Fairfield on multifamily: ‘From cowboys to core’

Multifamily in the US might have been a wild asset class back in the 1970s, but Fairfield’s Greg Pinkalla has seen it become one of the core holdings of US investors today – while still maintaining the flexibility to ‘roll with the punches’.

This article is sponsored by Fairfield

With more than 40 years in the field, Fairfield’s chairman and chief executive Greg Pinkalla has seen the US multifamily real estate space transform completely. Despite its unsophisticated beginnings, he is not surprised that it has become a bedrock of institutional investors’ portfolios today. He shares why multifamily has continued to perform well even through two economic crises, and how important it is to keep a flexible, dynamic strategy to adapt to different market conditions.

Looking back over the past 40 years, how has multifamily housing changed? What were the key evolutions?

Greg Pinkalla

I started my career working in the real estate investment department at Prudential Insurance company right after business school in 1977. In the early 1970s, Prudential created PRISA, one of the earliest open-end core real estate funds, which is still in existence today. It had no allocation for multifamily, as the sector was not even considered a core product type.

Today, it is a night and day difference. Multifamily is a cornerstone sector in many of the portfolios of the world’s largest and most sophisticated investors.

I can think of four events which shaped the rise of multifamily from the bottom of the barrel to the top of the class for many institutional investors. It started with the passage of the Tax Reform Act of 1986, followed by the S&L meltdown in the late 1980s, and the securitization of real estate debt and equity beginning in the early 1990s. You combine these events with the top performance of multifamily relative to the other asset classes over the last 40 years, and you begin to understand the transformation.

Prior to the 1986 Tax Reform Act, many of the developers and investors active in multifamily were motivated by fees and the tax write-offs allowed by the tax code, hence there was little institutional presence. The operators were dominated by cowboy developers and the primary capital source was tax loss syndicators.

Market fundamentals were not the drivers for new projects. Instead, it was the amount of tax write-offs relative to the required equity that attracted capital. These tax write-offs often exceeded two times equity, which meant poorly conceived projects would attract capital even though there would be no fundamental support to build the project.

Once these generous write-offs were eliminated by the tax code, developers were deprived of this easy capital source. What replaced it? Another failed government initiative: the deregulation of the nation’s savings and loan (S&L) industry. Historically, S&Ls provided financing for single-family homes. With the expansion of the S&L charter to include commercial loans, they went on a lending spree despite little experience in underwriting these projects. As we all know, this ended badly.

Oddly enough, it was Wall Street to the rescue. I had left Prudential in the early 1980s and went to work for Merrill Lynch as an associate in the real estate investment bank. One of my first projects was working on the early mechanics of the securitization of the real estate debt market. Little did I know that it would grow into a $200 billion commercial mortgage backed securities market at its peak 20 years later.

After the S&L meltdown, Wall Street revived a dormant REIT industry and rapidly securitized a huge swath of the real estate industry, including office, retail, industrial and multifamily.

In my view, it was this securitization of the multifamily sector that created the  transparency, data analytics, and operational sophistication that institutionalized the investor base on a global scale. But this alone did not propel multifamily to the head of the class. It was the above average performance as an investment class relative to the other sectors.

Multifamily also performed well post-GFC, and even during the covid-19 pandemic. Why have fundamentals and returns been so strong?

Multifamily has had strong tailwinds since the GFC that will continue to drive solid performance through the next decade. Let’s start with the power of demographics stimulating housing demand, especially multifamily.

Millennials and Gen Z are the two largest demographic groups ever. Millennials are 75 million strong and Gen Z is slightly larger. Roughly 70 percent of households ranging 20 to 30 years old rent, which has been a huge driver of demand since the GFC.

Homeownership peaked in 2005 at 69 percent and tumbled to a low of 63 percent in 2016. This shift in shelter preference resulted in approximately nine million new renter households. At the same time, young people were postponing marriage and child-rearing and delaying the move into homeownership.

During the GFC, housing supply declined sharply, falling from a high of 2.1 million units started annually in 2005 to a low of 500,000 units in 2009. Only in 2018 did housing production return to its long-term average of 1.3 million units. This undersupply of housing over a prolonged period is still affecting the housing market today, especially the for-sale single-family market.

Housing is a basic need and as a result it is supported by the federal government through Fannie Mae and Freddie Mac. These agencies provide trillions of dollars of financing for the housing market. They tend to expand activity to support housing during periods of stress in the financial markets. This type of support is not available to the other asset sectors.

Consequently, this helps provide liquidity to the market and allows for a competitive environment, which helps support apartment property values.

Even during deep recessions, occupancies very seldomly fall below 92-93 percent in the rental housing market. People need a place to live.

Rents may fall to maintain occupancy, but decreases on a macro basis are generally in the low single digits. Combine relatively high occupancies and only moderately decreasing rents, with lower turnover and modest capital associated with this turnover, and you begin to understand why multifamily performs relatively well during down cycles.

Where do you see the best investment opportunities in the space today?

We don’t necessarily view strategies creating the “best” or “worst” opportunities on a macro national basis. Really, the US real estate markets are large and diverse, so we try to view each market individually and identify where we see best strategy execution by market. That being said, certainly some strategies look more compelling today from our viewpoint.

We like suburban development in major metro markets. Many of the coastal urban markets have become unaffordable. Supply in suburban markets as a percent of inventory has been significantly less than in urban markets.

Costs of construction are cheaper in the suburbs, and rents are cheaper too. Execution risk is lower. Schools and overall quality of life tend to be better. And America is spreading out – you no longer have to live in the San Francisco Bay Area to work at Facebook or Google. Work from home will change how we work in the future, so more space is better.

We also like the affordable space, both existing and new construction. Too many renter households are spending more than 30 percent of their income on rent, some over 50 percent. This sector is grossly underserved. We believe providing quality housing and services to this renter population is not only doing good for society, but can generate attractive long-term risk-adjusted returns for investors.

Lastly, we are attracted to the core-plus space. We see opportunities to acquire functionally current assets in major markets cheaper than current replacement costs. Cap rates are historically low in today’s market, but borrowing costs are even lower. We think investing in quality assets and locking into low-cost debt and attractive current cash returns makes a lot of sense.

What do you view as the keys to success for a multifamily sponsor, operator and developer, particularly over the next decade?

It starts with having a vision and a purpose for your existence. You need to establish a clear set of values that you live by every day. Then it’s all about the people – getting the right people on the bus.

Next, understanding your customer is key. At Fairfield, our employees, residents, investors, and the communities we do business with comprise our customer base. Your employees and residents are the secret. If you get this part right, your investors and communities will be well served.

We all know the current environment is in constant flux. We deal with not only economic change, but political and social change as well. You need an organization and business model that are dynamic and flexible.

And finally, you better be able to roll with the punches! Sometimes it makes more sense to be a builder, while sometimes it makes sense to be a buyer. In our business, it is all about execution. If you can execute across multiple strategies in diversified markets with a wide capital base, you will be successful.

Could a shockwave or recession hit the multifamily space as the US market opens back up?

Anything is possible, but I do not see a recession in the near future for the US economy, nor a reset for the multifamily space. We all know there will be a recession at some point in the future. We also know multifamily will likely perform comparatively well as it has in past recessions.

The fundamentals in our space are solid. Occupancies are at 95 percent, rents are beginning to grow again, interest rates are historically low, jobs are coming back, credit is available, investor demand is high, and demographics are favorable. Except for a Black Swan event, I just don’t see a multifamily reset in the cards.