Aligned Interests: The Case for Vertical Integration in Multifamily Real Estate

Vertical integration is a key element of StoneRiver Company’s (SRC) strategy to optimize property performance and investment returns, as it allows us to control all aspects of our multifamily projects: fundraising and debt selection, deal sourcing, construction management, development, property management, asset management, accounting and investor relations. In this post, we outline the benefits of in-house property management and illustrate these benefits with real-world examples drawn from our experience utilizing third-party property management and transitioning to self-management.

StoneRiver Property Management (SRPM), our in-house property management company and a wholly owned subsidiary of SRC, manages SRC’s entire multifamily portfolio. Below, we discuss three benefits of in-house multifamily property management to SRC, our portfolio and our investors:

1. Collaboration and consistency in underwriting: When underwriting an investment opportunity, our investment teams receive quick and candid feedback from SRPM. Additionally, utilizing in-house property management allows our investment teams to consistently project operating expenses, leading to more efficient and decisive underwriting and deal pursuit.
2. Alignment between investors and property management: Third-party managers earn a fee based on revenue and operate with this fee structure in mind, whereas SRC, our investors and SRPM share a goal to maximize property values and investor returns.
3. Proactive risk mitigation in operations: SRC and SRPM’s alignment of interests encourages proactive risk mitigation in operations.

SRC has invested in real estate since 1995, and since 2006 has focused on Southeastern multifamily real estate acquisitions and developments. We originally engaged third-party managers to manage our multifamily portfolio; however, we quickly learned that third-party managers do not operate with the standard of care necessary for us to successfully execute our business plans. Specifically, one of our assets developed considerable deferred maintenance and physical capital needs that could have easily been avoided, but our third-party manager was not forthcoming with these issues. We recognized that while in this instance, the third-party manager overlooked physical needs, similar mistakes could be made in operational areas such as leasing or administration, for example, overly focusing on occupancy rather than seeking to maximize NOI, miscoding expenses in a manner that interferes with our asset management oversight or producing incorrect or incomplete reports. SRC assumed management of the property and addressed the deferred maintenance issues before they compounded. In 2007, we officially formed SRPM to provide in-house property management services.

Around a decade later, SRC developed an asset in a market that was new to us. At the time, we did not manage other properties in the state, and we were worried about stretching SRPM’s resources too thin. Thus, we made an exception to our self-management policy and engaged a third-party manager to oversee the lease-up process. We chose a recognized firm with a nationwide presence to avoid the issues we encountered in the past, but, ironically, engaging a large firm led to those exact issues arising again. Adding further difficulty, the property experienced constant staff turnover as the third-party manager shuffled staff among our property and other, non-SRC properties within the third-party manager’s local portfolio. We also discovered on multiple occasions that information relayed by the third-party manager was not accurate. These lapses hindered leasing velocity. Fortunately, we quickly noticed the inefficiencies and inaccuracies and brought on SRPM to manage the property. The lease-up accelerated, operations rebounded and we received several unsolicited offers to purchase the property. We successfully closed the sale less than six months after SRPM’s takeover, generating returns for our investors that exceeded our expectations.

Following this experience, we decided that except in the case of unique circumstances specific to a property, SRPM will manage all our multifamily investments.

The benefits of vertical integration and in-house property management start at the beginning of an investment’s life cycle. As our acquisition and development teams source and underwrite investment opportunities, they receive quick and candid feedback from SRPM and SRC’s in-house asset management team. This applies to general market selection, where they openly discuss pros and cons of certain locations, as well as operational nuances specific to a certain asset under evaluation. Alternatively, third-party managers are less likely to be candid with negative opinions on an asset or location – if their client does not buy the asset, the third-party manager does not earn fees. The need to win business also incentivizes third-party managers to provide overly aggressive proformas, which often creates problems while the third-party manager is managing the property.

Example: A sponsor is pursuing an acquisition opportunity and bids third-party management out to several third-party managers. The third-party managers, knowing they have competition, present proformas that are overly aggressive. A third-party manager is selected, and the sponsor builds an operating budget based on the third-party manager’s proforma. While managing the property, and knowing it is being scrutinized against its proforma, the third-party manager makes short-term decisions to attempt to meet the overpromised budget. This presents itself in many ways: for example, ignoring or delaying maintenance needs, leasing to unqualified tenants or blindly softening rents to chase occupancy.

Furthermore, utilizing in-house property management allows our investment teams to consistently project operating expenses, leading to decisive underwriting and deal pursuit. For example, controllable expenses such as payroll, administrative costs, marketing and advertising, repair and maintenance and turnover costs are more predictable and easily communicated with in-house property management.

Example: SRC’s acquisition team was recently analyzing an acquisition opportunity with SRPM. When reviewing historical payroll expenses at the property, SRPM noticed that the existing operator’s payroll tax and benefit structure was more costly than SRPM’s. This meant that SRPM could compensate the onsite staff at their current level, but the overall payroll expense to the property would be lower – creating value for our investors. A third-party manager would not provide that level of depth in their analysis, and certainly not at that stage of the process.

The second benefit of in-house multifamily property management is alignment between investors and property management. SRC seeks to maximize its investments’ values to drive returns to its investors, while third-party managers seek to maximize their own management fees. SRC can create tremendous value for its investors by outperforming its expectations; however, third-party managers are primarily paid a flat percentage of revenue and are therefore less financially sensitive to property performance. While there are performance-based incentives for third-party managers that reward expense reductions and other performance metrics, these incentives generally benefit the third-party manager and not the individuals staffed to the property. Additionally, any incentives to a third-party manager pale in comparison to property performance’s ramifications to the property’s investors. This asymmetry creates a systemic misalignment of incentives whereby third-party managers are not sufficiently motivated to outperform return targets.

Example: The tables below illustrate a scenario in which the incentives created by a third-party manager’s fee structure do not align with the incentives of an owner to maximize investment value. Overperforming the baseline underwriting increases investors’ equity value by 30.2% in year five of the investment (which figure does not include any additional cash flow distributed to investors during years one through four), whereas the third-party management company’s aggregate fees over the five-year period only increase by 1.0%. This misalignment is solved by using in-house property management.

Our observation is that while good third-party managers may strive to hit predetermined benchmarks, once the benchmarks are achieved, third-party managers do not seek to exceed them. For example, most occupancy benchmarks are set in the 92%-95% range, and once a third-party manager hits that target, they often maintain the status quo rather than increase rents or further push occupancy.

Example: We pulled data from all markets in which SRC operates and compared vacancy rates at self-managed properties to vacancy at properties utilizing third-party managers. Self-managed properties averaged an 8.6% vacancy, compared to a 9.6% average vacancy at third-party managed properties. Notably, 22 of the 25 largest multifamily owners in the U.S. self-manage.¹

The last benefit of in-house multifamily property management we highlight is proactive risk mitigation in operations. Third-party managers have no ownership stake in the properties they manage and only seek to earn a management fee, which can lead them to make short-sighted and reactive decisions. SRPM and SRC share a focus on driving property performance, which encourages proactive risk mitigation in operations.

Example: Several units at a third-party managed property experience roof leaks that create water spots on upper floor ceilings. The root cause is the same in each instance – worn flashing around the chimneys. The repairs are relatively minor; the ceiling is patched and repainted for $1,000 per unit, and the flashing is repaired for $500 per unit. This happens several times over a three-month period; however, it is a 300-unit property, so these expenses do not stick out on monthly financials. The third-party manager does not raise any concerns to ownership, and the pattern continues to waste time for the onsite staff and frustrates residents. Over the course of five years, this impacts 30 of the 40 units onsite with chimneys, costing $45,000. Alternatively, all 40 units could have received new chimney flashing for $20,000, preventing future damage, eliminating resident frustration and decreasing distracting work orders. To further quantify this, spending $20,000 to reduce annual operating expenses by $9,000 increases the exit valuation by over $170,000, assuming a 5.25% cap rate. An in-house property manager like SRPM, who understands the ownership’s ultimate investment goals and risk management philosophy, is more likely to take actions that would lead to the correct decision being made initially.

StoneRiver Investment Fund I, which made its first investment in 2016 and last disposition in 2022, delivered top-quartile returns.² We attribute this result and our ongoing success to our vertical integration, which is how we differentiate ourselves among our peers and position ourselves to deliver superior risk-adjusted returns to our investors. SRPM’s ownership mindset creates a level of commitment, accountability and buy-in that third-party management companies cannot replicate. SRPM knows that its decisions directly affect SRC’s investors, which aligns its interests with those of our investors and drives SRPM to maximize property performance, resident satisfaction and long-term value creation.