borrowers today can certainly get 60 and 70% loans on quality projects. It’s harder to get debt financing on second-tier projects, or projects in second-tier locations, or for second-tier operators to get the debt. You still see some signs of people pushing the envelope, but I wouldn’t call it widespread, and I certainly don’t see it in the better projects for multi-family and in the better markets that we operate in in the list.
Adam Hooper – Just for listeners’ background, why don’t you tell us a little bit about Pathfinders’ focus right now, and then we can get into some of these kind of economic macro indicators you guys are tracking.
Mitch Siegler – We started, Adam, as you know, with a broad-based, opportunistic strategy, buying whatever real estate assets in a variety of markets from financial institutions. We bought loans. We bought properties from the REO department, primarily residential multi-family, but we also bought some office buildings, and some retail centers, and even some land. Over the last dozen years, our strategy has really focused and honed to exclusively multi-family and residential, and the fund that we’re currently raising this year, which is Pathfinder Fund VII, is entirely focused on value-add apartments in seven markets in the West, with a little bit of ancillary residential, like condo and townhome projects sprinkled in adjacent to that.
Tyler Stewart – How come you decided to go exclusive with multi-family?
Mitch Siegler – We’ve concluded, based on decades of research, that multi-family provides superior risk-adjusted returns relative to any real estate asset class, and we think it’s far less risky than trying to predict, for example, consumer spending, or the degree to which Amazon will disintermediate retail stores, or what will happen to office utilization in the future as more people travel, and work in airports, and in Starbucks cafes. Those are really kind of tough things to forecast for an extended period of time, but people need a place to rest their head. They need a home or an apartment to live in, and it’s pretty much linked to population and job growth, which is very defined and very predictable.
Adam Hooper – Now, how has your approach changed, in terms of, how you’re sourcing products, or what you’re looking for in opportunities from early days, again, buying distressed opportunities, loan workouts, REO stuff, to the market today. How has that shifted?
Mitch Siegler – It’s not an environment today where you frequently have opportunities to buy distressed assets from financial institutions, although we still find things like that periodically. It’s more of an environment that I would characterize as a secondary wave of distress. It’s people who survived the downturn, but who did so in some cases by selling this asset in the portfolio in order to keep that one, or starving their properties of capital, which is what we see a lot. A long-term owner who’s had a property for 20 or 30 years, and hasn’t invested in it: hasn’t fixed it up, hasn’t improved the amenities, hasn’t kept up. Often these people self-manage the properties. We see situations where the income is not maximized. The property’s full, but the rents aren’t maximized. People are content to just keep them full and be $50 or $100 below the competition. When we see a situation like that, it’s often associated with a property that has been unloved and starved of capital. When we develop a business plan, it often involves a first-level rent increase just to catch up to the market, a secondary level of improvements to the common areas, repainting the building, improving the landscaping and the curb appeal, maybe fixing up the fitness center and adding some other amenities that drives another round of rent increases, and then, over time we’ll renovate unit interiors with new kitchens, and appliances, and flooring, and bathrooms, and so forth, and get a third premium relative to the unrenovated units.
Adam Hooper – One of the comments that we hear sometimes is we’re, call it nine or 10 years into this recovery, eight, nine years, probably, into this recovery. If an asset hasn’t had value added by now, at this part of the cycle, there’s a reason, or it’s too late? Do you agree with that, or are there always opportunities out there, regardless of market cycle, that you can find those ability the opportunities to add value?
Mitch Siegler – There are always opportunities for astute investors, whether you’re selecting stocks or picking quality real estate projects. We take a top-down and a bottoms-up approach to identifying potential investments. We look first at the markets that we believe are characterized by superior population and job growth, that are likely to do well over a period of time. They tend to be places… The places we invest, Adam, are Seattle, and Portland, and Denver, and Phoenix, and San Diego, Southern California. To a lesser extent we’ve begun investing in the last several years in Sacramento and Las Vegas, but those are the only markets that we’re investing in currently. They’re all characterized by superior population and job growth, as I mentioned. They’re places that millennials want to live. They’re places with attractive outdoor recreational activities, and cultural activities, and they’re constrained, from a housing-supply perspective. Many of those markets have natural geographic boundaries that limit the availability of land, and the places you can expand. In many cases there are solid transportation systems. There is vibrant retail, and they’re just places that are hitting on a lot of cylinders. When we find a market like that, then we peel back the onion and we look at submarkets, the various population centers and suburban areas, and we look for catalysts in those areas. It might be a new retail center. It might be a freeway on-ramp, a new light rail station that’s there or is coming, that we think makes that location better five years from now
Mitch Siegler – than it is today. We study that pretty carefully. Then, of course, at the property level, if we find a property that is vintage 1980, and it’s surrounded by a bunch of properties that are vintage 2000, that have superior amenities, and look more modern, and so forth, well, that often presents an opportunity for us to try to bring that old property up closer to current standards, and get the associated income boost, we call that manufacturing income, that results.
