By focusing exclusively on workforce housing, Watermark Partners Real Estate has found a way to do good and do well at the same time. “Workforce housing is not necessarily exciting and can be challenging, but it is consistent and high-income generating when operated correctly,” says Thomas Carroll, Watermark’s Managing Partner. “And providing safe, clean, affordable places for working families has a positive social impact.”
Watermark has found the right combination of data and determination to make workforce housing pay. Just five years ago, it was a friends and family fund with a handful of investments in Michigan. Today, it is a private equity fund platform with $300 million of assets under management and 6,500 apartments in five Midwestern and Southeastern states.
Watermark’s thesis — Managing for Investor Income and Community Growth — has stood up well in the face of an economic meltdown that has devastated other property types. In fact, Carroll believes that steady, unpretentious workforce housing will prove to be one of the most resilient sectors in commercial real estate.
Carroll sat down with Lument to talk about the challenges of working in this demanding corner of the multifamily market, the adjustments Watermark has made to its operations and underwriting in the wake of the crisis, and the value-added that a financial partner like Lument can provide.
Many investors might think that having a positive social impact would work against income generation — but you obviously don’t think so.
That’s right. Look, we buy assets that are capable of generating income from the moment we purchase them. We are also focused on long-term income generation. Although a property may be 90 or 93 percent occupied at acquisition, there is often significant deferred maintenance to take care of. We renovate units, add playgrounds, improve the landscaping, and get pools back online.
We make our communities nicer and more enjoyable places to live, which is good for current residents and the surrounding community. When you create a nicer community, you can eventually charge higher rents and reduce turn cost, improving income generation and ultimately property values for investors.
But this model might not work everywhere. How do you narrow down your choices?
First of all, we focus on the Southeast and Midwest. We are looking for locations where there is a significant spread between retail-sized deal cap rates and the cap rates on institutional-sized deals. Our founders started in the Midwest, which was harder hit by the recession in 2008 and slower to emerge than the rest of the country. At the time, there was some cap rate compression to be had. Currently, the area with the widest differential and some of the fastest population growth is the Southeast.
Drilling down even further, we know that part of what gives us better performance is being able to pool our resources. This is particularly important because of the number of properties we own. We have executed more than 100 transactions in the last four or so years, mostly in the $3 million to $15 million range.
As a result, we focus on a series of cities with attributes conducive to workforce housing. They should have a significant industrial presence, a strong workforce, and a diversified economy. We favor towns with universities, healthcare, government, and S&P 500/national corporations as significant employers. Together, all these factors contribute to a stable or growing resident base.
In the Southeast, we are concentrating on such cities as Columbia, South Carolina; Valdosta and Macon, Georgia; and Fayetteville, North Carolina. In the Midwest, we are in places like Akron, Ohio, and Lansing, Michigan.
Your business is transaction-heavy. What does it take to maintain that pace of activity?
It all comes down to the team. We run at a very high rate. We need people who have the energy and drive to maintain this pace. At the same time, you need people who are smart and who are interested in becoming smarter. The members of our team come from a variety of backgrounds, an advantage we try to leverage when we make decisions. One thing they have in common, however, is that they’re interested in learning how to become better at what they do.
Character is another quality we are looking for. We need people who are responsive to and respectful of the needs of others, whether they be residents, investors, vendors, brokers, sellers, or fellow team members. And finally, we look for people with a social conscience, who want to do make our communities better places to live.
How do you find your deals?
Our typical seller is an individual owner-operator. To reach them, we have developed a broker network that consists of a mix of larger companies and local independent brokers. In addition, we proactively reach out to owner-operators and smaller real estate investment groups.
We have learned a massive amount over the past five years about how to do this well. We are extremely responsive. We come back to brokers and potential sellers within a 24-hour period after a first read and can be onsite in 24-hours. That’s one advantage of being based in Charleston, South Carolina as compared to New York, Los Angeles, or Dallas.
You would think that your residents would be particularly hard hit by the economic downturn.
As it turned out, our residents are holding up well. We monitor rental collections on a daily basis and found them virtually unchanged from the previous two months. Our high collection levels were the result of a combination of circumstance and hard work. The Southeast was later to close and earlier to open than the rest of the country, which lessened the immediate impact on the economy.
At the same time, our rents are low, and stimulus checks and additional federal unemployment benefits go much further in the Southeast than in other parts of the country. Our operating team has worked incredibly hard over the last six weeks to educate our resident base about accessing federal funds, making sure they had the information they needed and, in some cases, access to computers.
