Charting The Course
By Mitch Siegler, Senior Managing Director
We held our annual investor meetings in March and a recurring question was “Where are the opportunities today and in the next couple of years and how do they differ from the opportunities you’ve been finding for the past few years?” That’s a question we ask ourselves on pretty much a daily basis (and have asked ever since we conceived of Pathfinder a decade ago). We’ve long prided ourselves on not following the herd – when others zig, we try to zag. But, what does that really mean today, when multifamily cap rates – especially in gateway cities – are at historic lows, debt is widely available and it’s never been more of a grind to buy truly off-market, deep value-add properties.
As we reflect on that essential question, we recall Apple’s 1997 “Think Different” ad. You remember – it was black and white and featured luminaries including Albert Einstein, Bob Dylan, Martin Luther King, Jr., John Lennon and Yoko Ono, Thomas Edison, Mahatma Gandhi, Amelia Earhart, Alfred Hitchcock, Frank Lloyd Wright and Pablo Picasso. Richard Dreyfuss’ voice-over began: “Here’s to the crazy ones. The misfits. The rebels. The trouble makers. The round pegs in the square holes. The ones who see things differently.”
Now, we don’t presume to lump investing in the same category as physics, music, art, non-violent resistance, architecture or cinema and most investors aren’t inventors. But, astute investors know that if you buy a market-indexed fund, you’ll almost certainly generate market average returns. That’s just fine sometimes, awful at other times and in between more often than not. But, if you want to generate “alpha” (a measure of performance on a risk-adjusted basis – the excess return of a fund relative to the return of the benchmark index is a fund’s “alpha”), you need a point of differentiation – which generally means a strong point of view.
When making investments at Pathfinder, we try to remain true to several tried-and-true points of differentiation. These include:
1. Investment size – The vast majority of the capital aggregated to acquire real estate since the Great Recession has been concentrated in the hands of a few mega-funds. Case in point: the March 30 announcement by Blackstone that it raised $14.5 billion for Blackstone Real Estate Partners VIII – in under four months! Blackstone and other colossal funds have amassed the lion’s share of capital raised and these multi-billion dollar behemoths need to deploy the equity capital in chunks of $100 million and up. Some of the smaller institutions can make $50 million equity investments and a handful might dip all the way down to $25 million. So, when we try to fly below the radar by making $5 to $10 million equity investments, we don’t have nearly the competition we would have on the larger deals.
2. Property Type – While Pathfinder is a broad-based opportunity fund – meaning we can take advantage of juicy opportunities where we find them – our strong preference is for multifamily and residential investments. This is founded on our belief that multifamily properties provide superior risk-adjusted returns over long periods of time and our research (and proprietary third-party research) suggests a significant supply-demand imbalance in many of our favorite markets (more on this below). Long story short (as to our target markets): very few apartments were built from 2006-2013, employment growth is fairly robust and millennials – the primary beneficiaries of much of the growth in higher-paying technology sectors – are waiting longer to get married (if they get married at all) and are having fewer children (if they have any at all). That translates to a higher propensity to rent apartments rather than purchase homes now and for the foreseeable future.
3. Geography – We’ve gotten pretty deep into a handful of markets – and they’re generally not the gateway cities. We’ve made quite a few acquisitions and benefitted from a number of dispositions in Denver, Phoenix, Seattle, Portland and our home-town of San Diego. Sure, we look at opportunities in other cities and sometimes venture to areas near L.A. and the S.F. Bay area. We also look regularly at opportunities in Salt Lake City, Las Vegas and elsewhere. But, when we find something we like in a tried and true market we know well, it tends to set our hearts aflutter.
The Herd Mentality
Wildebeests on the African Savannah know that if they travel together in a herd, the individual isn’t as vulnerable to lions, tigers and other predators. Humans, too, are driven by fear. That’s why you see see-sawing stocks, powerful rallies and teeth-chattering crashes. There’s safety in numbers (until there’s not).
Many investors congregate in the middle of the pack. Some might call that following. Sure, those around you might get picked off by the predator but if you don’t time it just so, you could get trampled by the herd. Oversupply (relative to demand) drives real estate cycles.
Instead of hanging in the middle of the pack, following another path – one that’s not wide enough for the herd – can actually be safer (and more lucrative). The road less traveled. Naturally, it’s not as familiar so it’s sometimes perceived to be riskier. However, if the investment is a true diamond in the rough – an investment predicated on solid research, proper blocking and tackling (execution) and a reasonable margin of safety – you’ll be less likely to get trampled by the herd.
Real estate diamonds in the rough take the form of true off-market acquisitions and other purchases at prices that may not reflect the asset’s potential. If you’re acquiring a property that hasn’t been optimally managed or one that’s been starved of capital and you have confidence in your (or the operator’s) ability to really add value (by renovating the property and raising rents – we call this “manufacturing income”), you’ll be far less likely to get trampled by the herd. And, if you work hard, create meaningful value and are fortunate enough to find yourself in the other camp – when there’s more demand than supply – you’ll be amply rewarded.
A Few Pathfinder Examples
What fits the bill? Examples of four recent “Think Different” and “Don’t follow the herd” Pathfinder investments:
1. The former Butterball® turkey processing plant in Longmont (near Denver), CO. We acquired the former Butterball® site, 27 acres, last year at 25% of the price one of the leading national brokers had been seeking for the property. The city is most desirous of redevelopment, since the plant was located at 1st and Main (literally) – so they kicked in millions to fund building demolition, road and park construction and other incentives (you don’t see that too often in California, we’ll tell you that). Oh, and we’ve leased a number of buildings and are generating six figures of cash flow – in just nine months, our effective cap rate is about 5% – not too shabby for a covered land investment.
2. A block of 73 townhomes, from a 100-unit project in Portland, OR. Circa 2000 construction, acquired from the widow of the original developer. Operated as a rental community but not optimally managed by a long-shot – rents more than $200/month under market. Units acquired at prices which are 25% below the price of today’s townhome values. We also like our optionality on the exit – we can sell a stabilized rental projects or individual townhomes.
3. A retail center in San Diego County that’s a residential development in disguise. The center includes two free-standing buildings – one a national drug store chain and the other a national bank, both triple-net leased investments. Red hot demand for these – we’re planning to sell them and recover our entire investment. And we’ll be left with the 10-year-old, floundering inline retail center in back – for free. Highest and best use isn’t retail but residential – a publicly-traded real estate investment trust is building 200+ units across the street from our project. We hope to demolish the retail center and build 100 apartments.
4. A 100-year-old church in Seattle that was partially converted into 12, luxury townhomes. A mix of old and new, 3- and 4-story units, many with panoramic views. “Partially converted” because the original developer ran out of money and the lenders moved for the appointment of a receiver, creating an opportunity for an attractive entry price and room for us to add further value. We think we’ll see more such adaptive reuse opportunities in the years ahead.
Sure, we could run with the herd and acquire the same-ol’, widely marketed properties in the best neighborhoods of New York or San Francisco. But, we’re happier taking paths less traveled. For us, it feels more comfortable to think different.
Mitch Siegler is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. Reach him at email@example.com.