Adam Hooper – Basically, f you’re astute, if you’re doing your research, you can find these opportunities, like you said, or maybe self-managed, undercapitalized, haven’t had that value added due to the current ownership not wanting to do that, basically, and that’s where you guys can find the value.
Mitch Siegler – That’s right, and we often find, in those situations, that the seller has a catalyst to sell the property. There might be a lifecycle event. The patriarch of the family might have passed away. There’s perhaps an estate that all the heirs can’t agree on what they want to do, but they certainly agree that they don’t want to put $2 million, collectively, into the property, and that may prompt a sale. Or there may be a situation where there’s been that event, and the family wants to sell, but there’s constraints on that sale, and one such constraint might be that their loan has a prepayment penalty associated with it. We’ll get creative, and we’ll, in cases, assume the loan from the seller. Not a lot of people will do that. Often the loan doesn’t have appropriate leverage, and we’ll assume the loan, and then we’ll subsequently, a year later, apply for supplemental financing to bring the loan-to-value to a more appropriate level. That’s an example of a technique that we’ll do to meet the needs of the seller, to differentiate ourselves from the buyers, and create value, and make a better buy. We’ve also had a few situations in the last year or two where we’ve acquired properties from non-profit organizations that have non-core excess real estate, and that’s often something that we do by virtue of relationships, and similarly it tends to be a thinner competitive environment when you do something like that, because it tends to not be widely marketed.
Tyler Stewart – Mitch, how are you finding sellers who’ve gone through an event and they’re looking to sell? How do you identify those sellers?
Mitch Siegler – Well, we’re highly focused on these seven markets. We’re in these markets regularly. We have deep relationships with influencers there. The people that tend to transact in this Class B apartment space, in the markets that we’re in, tend to be highly focused on those property owners and those properties. They know Pathfinder’s track record or reputation. They know we have a strong balance sheet. They know we deliver on what we say. If they have a situation where someone needs to transact quickly, or has a loan that needs to be assumed, or the property just fell out of contract with somebody else, and we get a phone call saying, if you can hit this price, the deal is yours, or if you can close by the end of the quarter, or the end of the month, or whatever it is. We pride ourselves in throwing a lot of resources at the deals that we get excited about, and we’ll often dig in and do a ton of due diligence, and hire third-party consultants, and really get smart on a property in a matter of two or three weeks, and differentiate ourselves from somebody else that might need 45 or 60 days to get to the same place.
Adam Hooper – One of the things that we’ve talked about multiple times on the podcast here is the changing nature of return profiles from five, six years ago to today and looking forward. Do you have again, earlier on in the cycle you guys were more on the opportunistic side. Now it sounds like more of a kind of just traditional value-add play. How have you seen the return profiles change over the last several years, and where do you see those going forward? Are we going to kind of stabilize? Are they going to continue to tighten? What’s your take on that?
Mitch Siegler – Well, that’s a big, sweeping macro question, and my short answer is, it depends. It depends on the property types. It depends on the markets, the holding period, your appetite toward risk and debt, and all that. For us, we tend to play it safe. We tend to value preservation of capital, if you will, over stretching to get that extra return, but we’re underwriting on the Fund VII portfolio to target returns of 16 to 18% per annum gross internal rate of return, which equates to about a 12 to 14% net return over a five to seven-year period of time. We think those are very, very attractive returns in this environment, with the stock market where it is, and bonds vulnerable to rises in rates, and we do all that with, typically, leverage profile in the 60-65% range. We’re not really getting there through financial engineering, and pushing the envelope on debt, and taking on more risk. We’re doing it by buying these older properties at or below replacement cost, that we believe gives us a margin of safety, and immediately adding value, and raising the rents, and driving the property value higher, which has the effect of creating even more downside protection.
Adam Hooper – Now you mentioned, in this market that you guys are tracking, job growth, population growth, kind of quality-of-life standards. Do you see that continuing, or what are some of the indicators that you guys are looking at, from a metric standpoint, that are driving these market decisions, and how do you see the tailwinds behind those continuing?
Mitch Siegler – Those tailwinds remain in place. We have unemployment in the country, as you know, that’s historically low, sub-4%. We have population growth as the millennials, finally, over the last several years, leave their parents’ couches and basements, and start their own homes or apartments. That’s creating household growth, but the fundamental macro change, the big secular shift that is behind all of this is, and it supports our strategy in a very significant way, is the decline in the homeownership rate. As you guys probably know, the homeownership rate a dozen years ago, when we started Pathfinder, was close to 70%, 69.5%. Today, it’s below 62%, and projected to fall to around 60% by 2025. What does that mean? Well, there are 130 million, thereabouts, homeowners in the United States, couple people in each household, so an 8-point decline in the homeownership rate represents 10 million households, 20 million people that used to own homes, that now rent apartments. That’s the average. In the markets that we’re in, in places like Portland, where you’re based, and Seattle, and Denver, population and job growth is above the national average because millennials are moving there, and as a result, rent growth, too, and the pressure on apartment occupancies is even greater than on average, but on average, in our markets, we are north of 95% occupancy in pretty much every property and every submarket that we’re operating in. 95%, most people believe, is equilibrium, full occupancy, because people are always moving in and moving out.
Mitch Siegler – You can’t really operate at 100%, but we’re 95 to 98% everywhere, and we’ve had rent growth the last several years that’s been well above the national average in our markets, and well above historical averages. While we expect that to moderate, we still expect it to be significant over the next several years. When you add that all up: strong demand, limited supply, the only new supply coming online being luxury Class A apartments where rents are 50 or 100% more than the rents in our properties, we think that creates an umbrella that we’re playing off of. We call it We refer to it as a supply-demand imbalance, and that’s the essence of our strategy.
Adam Hooper – Putting the risk hat on, what could change that?
Mitch Siegler – Well, I don’t think there’s anything that’s going to turn that homeownership back around. To put a finer point on it, the baby boomer generation owns homes at the rate of around 70%. The millennial generation, which just surpassed the baby boomers in terms of size, is around 35%. So will it grow? Will some of those people buy homes in the suburbs, and commute, and mow the lawn, and all that, like their parents did? Sure, but it’s never going to get anywhere close to 70%, and when you factor in all the things that are behind it, the millennials’ desire for mobility, their delayed marriage and family life. They’re getting married later if they get married at all, having fewer kids later in life, if they have any at all, you put all that together, and you overlay the 1.5 trillion of student loan debt that gets in the way of a lot of these people having down payments. Renting is just a very attractive option until you get to your 30s, and that’s why we’re seeing occupancy rates strained. Put that together, that’s the demand side of the equation, with the supply side in markets that we operate in. There’s not a lot of available land. There’s community opposition to new development. There’s a labor shortage to construct new products. If you’re a developer, and you can get financing, and you have the stomach for building, well, the only thing being built today, with all the cranes that we see in the sky, is Class A luxury apartments, and again, those rents are much higher.
Adam Hooper – Are there any other leading indicators? As you guys are looking at markets, what are some of those indicators that you guys are following that might indicate a shift in those trends, or maybe an indicator to look at a new market?
Mitch Siegler – We have staked out, in this fund, something a little bit unusual. Not too many people do it, but we put very tight guardrails on this fund, which we did because we have high confidence in our ability to execute the business plan that we have, and we believe in having high focus. We told investors, we’ll raise all the money this year. We’ll put it all to work this year and next year. We’ll put it all to work in seven markets that we’re already deep in, and if we find the greatest deal in the history of the universe in Austin, or Nashville, or somewhere that’s not one of our seven markets in the West, we won’t do it. We think that creates a situation where we stick to our knitting, and we remain focused, and we remain deep in the markets that we’re already experienced in. High-level, I don’t see anything that’s slowing down the job growth, the population growth in these markets. These seven cities that we selected are not highly correlated with each other. For example, if Amazon slows down in Seattle, well, that could impact the Seattle market generally, but we still have properties in the portfolio in a market like Denver or Phoenix, which behave very differently than Seattle, and we’re pretty intentional about the portfolio construction and diversification, and we think that balances one city balances out the other. I want to come back to your question from a different direction, because I think the essence of your question was risk, and if I might paraphrase it: What could go wrong?
Mitch Siegler – What are the risk factors inherent in the strategy? I would say that the risk factors are not so much that we’re going to see a fundamental collapse in demand, household formation, job growth, population growth, or whatever. It’s really more, if you’re too aggressive, and you’re too dependent on, for example, financial engineering, a massive movement in interest rates or cap rates could play havoc with a real estate strategy, and we’re very aware of that. We made our bones on the backs of others who pushed the envelope too hard with respect to debt, and we bought a lot of those assets from lenders a decade ago. We don’t want to make the mistakes that other people made, certainly, and that’s why we put the debt on at the property level for each and every one of our properties. We firewall that property in its own special-purpose entity. We tend to use fixed-rate rather than floating-rate debt. We don’t have debt at the fund level. We’re not cross-collateralizing things. We have a ceiling on that debt, the fund limit for portfolio-level debt is 70%, but as I mentioned earlier, we’re, as a practical matter, in the 60-65 range, which we think puts a lot of equity into the property, and then we continue to invest in the property with further equity infusions as part of our value-add strategy.
Adam Hooper – Now can we pick that apart a little bit, the asset-level debt versus fund-level debt scenario? Then I also want to circle back, after we talk about that, on the kind of discipline and how your prior experience buying distressed might have informed your requirement to keep discipline going forward, but… So asset-level versus fund-level debt, let’s just let’s dig into that a little bit, and then also, for listeners out there, when they’re looking at opportunities. What questions should they ask, or how can they ascertain whether the fund has a cross-collateralized debt, or if it’s at the asset level, specifically?
Mitch Siegler – It’s a legitimate question for an investor to ask: What is the fund manager’s debt strategy? What is their attitude toward debt? What do they believe is appropriate leverage? How far will they go? We’re typically borrowing from one of the government-sponsored entities: Freddie Mac or Fannie Mae. The government is, in a certain respect, still subsidizing housing and apartment ownership. That’s pretty attractive debt. We’re working hard to match the type of debt and the nature of the debt to the business plan that we have, so if it’s a property that we can transform in three to five years, we’ll probably put it on five-year fixed-rate debt, and if we think it’s more like four to six, that probably augurs for seven-year debt. As I mentioned, it’s fixed rate rather than floating rate, so we’ve taken the risk of interest-rate moves out of the mix, and we’ve also, typically these types of loans bring with them prepayment penalties, so if we get to a place where we want to sell this property with seven-year debt in year five or year six, we’re anticipating that possibility, and we’re negotiating, generally, no prepayment fee or penalty in the last couple of years of our holding period. Each of those things is a support pillar for the overall strategy, which I guess I could characterize is, let’s all sleep well at night and not worry about losing our properties.
Adam Hooper – Now, can you contrast that with a fund that might be taking debt on at the fund level, and what the risks are there, versus the asset level?
Mitch Siegler – If you do it at the fund level, it’s like the old saw, one bad apple can rot the barrel. If you have 10 properties in your portfolio, and you have debt at the fund level, and one of those goes bad, it’s probably supported by the other nine. You’re putting your whole portfolio at risk, if you will, for the sake of a little bit of savings on your debt cost, or a little higher leverage, or some combination. We’re not we don’t need to do this sort of financial engineering to earn attractive returns for our investors. Our investors tell us that if we can deliver, in this case, a 12 to 14% internal rate of return, with mid-60% leverage, that’s fine, and if we were to sit down with a group of them and say, well hey, guys, we’ve got this wonderful idea: now we’re going to go from 65% leverage to 80% leverage, and we can add a couple percentage points to your returns, they’d probably look at us like we have a third eye in the middle of our forehead and tell us not to do it. We’re already there, and we’re already not willing to do it. We have substantial personal capital, my partners and I, in our funds. We, the general partners, have committed $5 million to Fund VII, so we eat our own cooking, we don’t really want to take excessive risk with our investors’ money, just like we don’t want to do it with our own money.
Adam Hooper – Good, and so that also, again, gets back to the other point I want to check, and it was just the discipline, right? How much of your early days of buying other people’s lack of discipline has kind of formed your view on putting those tight reins around the fund, right? Not every fund, like you said, has that. Some are very generic, very open, very opportunistic, and they’ll just find a deal that looks great, and they’ll go do it. How has your history kind of informed the disciplines you’ve baked into this fund?
Mitch Siegler – We believe great businesses are disciplined and focused, and through the process of editing down the world of opportunities into the ones that you believe are the best and most appropriate for you, as a company or management team, that’s where success comes from. In our case, we just felt there would be value and credibility associated with doing walking the walk and talking the talk at the same time with respect to, we’re going to have a short fund-raising period: it’s this year. We’re going to have a short deployment period: it’s this year, next year. We have strong deal flow, and we don’t need a three or a five-year deployment or investment period. We also are mindful of the risks associated with interest rate and cap rate moves in excess of leverage, and cross-collateralization, and through the process of building the business, we’ve made a bunch of intentional decisions about keeping the debt at a certain level, fixing the debt cost, doing these other things to match the term with the business plan, and so forth, and that, too, drives discipline, as does the geographical limitation, the product type, focus on these Class B apartments. It makes the conversation at our investment committee meetings a whole lot easier because we don’t have to wonder whether we should dip our toe into that new market, or go beyond our expertise into another product type, or anything else. We’re very clear on what we do well, and we’re very focused on putting one foot in front of the other and doing it.
Adam Hooper – The seven markets that you said you guys focus on, had you been tracking those how long have you been tracking those before? Were you active in those markets before this fund came around, or how did you identify those originally?
Mitch Siegler – They’re the product of 12 years of experience, and we’ve probably operated in 20 markets during our tenure, and these seven are the markets that we feel the best about, that we have considerable experience in, and so forth. Five of those seven markets we’ve been investing in for, call it a decade, and two, Sacramento and Las Vegas, we’ve only begun investing in seriously in the last several years. They all have drivers. I could talk to you about any of those markets as to what our point of view is, and why we like it, but that’s where we’re operating. They’re all within a two-hour Southwest flight from San Diego, so we’re not schlepping across the county, which has certain advantages as well.
Adam Hooper – Let’s do that. For listeners out there that are looking at opportunities across these markets. I’d be curious to get your take on, just high-level, what attracted you to these, right? Seattle we talked about. Obviously, Amazon a big driver there, technology. Maybe give us the top two or three points that you guys are that attracted you to these markets at just a super-high level.
Mitch Siegler – Okay, so Seattle: tech focus, tech-centric, Amazon has really moved the needle for the market, but Boeing’s a big employer, Whole Foods is there, Twitter and Starbucks, good depth, Fortune 500 employers, and a lot of health. To juxtapose Seattle, Phoenix is a market with very few Fortune 500 corporate headquarters, but pretty much every Fortune 500 company has a back office presence in Phoenix: call center, distribution center, or both, and what that has done is that’s created a lot of mid-level jobs. Housing is much less expensive in Phoenix than it is in California, and Washington, and Oregon, but a lot of those people who have those back-office jobs tend to rent apartments, and that plays well to our Class B value-add apartment story. Denver is a market that has had a lot of growth, and development, and balance to the economy over the last 20 years. Used to be highly dependent on energy. Today there’s a tech component, an education component, a health care component. It’s a burgeoning center for the new cannabis industry, recreational activities, obviously. Many of our markets also have universities, and multiple universities in the cities, and we think that tends to create act as a magnet for talent, and keeps talent there. That’s something else we look at in addition to strong transportation systems and cultural activities. San Diego is our home base. San Diego is a very attractive market because for 25 years we have undersupplied the housing that’s needed just to keep up with normal population growth by about 50%,
Mitch Siegler – and what that’s done is it’s created a dynamic where, if you can buy an apartment, it’s like gold, because there’s not enough. It’s hard to find land. It’s hard to get anything approved if you can find the land, and so forth. Sacramento is another market that we like. It’s an hour from San Francisco Bay area. Home and apartment prices are 50 to 75% less. We think that is causing companies and residents to be willing to commute to get more housing than they otherwise could, or to have cheaper office space, or both. It’s the state capital of California, and we believe is a place that will become the home for more technology businesses over the next several years.
Adam Hooper – And Portland?
Mitch Siegler – Portland, I don’t know, I would characterize it as a mini-Seattle. It’s had some decent tech growth, but always a few steps behind, but it’s got a hip and cool vibe, and young college grads seem to go up there for school, and stay there, or move there after school, and bit of a different tenor to the city, but it’s fun and young people like it.
Adam Hooper – Just the right amount of weird, we say.
Mitch Siegler – Right.
Adam Hooper – When you’re looking at these markets, how are you trying to forecast what the growth potential is, or are you just looking at these demand drivers as kind of a good fundamental, and growth will come?
Mitch Siegler – We do it the best we can internally with our own research, and by virtue of being in the markets, and talking with knowledgeable people and influencers, but we also, every so often, and we did in December, in advance of launching Pathfinder Fund VII, we retained a third-party market analysis from a group, John Burns Real Estate Consulting. If you know those guys, they’re one of the preeminent consulting firms for public home builders, and hedge funds, and private equity real estate firms, and so forth. We’ve worked with them for many years, and they did an analysis of western US supply and demand to match up with our thesis, and they helped us understand where the new supply’s being created, and what kind of product it is, and how that relates to our Class B apartment strategy, and they have rent growth forecasts going out a number of years, and occupancy forecasts market-by-market for the markets that we’re in. We asked them to also do a deep dive on our markets, and they gave us a 50-plus-page detailed report that is the basis for our property-level underwriting at any property in any of our seven markets for the foreseeable future, and we’re happy to share that with–
Adam Hooper – They sound like
Mitch Siegler – Prospective investors.
