Altus Insight: July, 2016
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: July 31, 2016
FR: Forrest Jinks
RE: But What of Real Estate?
A natural follow up question to the stock market valuation article from May click here to read is, is real estate also overvalued? Yes…and no. Below I outline some reasons why real estate should be considered overvalued, some reasons why it shouldn’t be, and my personal conclusion.
Yes, it is overvalued:
Real estate is hot all across the country. Residential markets are dealing with high demand that continues to push prices substantially higher than where they were even a couple years ago. With some exceptions, investment grade real estate prices have skyrocketed. While there is evidence of some backsliding in farm land, farm land prices are still substantially higher than where they were a few years ago. But price increases in and of themselves don’t mean prices are too high, so how can we tell when they are? There are many types of real estate (residential, investment, farm land, etc.) and the market price of each is determined differently. Even with each real estate segment there may be multiple ways the market uses to price a piece of property. Using investment real estate as an example, apartments can be priced based on cap rates, gross rent multipliers, or per door prices. Likewise, office or retail can be priced based on cap rates or per square foot prices. Different pricing methods may indicate different points in the pricing cycle.
- In many markets home prices are at or above the highs of the cycle that ended in 2007 – 2008. In some markets, like Dallas, the prices are substantially higher. While in many cases higher prices at the top of ensuing cycles would make sense, the highs of the last cycle were fueled by exotic loan structures and easy underwriting that allowed people to purchase homes at prices they couldn’t really afford. The ramp up in prices led to speculators piling into the markets which in turn drove prices still higher. And we all know how that turned out. Incomes have been flat for many years and cheap credit through low interest rates (as opposed to exotic loan structures) has allowed people to buy more home than they would normally be able to afford. Unlike some prognosticators, I don’t necessarily believe this means we are due for a huge price crash like what we saw in 2008, but I do believe home prices in many parts of the country are historically high. Click here to see price charts for several metro areas. This site is calling our current situation “Bubble 2.0”.
- Interest rates are very, very low. Cap rates, as the most common way to price investment real estate, are highly correlated to interest rates. A cap rate higher than the interest rate creates additional profit for the borrower, so as interest rates rise, buyers expect to pay less for the property (thus a higher cap rate – cap rates and price are inverse to each other) to be able to continue to borrow money profitably. Acknowledging that the spread between interest rates and cap rates can widen or narrow for non interest rate reasons, over time higher interest rates lead to higher cap rates, which means lower prices (assuming constant income). Interest rates are near all-time lows and have little room to move farther south. Unless banks get to the point of paying borrowers to borrow money from them there is far more room for interest rates to increase than for them to decrease. This indicates market property prices have a higher likelihood of a large decline than major appreciation.
- Cap rates are very, very low. Several months ago I heard of a single tenant retail property in Orange County selling below a 3% cap rate. Even assuming yearly rent bumps the average return for the 15 year lease would be below 4%, nominal, not real. There have been several times within the previous 15 years where yearly inflation has been over 3% and as high as 4%, meaning the real return (calculated as return % - inflation %) on that investment is close to zero. There is little evidence that the buyer can hope to benefit from appreciation either. Using leverage to increase returns on real estate is one of the great advantages of real estate, but since financing is more expensive than 3%, using leverage to purchase the property lowers the returns generated by the property as opposed to increasing them. As mentioned above cap rates and interest rates are highly correlated so there is far more room for cap rates to increase than decrease. Even assuming cap rates don’t increase over the next ten years and the property can be resold at the same sub 3% cap rate, the total returns generated (assuming no debt) would be around 6% nominal annual return. And that is best case! If interest rates increased even 1% the nominal returns would fall to around 3% annually (nominal). This is lower than most corporate bonds. Since this example property sold several months ago I am aware of many, many more that have sold with the same sort of pricing.
