Finding Your Path

Musings from the Front Line

By Lorne Polger, Senior Managing Director

Lorne PolgerI haven’t turned my television on since the election. Literally. Not that I was a big television watcher to begin with, but frankly, I felt so overloaded with the daily political battles and over-analysis of the smallest of non-news events, that I just decided to tune out. It’s been quite refreshing. I’ve caught up on reading some professional periodicals, fun periodicals and a couple of works of fiction. I binge-watched the second season of Narcos on my iPad. And I’ve played my drums more. I like that. It’s also calmed my nerves about what America may look like four years from now and beyond. Frankly, I got pretty darn tired of “the world is coming to an end” talk around the holiday party circuit. It’s not.

That said, the world (and the U.S.) will be different going forward. Our foreign policies will change. So will some of our monetary policies. Market volatility may increase. And regardless of whether Donald or Hillary was elected, the reality is that neither candidate was likely to stop the end of a significant growth cycle. Politics can impact the depth or duration of cycles, but they generally don’t stop them.

A lot of people are nervous about the economy right now. Very nervous. We hear a lot of talk about frothiness. We know that trees don’t grow to the sky and the music doesn’t play forever (in fact, we predicted so much back in 2006). As we embarked on our newest real estate fund (launched a couple of weeks ago), we asked ourselves many of the same questions that our investors and readers also may be asking themselves. Are we near the top? If so, is now a good time to buy? Where are the opportunities? Where is the position of safety? Are there real estate product types to pursue and those to avoid? Are there geographies that will perform better than others? How much will interest rates increase? How should you look at holding periods now? If you aren’t asking yourselves those questions for your various investments, you may want to.

BOur conclusions, drawn from decades of experience across many cycles, product types and geographies along with constant and in depth review of research and commentary, is that there are some safe plays out there. In particular, we are strong believers in class-B apartments.

We’ve written a bunch before about the proliferation of new apartment projects in the cities where we do business. We’re starting to see a few cracks in the armor in the development sector. Concessions (i.e., some free monthly rent) have started to appear in some (but not all) markets for the first time in many years. That’s what happens when supply begins to exceed demand; as housing options increase, you have to fight for tenants. You do so initially with location and amenities, but eventually, that may not be enough and price enters into it. But with all of the new construction, the vast majority has been in the new class-A space. I’ve read recently that the proportion is 99%. Why? Because you could not cost effectively construct a new class-B or C apartment given the high costs of land, increasing difficulties in obtaining entitlements and escalating construction (primarily labor) costs. In order to generate the rents that make those new projects pencil, developers needed to set the bar pretty high; it’s not at all uncommon these days to see monthly rents in those projects in the $2,500-$4,500 ranges. Great stuff if you can afford it and some can. But many can’t. And if the overall economy begins to slow and the investment markets soften, we believe that more won’t.

HouseThat’s why we like class-B apartments. There is a massive difference in rents between class-A and class-B across our markets. In some cases, the asking rent differences might be double, in others, even more. So even if the class-A buildings have to drop their rents five, ten or even shockingly, 20% in the event of a significant economic downturn, we believe there is still plenty of room to run in class-B rents, especially after employing a tested and proven value-add strategy. Even then, a substantial difference between class-A and class-B rents will likely remain.

In the event of a big economic dip, people will still need a place to live. They are buying fewer homes – the homeownership rate has fallen from 69% to 63% in the past decade. Populations are growing (especially in our markets). If you can’t afford that shiny new apartment, you’re still going to need a place to rest your head. A step down to a class-B is not that great, but it’s a potentially large saving in monthly outlay for most folks.

We also really like the markets we are in. Ultimately, much of the success in real estate ties to population and wage growth. There’s lots of evidence that we’ll continue to see solid population and income growth in Seattle, Portland, Denver, Phoenix and southern California. You may be able to get better short-term yield in Indianapolis, but are you going to achieve growth? Not likely.

We also think that in the event there is a dip in 2019 or 2020 as some have predicted, class-B apartments will weather that storm better than any other sector, and come out the backside in good shape. It’s one of the reasons that we matched up the duration of our latest fund with that type of cycle. Ride safely through the storm and think about exits in 2022 or 2023.

Where do I not want to have my real estate capital allocated these days? I wouldn’t touch office or retail with a ten-foot pole. The ways we work and shop have changed so rapidly over the past ten years that it could be foolhardy to safely predict where they are heading in 2027. The trends are daunting. My young adult kids purchase 90% of their goods online. How about yours? Think about that.

Now may not be the time to be swinging for the fences. We think it’s a good time to hunker down a bit and play things safe. Hit some singles. Maybe sprint hard and hit second base for an occasional double. The next few years are going to be an interesting ride. Perhaps unprecedented in many ways. That said, if future volatility makes you sick or nervous, we believe the real estate prescription is in class-B apartments. Call it the Pathfinder flu shot for the next few years.

Find time this year to enjoy your families and friends. It’s important.

Lorne Polger is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Lorne was a partner with a leading San Diego law firm, where he headed the Real Estate, Land Use and Environmental Law group. Reach him at lpolger@pathfinderfunds.com.