Adam Hooper – sound like a great podcast guest. We should probably get them on. Good info.
Mitch Siegler – They’re very smart on the housing market.
Adam Hooper – Are you guys looking at getting back to the risk side of things, I assume you’re looking at different, whatever you’re looking at as a potential risk factor for those markets, you’re looking at similar metrics across markets, or do you look at different potential risk factors like the you know, Phoenix might have a very different potential risk profile than Seattle, right? How do you look at the different risk profiles of these markets?
Mitch Siegler – Let me give you an example. We expect there to be a ballot initiative in the city of Sacramento this fall. One of the big labor unions is financing an effort to gather signatures to put on the ballot, a rent-control initiative that would essentially roll back rents to where they were in February of this year, and create an environment where it probably doesn’t make a whole lot of sense for an apartment owner to plow half a million or a million dollars into fixing up the common areas of a property, or even to renovate the unit interiors. For the moment, until that comes on ballot, and we see where the dust settles, and all that, we’ve hit the pause button for new acquisitions in Sacramento, and we’ve also shifted gears a little bit with respect to our value-add strategy for a 175-unit property that we own up there, and things like that are indicative of what can come at you from left field, and how you have to be willing to shift gears if you need be, or to bob and weave.
Adam Hooper – Again, like you said, the diversity across these markets helps kind of build that balanced portfolio, right? You’ve got different industries. You’ve got different vertical layers of those Fortune 500 employment stacks, right, where you’ve got more of the back office. You’ve got the tech. You’ve got some health care. Pretty good mix across all those different markets.
Mitch Siegler – That’s exactly right, and if you look back in time at great investors, regardless of whether they were equity investors, or real estate investors, or something else, the portfolio construction and the diversification is, far and away, more than market timing, more than good asset selection. That’s the thing that determines outsize returns over a long period of time, and we give a lot of thought to the portfolio construction. For example, in Fund VII we expect that we’ll have 12 to 15 assets in this fund by the end of next year, these Class B value-add apartments in these seven markets, but all markets aren’t created equally. Seattle and Phoenix are bigger markets than Denver and San Diego, which are bigger markets than Portland, and Sacramento, and Las Vegas. While we might have three or four of our 12 to 15 properties in the biggest markets, like Seattle and Phoenix, we might only have one in the smaller markets like Las Vegas and Sacramento.
Adam Hooper – Okay, that makes sense. That’s one of the benefits that’s one of the key things that we’ve been trying to bring to investors, right, is the ability to build that diversified portfolio across all different product types, all different markets, different managers. That’s a good kind of core tenet of what we’re trying to do at RealCrowd, and bring people access to these different markets and assets to build that diversified portfolio.
Mitch Siegler – Yeah, very important.
Adam Hooper – So now we talked a little bit about supply, earlier. Do you see any and are you concerned at all with the new construction going on? I mean again, like we said, a lot of that is the luxury residential. Doesn’t really compete, necessarily, for what you guys play in the Class B space, so maybe we can take a minute to define how you guys look at Class B, what characteristics that might have, and then also how any new construction might impact what you guys are looking at in the Class B space.
Mitch Siegler – Okay, several good questions there. First, definition of terms. Class A apartment is the new apartment that you see being built today. It might be a garden-style property. It might be a mid-rise property. It might be a high-rise building downtown. But typically it’s got the newest amenities. It’s got technology and it’s new. A Class B property doesn’t have the same level of amenities, is a little older. We define it as ’70s to ’90s vintage. Some people might lump a ’60s building in, or a building that wasn’t of the same caliber built in 2000, but it’s a several-decades-old property that has good bones, for us, but hasn’t been upgraded in a long time, and certainly doesn’t have the best amenities. Class C, which we don’t really do, is another notch down. It’s older still. It might be smaller units. They certainly have fewer amenities, if any. And that’s the hierarchy. We think there’s a hole in the market with respect to the Class B. You’re not building Class B anymore, for all the reasons we talked about, ’cause if you can find land, and you can overcome community opposition, and you can find a contractor that has capacity, that’s willing to work in an environment of rising wage rates and material costs, you’re only going to build the best of the best. You’re going to build the Class A luxury, and that’s if you can get the financing for it, and given that the rents are a lot higher, it’s easier to make that kind of a property pencil for a developer than it is for something a notch or two down.