- Per door prices (or per foot, etc.) are high. A property hit the market this month in Santa Rosa, CA at $300,000 per unit. For comparison it has only been in the last 12 – 18 months that anything but really nice class A apartments in that market sold for over $200,000 per door. While true that per door prices don’t really tell us anything about the returns a particular property is generating they can be a useful high level tool for comparing markets or cycles. They are also useful in determining the top of a current market. In many cases even if a cap rate at an advertised price is higher than whatever else is available in the market but the per door price is also higher than any of the comparables the seller will have trouble selling the property. And $300,000 per door is far higher than the highs of previous cycles, and considerably higher than the per door prices in most other secondary markets. In this particular case, the $3000,000 per unit price gets you a little over a 3% cap rate on a building that is restricted to 3% annual rent increases by a city rent control ordinance.
No, Real Estate isn’t overvalued:
Unlike the stock market in general, which many invest in funds mimicking the S&P 500 or some other index, real estate investment is generally made into a particular property or portfolio of properties. Because real estate can’t be valued on a daily basis like the stock market there isn’t an easy tool for investing in real estate en masse. Starting in 2008 there was massive price misallocation in the residential real estate markets that lead to the availability of great investments across entire markets. Later apartments (and to some extent office and retail) had the same characteristics. The market was going up and more important than figuring out the best opportunity was just getting into the market, period. Those days are long gone. For all the reasons mentioned above, investing in generic “real estate” as a broad strategy may not be a great idea, but because of the dynamics of real estate, along with many other alternative asset classes, there can still be great investment opportunities even when the overall market doesn’t appear overly promising.
- Because real estate transactions are done one at a time directly between a buyer and seller transactions often occur that a third party observer would consider being “priced” incorrectly. Some sellers are desperate (the industry calls it the 5 “Ds”: death, disability, disease, divorce, disagreements) and some buyers are desperate (1031 buyers). Because real estate isn’t as easily priced as traded securities there also can be a lack of knowledge of current market conditions. We are currently working on a portfolio of properties in the Dallas metro which appears like it might be available due to the 5th D: disagreement. While a long shot that we will be able to get them in contract, if we are able to do so it will be a hugely profitable opportunity. Because of the Disagreement the seller is backed against the wall and in default on a large loan. This sort of situation creates opportunities to profit regardless of the market conditions, while also helping the other party out of their own rough situation.
- Entrepreneurial Profit is a term used to describe what should be earned for turning one enterprise (a property, business, etc.) into something bigger and better than what it was previously. Unlike an investment into an S&P ETF, or even into a share of a particular company, real estate can be improved and the income being produced by that property can be increased. Generically speaking investment profits come from two sources; cash flow and appreciation. In real estate increasing the cash flow obviously increases the return simply through the increased cash flow, but increased cash flow also increases the market price of the property. Additionally, improving the physical condition and/or the management performance of a property often results in the market viewing that property in a better light, and therefore assigning a lower cap rate to that property. The lower the cap rate, the higher the price. Real estate investors can capture this increase in cash flow and market price (entrepreneurial profit) by doing the work on their own or by investing in a third party sponsor who shares a portion of that entrepreneurial profit with the investors. The change in value through improvements to the income or property is often called “forced appreciation”. It should be noted that forced appreciation is a benefit even in times of falling market prices. If a 20% increase in price was to be gained through price appreciation and the market falls 20% the value of the property is down 4%, but if that investment had been made in the general market, or in this case a stable property price in accordance with the market the property would have lost 20% of its value. This subject is discussed in more depth in October’s Altus Insight here. There are many caveats to this claim which would take more space than is available here.
- Strategy trumps volatility. As discussed above, interest rates are very, very low. Yields across all investment classes have followed. What are investors who desire cash flow to do? Even with prices higher than normal many market still offer a nice premium between market cap rates and available interest rates. While investing in Orange County retail or Santa Rosa apartments may not provide a return needed yields north of 6% (well north in some cases), those returns can be found on solid properties in many parts of the country. Where a person stands on the possibility of future inflation should impact the type of property purchased. If inflation is a concern, or even an assumed possibility, then long term leases may not be as attractive as lots of shorter term leases. Even assuming no inflation and little rent growth, a 6% yield and loan amortization provides higher returns than most anything else available for investment. Of note, Altus currently targets closer to 8% yields to our investors, generally with a preferred return hurdle of the aforementioned 6%.
- Interest rates are low. