Doing Well by Doing Good: Investing in the “Missing Middle”*

By: Inna Khidekel, Partner, Client Solutions Group

Providing high-quality housing affordable to the “missing middle” of US renters is an attractive, demographic-driven investment opportunity, yet many managers and investors alike had previously overlooked the sector. It is straightforward to understand why this housing has been missing from developer blueprints since the early 2000s: elevated construction, as well as land and labor costs, have made it prohibitively expensive to build anything but Class A luxury housing in which high rents could theoretically offset construction spend. Yet the middle base of US renters earning less than 80% of their Area Median Income has also been largely invisible to the broader multifamily market. This lack of attention seems perplexing considering this subcategorization comprises by far the largest (approximately two-thirds), and fastest growing, swath of US renters. It also embodies what should be a very visible core of the workforce: the teachers, policemen, firemen, public city workers, healthcare personnel and workers essential to the vibrancy of any successful community.

Part of the seeming neglect is due to the historical definition of affordable housing as exclusively encompassing that with a Capital A, or in other words, government-subsidized programs such as Section 42 and Section 8. Yet those solutions ignore the missing middle, due to both income requirements that are too low as well as deeply insufficient availability. From an investable perspective, they are also a difficult source of scalable returns. That presented a conundrum for many institutional investors with an interest in the sector, including banks with Community Reinvestment Act (CRA) requirements, endowments and foundations, and the myriad of public and private pension plans facing scrutiny over the affordable housing crisis from underlying beneficiaries. These investors sought to align their portfolios with the long-term demographic tailwinds, as well as the resilient and cash flowing profile, of affordable housing. However, tax credits and other subsidy-driven solutions were too localized, niche and increasingly less valuable.

That is why private sector solutions that preserve, rehabilitate, and selectively develop high-quality housing catering specifically to the missing middle fill such a void in the marketplace. For one, such a strategy when executed by a specialized and experienced operator that prioritizes resident quality of life becomes an elegant embodiment of the “double bottom line,” whereby doing good for communities also drives better performance in a commercial sense. ESG considerations increasingly play into investor allocations, but investors expect a clear and measurable demonstration that ESG is accretive to returns. It would be challenging to find an asset class that proves the value of community revitalization more than workforce and affordable housing. By implementing life-enhancing social and community programs that advance social and economic mobility, environmental sustainability, and equity and inclusion, an operator can enliven an inefficiently managed, sub-optimized asset and turn it into a thriving community of sticky residents who are getting so much value that they may not want to leave. Programs such as credit score enhancement, English-as-a-second-language, technical training, career counseling, health and wellness, after-school enrichment, coding classes for youth, and college preparedness for first generation students brighten hopes, dreams, and futures, but simultaneously drive the bottom line in the form of retention, net operating income and lower attrition costs. Most importantly, results from these programs can be granularly measured at the asset level, providing the type of transparency and actionable intelligence that has often been the missing link to widespread adoption of ESG-oriented alternatives strategies.
Second, the COVID-19 pandemic has further served as an accelerator of demand for high-quality, affordable housing, while exacerbating supply. This is a long-term secular shift rather than a trend, both in the growth of the low-to moderate-income renter population and in the flow of human capital towards lower cost of living metros such as Phoenix, Dallas, or Tampa. Multifamily housing starts were down 45% year-over-year in the last three quarters of 2020, and Capital A has further been stretched as local, state, and federal governments suffer from lower tax revenue and depleted budgets. Not only are we as a country not building enough housing, period, to keep up with the roughly 475,000 units needed annually net of obsolescence, but what we are building does not serve the needs and demands of most renters. Add in the migration down from more expensive housing and continued rent growth in knowledge-based markets, and it is no surprise that the workforce and affordable housing sector was such an outperformer during COVID-19. From a sheer volume perspective, there are thousands of assets for sale each year that are sub-optimized or inefficiently managed and that can thrive with a hands-on operational touch. The pandemic also opened additional areas of opportunity to create new affordable housing, including hospitality conversions and responsibly managed manufactured housing.
Finally, the value-add multifamily community is increasingly being squeezed by the government-sponsored enterprises (GSEs) due to its role in the affordable housing crisis, an unfortunate but evident externality of historically strong financing that was used to push rents far above the rise in real wages. The missing middle is thus increasingly becoming more visible and was clearly prioritized in recent Federal Housing Finance Authority (FHFA) guidelines that mandated that the majority of Freddie Mac and Fannie Mae lending volume in 2021 be mission-driven to support the sub-80% AMI population. Investment managers with a mandate aligned with that mission will benefit from more attractive financing and terms, providing a sizable competitive advantage on the close in today’s tightly bid multifamily market.

Ultimately, the interplay that comes from a shared community-oriented, data-driven approach by both onsite property management teams and nonprofit programming staff becomes the “special sauce” in executing an above-market return-generating strategy with real-world impact. For institutional investors, finding the middle may be just what they were missing.
*This post contains the views of the author and does not necessarily represent the views of Bridge Investment Group or its affiliates.  Such views are subject to change and may be based on factors that are outside the control of the author or Bridge Investment Group. This post is for information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any interests in any investment fund sponsored by Bridge Investment Group or any other securities.