Mitch Siegler – We think there’s arbitrage for us in buying a… And I’ll give you an example, a Class A property in a market like San Diego or Seattle might rent for $3,000 or $4,000 a month, and this is just a placeholder by way of comparison. Our Class B property that hasn’t been upgraded might be renting for $1,200 a month, and after we fixed it up, and improve it, and add amenities, we’re taking the rents to 1,500 or 1,700, but you can see that even after we’ve fixed it up, those rents are half of the Class A alternatives, so it really creates an incredible value proposition for the tenant, who says, I can’t afford this new thing downtown. I’ll drive 20, 30 minutes to be at something that’s almost as good, and we then create a competitive advantage by trying to be in tune with what the amenities are that that demographic desires, whether it’s a bigger gym, or a dog park, or gathering areas with fire pits, or community garden, or whatever it is that we think the cohort in that city wants.
Adam Hooper – Class B supply is either former Class A supply that then ages into Class B, or it’s… Can you take a Class C and move it up to a Class B? What is the supply part of the equation for a Class B? It’s just not being built right now, right? There’s no new Class B coming online.
Mitch Siegler – That’s right, it’s not. Exactly, it’s not being built. You can’t create it. If you were to buy the If you were to buy the land, and get it entitled, and put in the underground utilities, it might cost you just as much as what we’re buying the already-built project for. For us, we look at two things. We look at the area, and we look at the property. We don’t really want to buy in a Class C area, if you will, because we’re never going to be able to move the needle, and turn that Class C area into a Class B area, but if it’s a Class C property in a Class B location, we know that that property can be improved, because the location’s already a step up in terms of quality.
Adam Hooper – This is maybe more of a philosophical veering into possible political debate about what is preventing Class B? Is it land prices? Is it construction cost? Is it capital return expectations? All of the above? Why can’t more affordable Class B units be delivered via new construction today?
Mitch Siegler – It is all of those things.
Adam Hooper – It’s all the above.
Mitch Siegler – This is probably one that’s better discussed over a bottle of wine, but yeah, there are political dimensions to it. There are geographical dimensions, and all that. Some cities are taking steps to be more encouraging of that sort of development by creating density bonuses near transit locations, and speeding up the permitting process, and reducing some other impediments, but all things the same, you just can’t move the needle enough on a pro forma, going back to our earlier example of a newly-built property with $1,700 rents, as compared to the same pro forma for Class A with some nicer finishes, where the rents can be $3,000 or $4,000. At the end of the day, that’s why we have a mismatch in what’s desired and what’s being created, but any way you slice it, we’re creating far less than is needed, irrespective of what type of property it is.
Adam Hooper – Do you see anything on the horizon that’s going to change that equation, or that’s just a fairly solid, concrete reality of what Class B is right now?
Mitch Siegler – Long-time San Diegans used to joke that when their relatives from the East Coast and the Midwest would ask them how everything was in San Diego, we would tell them it was another cold and rainy day, because we didn’t want millions of additional people coming here, driving further increases in housing prices, and adding to the traffic. At the end of the day, if young people want to pick up and move to a city like Seattle, or Denver, or San Diego, in droves, that’s just going to put pressure on a limited resource, whether it’s housing or room on the freeway, and that in the first case it’s going to just drive up the price, and that’s what we’re seeing, and typically these cities, because they have good weather, and because they have access to the water, and so forth, they also have geographical barriers to entry. In the case of San Diego, we’re bounded on the west by the Pacific Ocean, and Mexico to the south, and the mountains on the east, and Camp Pendleton to the north, and there’s just nowhere to grow. And we have lots of NIMBY-ism added to, it’s not in my backyard, as to new development, and there’s just not much land. The only new construction for residential is the odd pocket of land here or there, or something that’s being repurposed, like an old elementary school or church that closes down and is turned into residential, but many of the markets that we operate in, even markets that folks believe, well, there’s land as far as the eye can see, in Phoenix and Las Vegas. Not the case, even there,
Mitch Siegler – because when you factor in the land that’s owned by the Bureau of Land Management, or the Indian reservations, or is unbuildable because it’s in a flood plain, or whatever the reason is, there’s just land than you think in the markets that have seen the dramatic population growth.
Adam Hooper – You don’t see the dynamic changing any time soon. Demand is going to continue to be strong, and this and again, this is echoed on many of the people we’ve had on the podcast, right? This Class B is just a very fundamental supply-demand equation opportunity that we don’t really see anything forecast to change that very much going forward.
