Why Did I Decide to Invest in the Midwest?

Cyclicality in San Francisco taught me a lesson I will not soon forget

In 2001, I purchased a small multifamily property located in the Marina district of San Francisco. It was a classic Edwardian style building that had been in the same family for over 100 years. Translation: this property needed a lot of love.

After extensive renovations, which included jacking up the building to install brand new steel structural framing such that I could expand off-street, covered parking from two parking spaces to five, and adding two new bedrooms out of thin air, I felt like I had generated about a much value as I could with this property.

At the same time, the market for San Francisco apartment buildings was increasingly hot and getting even hotter. Unbeknownst to me, UBS and Credit Suisse had been looking for ways to break into the San Francisco apartment market, which traditionally been a non-institutional “mom & pop” market.

They did this by giving the city’s largest landlord, Walter Lembi, a $100 million line of credit to buy property with only 5% down. They would then sell the debt to institutional investors by securitizing it, and earn fees along the way. In the process, Lembi became the largest landlord in San Francisco.

Everything worked great until the music stopped in 2009. This is when the Great Financial Crisis hit, and capital markets worldwide ceased to function. Neither UBS or Credit Suisse could sell anything at any price, never mind a bunch of debt tied to over-levered real estate in San Francisco. At the same time, apartment vacancies were increasing and Lembi found that he could no longer raise rents to satisfy his lenders. So Lembi began giving his properties back to the banks by the truckload. Lembi passed away one year later, nearly bankrupt.

In 2005, when I decided to sell the renovated property in the Marina, I did not know how Lembi was funding his buying spree. All I knew was that selling into this market would be much more fun than trying to reinvest in it. After all, if I was selling because I thought the market was fully valued, why would I attempt to reinvest the proceeds in the same fully valued environment? Shunning San Francisco took some courage, as numerous local brokers were selling me hard on all the wonderful 1031 exchange opportunities they thought existed in San Francisco.

So I went east in search of better value for my 1031 exchange. Oakland in the East Bay was a logical first stop, but Oakland is a perpetual “also-ran” market that is always on the cusp. I passed on everything I saw there. After Oakland, I drove back and forth to Sacramento looking for better value. However, the years leading up to the GFC were years of financial excess, and Sacramento was a market favored by institutions with a mandate to deploy capital — which they were doing in Sacramento with great enthusiasm and without much regard for the potential downside. After Sacramento, I went to Reno, but Reno was not much better than Oakland or Sacramento. Even worse, I thought Reno was depressing.

By this time, my 1031 exchange deadline was approaching, so I decided to break the boot and pay taxes on the capital gains from my San Francisco property. This turned about to be a pivotal decision, and it was based on an important investing maxim that I had learned years earlier: never let the tax tail wag the profit dog. By taking the cash (the so-called “boot”) and paying taxes, I gave myself more time to find the value I was looking for. More important, I did not force myself to invest in the wrong markets at the wrong point in the cycle. This led me to Ohio, where I could invest my fully valued California sales proceeds in a more contrarian, value oriented way.

Ohio turned out to be the perfect opportunity for price arbitrage, as well as regulatory arbitrage, as there was no threat of rent control. In addition, unlike San Francisco and Sacramento, where capital was aggressively moving in, in Ohio capital was assertively moving out. For example, AIMCO, a Denver based Apartment REIT (NYSE:AIV), was selling all of its Midwest assets and recycling the proceeds into multifamily property in the Western and Southwestern United States.

Even more important, Fannie Mae and Freddie Mac had classified the entire state of Ohio as a “Pre-Review” market. This meant each new loan decision in Ohio was assessed on a case by case basis individually by Fannie Mae itself, rather than delegated to third party lenders under the agency DUS model. This made it extremely difficult to obtain debt in Ohio for apartments, never mind raise equity.

These conditions created what I began calling a “yield vacuum,” where yields rose to levels that were compelling, even in the context of the still prevalent “Rust Belt” economic conditions. Naturally, there were numerous objections to my Ohio strategy. One New York hedge fund manager reminded me that Ohio had the highest single family foreclosure rate in the country (it would soon flip: during the GFC, Ohio’s worst hit cities would be eclipsed by California cities like Sacramento and Stockton).

Other lenders were skeptical that I could manage a larger Ohio asset remotely from California. They insisted that I buy property that was no more than a 90 minute drive from my home. I thought this advice was preposterously stupid, as all the assets within a 90 minute drive from my home were already fully valued (and values eventually crashed in the GFC, wiping out many of these investors in the process).

I did not simply ignore this advice and charge forward, however. Rather, I factored it into my underwriting and ultimate purchase decision. I knew that the one thing I could not fix after closing was my purchase price, so I worked very hard to find an asset whose price reflected the risks of investing in Ohio from a distance, and I sought to limit any remaining downside exposure. In addition, I extensively modeled price, rent growth and occupancy sensitivities. If things got any worse, I wanted to know what my downside scenarios were and whether I could survive them.

In 2006, I finally purchased my replacement property, although I was no longer in a 1031 exchange. It was a 58-unit property on the I-75 corridor in Southwest Ohio that I still own to this day. In retrospect, the bottom for the Southwest Ohio apartment market was in 2005, when the market for subprime single family mortgages was at it’s zenith, and people were abandoning apartment rentals in droves in favor of home ownership.

The subprime market crashed two years later, and the national homeownership rate finally started to revert back to rentals. I may have missed the 2005 Ohio apartment market nadir with my 2006 purchase, but I came very close to buying at the Ohio bottom, while avoiding the carnage that unfolded in San Francisco and simultaneously in Sacramento during the same period.

Most important, I learned that there were pockets of growth in the Midwest that were routinely overlooked by coastal investors with “flyover state” mind sets, and almost no new supply. These opportunities are not quite as prevalent as they once were, but we’ve now been investing in the Midwest for nearly twenty years, and we still see plenty of opportunities for growth like the one I discovered in 2006.