Are you ready to return to the market?
We are. All deals that were under discussion in February, both on the buying and selling side, fell out of contract in March. We communicated with all our brokers and sellers that we were not buying any more properties until we had a firm grasp of April payments.
Now that stimulus checks have hit residents’ accounts, we feel confident that May is going to be strong. June remains an open question for us, but we are pretty happy with our situation. We are now back on the offensive and using the opportunity to go out and make acquisitions. A lot of deals that we were negotiating pre-COVID have come back.
What’s your sense of how the market has changed?
Before the crisis, it was very much a seller’s market. Post-COVID, there has been a subtle shift toward the buyer, though we have not seen significant price changes. After all, the properties we are interested in are cash-flow assets. If sellers don’t like where the market is right now, they can just withdraw their offering. There are, however, fewer buyers out there. Stronger buyers with solid access to debt like us are getting that second callback.
Overall, I would say that we are definitely in a buyer’s market. Deals that might have had a 5.00 percent cap rate in January have a 5.50 or 5.75 percent rate now. Sellers have also become more flexible on deal terms and are more receptive to the provisions we need to make the deals work for us.
Are you underwriting differently in this environment? Certainly, your inspection process must have changed.
Definitely, we are underwriting to no rent growth, lower physical occupancy, and higher bad debt. We are also underwriting to an 18-month principal and interest reserve on the debt side. In other words, we are adjusting to the economic consequences of the pandemic and changing agency regulation. This means that we will offer 5 to 10 percent less for a property than we might has asked before.
The health risks have impacted our inspections. We are still looking at every potential deal, but our approach is very different. We can conduct exterior inspections without much of a problem. However, even though most of our Southeast states are open, I am not going to ask my team to go into a unit that is occupied.
So, we are inspecting unoccupied units, checking physical occupancy by knocking on doors, and asking for a reserve of a few thousand dollars per unit on a portion of the units just in case some don’t match what we feel the standard for the property should be. If the property is running at 95 percent occupancy with average rents, we can be reasonably sure that most units will be in good shape, but we want to protect ourselves. That reserve will extend for 12- to 18- months in escrow until we feel comfortable going into these units. We feel that asking for a reserve of $100,000 or $200,000 on a $15 million transaction should not be a deal-breaker.
It sounds like you’re feeling confident.
If anything, the coronavirus crisis has confirmed my belief that we are in the right property type in the right area of the country. Right now, the stimulus has been particularly effective in keeping these households afloat, at least in the immediate term. There is also the supply/demand dynamic. For the last 20 years, there has been virtually no investment in workforce housing. As a result, while we won’t be raising our rents in the immediate future, we won’t be dropping them either, and we anticipate our occupancy remaining constant.
As we begin to open up the economy, we expect to see more money flowing to our sector as people exit sectors like hospitality and retail and investors tire of the kind of fluctuations they have been seeing in the equity markets. That’s good for our business. We have a number of active deals right now that we will be pursuing in the next few months.
All told, along with warehouse space and industrial, we believe that workforce housing, after a bit of short-term turbulence, will emerge from the crisis as one of the most attractive of commercial real estate sectors.
What are you looking for in debt provider? How does Lument measure up?
About a third of our deals have been agency financing, and we’ve done the bulk of those with Lument. Quite simply, their execution is the best we have dealt with. They are knowledgeable, fast on the uptake, and responsive.
Because of the nature of our business, we are looking for a partner who goes beyond the obvious — competitive pricing, competitive terms — and provides the degree of insight, flexibility, and responsiveness that’s vital for our business.
For instance, our sellers often have poor-quality financial data. We need a financial partner who can help us work though complicated underwriting and tease out information from sellers. We also need a partner who comes up to speed quickly. We are repetitive borrowers, and we just don’t have the time or patience to answer the same questions over and over again with each deal. And we need a partner who is knowledgeable and responsive, who will answer our calls and get right back to us with insight and information we need. Lument more than meets these requirements.
Lument also acts as a sounding board. We’ve explored hundreds of deals in the Southeast and Midwest over the last few years, and just about every one of those deals has some sort of twist or turn that we need to understand. Having a partner that we can bounce ideas off of and ask questions of is critical in determining whether or not we can proceed.
During the crisis, Lument has been invaluable in keeping us abreast of the changes the agencies were making about such things as reserve requirements and spreads. This kind of real-time information is absolutely vital for us now that we have resumed quoting sellers.
When it comes down to it, we demand the same qualities from a financial partner that we expect from the rest of our team. That’s what Lument delivers.