Mitch Siegler – I want to be optimistic rather than pessimistic if I can. I’m encouraged by recent discussions. For example, in San Diego our government has begun to talk about some of the things that cause housing prices to be so high, cause rents to be high, that cause supply to be so constrained, and they’ve set forth some goals and objectives, and some specific strategies to reduce the regulations, increase the speed with which someone can get a permit, increase the number of inspectors to streamline the construction process, add to density near transit locations, and none of these things, on its own, is going to change the outcome, but if you do 50 little things together, that can have a dramatic impact. There are studies that show that 40 to 50% of the cost of a new housing unit, home or apartment in California, is directly or indirectly attributable to regulations. Anything you can do to chop away at that has a significant impact, can have a significant impact.
Adam Hooper – Yeah, and so those 40, 50% of new housing costs is due to regulations. What would you what are the actual quantifiable bits of that? Just… Certain land use, density restrictions, or what is that?
Mitch Siegler – Yeah, that in part it’s density restrictions. It’s, in part, the fees: the building permit, and sewer hookup, and school fees. Those are driven by the fact that the markets are already crowded, and there’s already a lot of pressure on the public resources, so those fees are an attempt to increase the capacity of schools, and sewer, and highways, and the like, but a lot of it is just bureaucracy and regulation. A lot of it is abuses of environmental laws. We have something in California, the CEQA, the California Environmental Quality Act, and under CEQA, anybody and his brother, for this rare bird, or this salamander, or little fish, or whatever, can hold up a project, and sometimes there’s a very real environmental impact, and sometimes it’s kind of made up, or it’s created by attorneys who wring settlements out of the developers in exchange for stepping aside, and that process is abused, and that process adds years and millions of dollars to a whole host of new developments, and crimps the supply. All this stuff is intertwined with other things, like homelessness. If we have a more sensible policy, we will create more housing, which will keep the prices from escalating, and if we do other things that aren’t as thoughtful, or we bring on programs that feel good in the short term, like rent control, but probably have disastrous long-term impacts, it can go another direction.
Adam Hooper – To wrap up some of the stuff we’ve been talking about, for listeners out there, when they’re looking at opportunities in different markets, jobs, population growth, diversity of employment, any other kind of key factors that you think listeners should really key in on, or ask questions of the managers that are looking at assets in those markets?
Mitch Siegler – Is this a city that’s likely to fare well on all these metrics over the next five to 10 years, relative to another city? Because people, like capital and water, can flow in the path of least resistance. If a market is well managed, if there’s a good transportation system, if there’s good universities that spin off emerging companies that have well-paying jobs, and all that, well, that’s where the young people are going to want to move, especially if there’s good stuff to do outdoors, and good coffee, and you have friends there who are like-minded. Those cities, as we’re seeing, are going to do well at the expense of other places that aren’t as proactive, don’t have as good a weather, don’t have as many exciting cultural activities. The tax rate has something to do with that. We’re certainly seeing population move from states and regions with high state taxes to those with lower or no state taxes, so that’s probably also something to be mindful of. All of these things are elements to the decision, but I’ll bring it back to diversification, since it’s hard to predict 100 variables in a half a dozen different markets over a five or seven-year period of time, we try to focus in on the most important ones, and then create a diversified and well-constructed portfolio, where the risks of one property in one market or submarket are balanced off by another one. We’re operating within a range, and we think there’s solid downside protection. Some could do a little better, and outperform,
Mitch Siegler – but we do sensitivity analysis on all of our properties, and we get comfortable that even if rent growth is slower, even if occupancy declines, even if X, Y, Z happens, our principal, our investors’ principal is still going to be well protected.
Adam Hooper – Good, so overall bullish on where we’re at and where we’re going.
Mitch Siegler – We are bullish on value-add Class B apartments. That’s not a prediction about the economy. That’s not a prediction about markets or real estate in general, but there is a supply-demand imbalance for housing. It’s not going to change any time soon, and a good way to capitalize on it is buying the older stock, pumping in capital, fixing it up, and driving income higher.
Adam Hooper – Perfect, well, I think that’s a pretty good spot to end it.
Mitch Siegler – Well, good. Nice catching up with you, Adam, Tyler.
Adam Hooper – Yeah, likewise.
Mitch Siegler – Thanks very much.
Adam Hooper – We definitely appreciate your time coming on today, Mitch. Thank you for a great conversation. Listeners, as always, if you have any questions or comments, feedback, please send us a note to firstname.lastname@example.org, and with that, we’ll catch you on the next one.
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