CRE is key to weathering stock market volatility
With 2018 coming to an end amid heightened volatility in the public markets, we thought it would close things out on a high note to remember that commercial real estate (CRE), as an asset class, provides refuge from the day-to-day ups and downs of market speculation and the whims of human psychology. With the VIX (a measure of market risk and referred to as the “investor fear gauge”) recently setting a 6-month high at nearly 3x the average seen between Jul-Sep, it’s no wonder that investors are looking for alternatives to the public markets, and long-term historical analysis shows that direct investments in real estate have experienced relatively lower volatility while earning higher risk-adjusted returns when compared with the public equities markets and US fixed income instruments.
VIX 6 months (as of 12/30/2018)
Source: CBOE Options Exchange
Volatility and risk-adjusted returns across asset classes (annualized performance for 20-year period ended 12/31/16)
|US equity||Non-US equity||US fixed income||Direct real estate||REITs|
|Standard deviation (volatility)||18.46%||21.86%||3.63%||11.37%||19.59%|
|Sharpe ratio (risk-adjusted returns)||0.31%||0.17%||0.43%||0.55%||0.30%|
The Urban Land Institute (ULI) urges investors in CRE to be on the look-out for complacency in their 2019 Emerging Trends in Real Estate report. This report is one of the most highly regarded and widely read forecast reports in the real estate industry, gleaning insight from interviewees and survey participants representing a wide range of industry experts, including investors, fund managers, and developers. The following is an excerpt from the ULI 2019 Emerging Trends in Real Estate report (click here to download and read their full 121-page report):
Complacency: One key risk toward the end of economic cycles is the supposition that expansion will persist well into the future. It seems self-contradictory, but many take comfort in the adage that turning points are impossible to predict and that no trigger for a downturn is now apparent on the horizon. At present, however, it seems that rather than a single trigger, there is an accumulating number of risks that interact with each other (labor shortages, a flattening yield curve, a potential asset bubble on Wall Street, tariff and trade tensions, ongoing geopolitical risk) and argue for greater defensiveness. The decline in real estate transaction volume seems to say that investors as a group are pulling back in the face of such concerns. But even while that is happening, cap rates not only have trended low but also are convergent (with just a 30-basis-point differential between offices, retail, and industrials at midyear 2018). At current cap rates, risk premiums are so thin that is likely that many deals are pricing risk too cheaply. That mispricing becomes apparent once recession strikes—and that is not a question of if, but rather when.
While opining on a specific projected timeline for any change in the current economic cycle would be a fool’s errand, we can share insights that may bolster a portfolio’s resilience to a recession in the market when it does occur. The following is a round-up of helpful resources.
Resources for designing a market cycle-resilient CRE portfolio
1. The Four Phases of the Real Estate Cycle
In this article on the real estate cycle, read in particular the strategies outlined in Phases 3 (Hypersupply) and 4 (Recession), which focus on Core commercial real estate investments are the least risky offering. They are often fully leased to quality tenets, have stabilized returns and require little to no major renovations. These properties are often in highly desirable locations in major markets and have long term leases in place with high credit tenants. These buildings are well-kept and require little to no improvements... More and Opportunistic real estate investments are the most high risk/high reward investment opportunities, requiring major development work. Opportunistic properties tend to need significant rehabilitation or are being built from the ground up. They have the chance to reach the highest rate of return for investors, but they little to no in-place cash flow at the time of acquisition and have the... More investor profiles. As the current Expansionary phase moves toward Hypersupply, some investors may decide to sell assets ahead of what they perceive as a coming decline in property values, thereby presenting opportunities to purchase Core properties with high occupancy and a rent roll full of credit tenants with long lease terms optimally timed to roll over during the next Expansion phase. Further into the Recessionary point in the cycle is an ideal time buy distressed Opportunistic assets at steep discounts to replacement cost, possibly in distressed scenarios such as special servicers and lender foreclosures, which can create an opportunity to then reposition the asset and sell during the next cycle.
Click here to review our current offerings that feature Core and Opportunistic investor profiles.
2. Making the Grade in Real Estate: Understanding Class A, B, and C
This article talks about how Class B multifamily properties have a unique propensity to benefit from their middle market position. During periods of strong economic growth, Class A multifamily owners may find their turnover rates to be higher than normal as their best tenants vacate to buy homes, which are absorbed by former Class B tenants that are ready to step up to Class A living. During recessionary periods, Class A owners often need to offer incentives such as lower rents to retain tenants who, otherwise, may look to move down to a Class B property to save money. It is due to these types of cyclical effects that Class B multifamily properties are often viewed as desirable investments because, regardless of the economic cycle, Class B assets’ middle market position means that there is usually an even balance of tenants entering and exiting the asset class.
Click here to review our current offerings that feature Class B multifamily assets.
This article discusses the lessons learned from the 2008-09 downturn and the importance of considering the Leverage is the use of various financial instruments or borrowed capital to purchase and/or increase the potential return of investment. Assume a buyer puts 20% down on a $5M property. Essentially, they paid $1M to own something worth $5M. Assuming the property appreciates at 5% per year, the sponsor’s net worth would grow to $5,250,000 in a year. Had they... More/equity ratio. High leverage can be a useful tool to boost returns on projects where there is high certainty of execution, but on the other hand, higher leverage can translate to higher risk in some cases. For example, there were plenty of three- to five-year loans issued from 2005 to 2007, just prior to the recession, at high leverage amounts of 85% to 90% of acquisition value; adding to that risk is the fact that those loans were based off of what we now know were peak property values. So, when the market shifted and property values dropped precipitously in 2008 to 2009, those borrowers found themselves underwater in the properties right at the point their debt matured. In cases where business plan execution may be less certain, such as In commercial real estate, the sponsor is an individual or company in charge of finding, acquiring and managing the real estate property on behalf of the partnership. The sponsor is usually expected to invest anywhere from 5-20% of the total required equity capital. They are then responsible for raising the remaining funds and acquiring and managing the investment property’s day-to-day... More with less experience and shorter track records, focusing on projects with low leverage may be prudent.
Click here to review our current offerings that feature relatively low Loan-to-Cost ratios of 70% or less.
This article highlights an oft-overlooked property type that has some uniquely recession-resistant qualities. It has a reputation of providing relatively high yields and has also been potentially to be resistant to recessions due to its lower declines and default ratios vis-à-vis other asset classes. Self-storage was one asset class that actually benefited from the recession of 2008-09 as new demand for storage was created by people who were displaced from their homes or relocated to new jobs.
Click here to review our current offerings that feature the property type of self-storage.
This article highlights a property type that has benefitted from heated competition in traditional multifamily assets as some investors have branched out into alternative housing investments. The economic recession of 2008-09 provided evidence that senior housing tends to be a more resilient real estate property type as it does not experience the same level of occupancy swings as other asset classes during economic downturns.
Click here to review our current offerings that feature the property type of senior housing.
Final thoughts on investing in CRE as a refuge from public markets volatility
A final takeaway is to consider that CRE is local, holding periods are multi-year in duration, and its transaction market is inefficient. This means that there are always good deals and bad deals to be had in CRE and that what’s happening in an asset’s submarket often has more relevance to its performance than what’s happening at a macroeconomic level. Against the backdrop of a stock market that can at times appear schizophrenic as it grapples with constant political and economic turbulence both within the US as well as abroad, a CRE offering backed by professional sponsorship and a logical business plan can present an attractive alternative.
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