Altus Insight - September, 2013
Starting in 2008 and with an increasing intensity thereafter, Altus dove heavily into the single family market, raising investment capital and deploying it as quickly as we could. While the market was still full of volatility and hadn’t yet begun its corrective climb in prices we felt comfortable buying and owning SFDs for two main reasons, both pertaining more to value than price. The first was that we were buying the properties far below their replacement costs in areas with growing populations. The second was that the periodic returns (rents) being supplied by SFD market had improved so drastically because of the drop in prices that higher yields could be obtained owning houses than through investment in more traditional real estate classes such as apartments or retail, and as became evident, most non real estate investment vehicles. In free market economies (or semi free market economies like our own) investment money will flow to the highest quality returns (quality is based on the combination of returns and risk). Because the investment assets available for purchase with unlimited quantities are restricted to US or Japanese government bonds (I say that tongue in cheek), as more money flows into an investment asset the price of that asset will rise (supply and demand), and will continue to rise until the returns produced by the asset at the new purchase price is no longer materially of higher quality than other investment options. Although in practice the euphoria of a “good deal” usually creates momentum to carry the asset value beyond the point of balance – this is what creates bubbles in the investing world. In short, we knew that certain SFD markets possessed much higher value than the accompanying prices within those markets (which also still had a lot of price volatility). Value and price eventually always come back into alignment so the price of our purchases would eventually rise, substantially, to catch up to the value that existed at our point of purchase, with value being measured both as replacement cost and investment returns.
By 2011 some large institutional investors also discovered the price/value gap that existed. After taking time to develop strategies to deploy money into the SFD markets, these large investors started buying up houses by the thousands, literally. Blackstone Group, alleged to be the largest private land owner in the US, purchase nearly 30,000 homes in roughly 24 months. Other groups also purchased thousands of properties. It is important to note that this entry by the institutional investors into the SFD markets was completely unprecedented. Up until this point SFD investors were nearly all private mom and pop investors hoping that their properties would provide for their retirement. In some cases small professional investors would control dozens or even hundreds of homes, but never had institutional money entered the fray.
Their entry into a markets instantaneously changed the dynamics of that particular market, usually causing prices to soar and left home buyers of those lower level homes scrambling to buy whatever they could get their hands on since so little was available to non cash buyers.
We have personal experience with the aforementioned Blackstone Group. We were purchasing properties in Sacramento at a pretty consistent clip of a between 2 and 3 properties a month. Blackstone entered that market about a year ago, after which time we purchased less than a property a month. We were both cash buyers and we had better relationships, but they were simply willing to pay more. As a result they bought a lot more properties than did we, although I feel confident our returns are better on a per property basis.
Once all these homes are purchased, what is a financial institution to do with them? These institutions require consistent movement. To simply own the homes isn’t enough. The major players in the space have used different strategies for distribution and/or repositioning. Some, realizing they weren’t getting the returns they had hoped have sold their portfolio of properties to others within the space. Other strategies include using the properties’ income as collateral for a bond offering (Blackstone) or going public as REITs (SBY, RESI, ARPI and AMH). Thus far, the REITs have not performed well.
Analysts have several reasons for the disappointing performance of the REITs and as someone in the trenches every day I have my own thoughts. Analysts feel individual investors have been slow to embrace these SFD REITs because they are a new concept in the market and because many of the companies that went public haven’t stabilized their portfolio yet. It is believed that larger money managers are staying away because they feel managing all the properties will be difficult and don’t think the institutional investors are up to the challenge. In sum, performance to date has not been that as strong as expected and it is hurting forward looking expectations.
While competing with these institutions, we have been able to beat our return expectations. I believe the difference in performance boils down to the incentive structure for the principals of the fund. Several days ago an Altus employee sat in on a presentation by Merrill Lynch trying to raise money for a new Blackstone fund which will invest in European real estate. While not passing judgment on the investment strategy itself, and acknowledging Blackstone has been a very successful investment company over a long time period, he was surprised at the compensation structure. Merrill Lynch and Blackstone received between 3 and 5.25% of invested assets prior to the investors receiving a dime of returns and an additional 2% to 3.75% of invested assets paid to Blackstone each year prior to the payment of any investor returns. Next, the investors received an 8% return on their money (if available) followed by a retroactive return to Blackstone, the structure of which would result in the investor receiving less than the 8% return on their money unless the total returns created, net of the upfront fees, were in excess of 12%. As we saw firsthand in our competition with Blackstone to acquire assets in Sacramento, this results in an investment team that is much more concerned with getting money placed than making sure it is placed in the correct assets. It also means that once it is placed, since strong consistent income is now being obtained through the asset management fees, there is less urgency to get and keep the assets performing at their highest level. Vacancy levels of various institutional investors bear this out. According to an article by Kathleen Ponder in the San Francisco Chronicle this past month, three of the largest players, American Homes 4 Rent, Silver Bay, and American Residential had vacancy rates of 44%, 35%, and 22% respectively at the end of the second quarter.
In stark contrast to Blackstone’s compensation structure, and as readers of the Altus Insight know, Altus Equity Group provides no fee funds, meaning we only get paid when (or in many cases after) the investors get paid. This sort of structure completely realigns the incentive for the principals to be in line with the best interest of the investors. If the investors aren’t getting paid, the principals aren’t getting paid, so you can bet the principals are going to put a lot of effort into execution of the investment strategy.
Generally speaking it is difficult to compare performance of different alternative investment funds because each fund’s information is private and strategies differ. Even returns are difficult to compare because quantifying the amount of risk taken to obtain a certain return is nearly impossible. However, because several of these large funds have gone public their performance numbers such as the vacancy rates mentioned above are public. Looking at those vacancy rates, the performance compensated principals are doing very well by their investors. Among all Altus’s California holdings we have only one vacancy among our stabilized properties. This a vacancy rate of less than 2%. Fewer vacancies (by a sizable margin), and net rents that create investor returns prior to principal compensation result in a higher quality return for Altus’s investors. It isn’t that the big companies aren’t good at what they do, it is just that what they “do” may not be in as strong alignment with their investors’ best interests as a smaller investment company who knows each of their investors personally and whose existence is dependent on taking the best care of their investors as they can. No matter where you as an investor are located or want to invest, I believe you can find principals that fit this description. They may not be easy to find, and it may take effort to sort through the chaff, but the payoff is well worth the effort. We at Altus would love to be that solution for investors reading this article but we understand it is impossible to be everything for everybody. If you have an interest in investing in a product type or geography that we don’t offer, we would be happy to help you vet investment opportunities presented to you. We certainly aren’t clairvoyant about the future performance of any particular principal, asset class, or geography, but we do have the experience to know the right questions to ask.
Until next month,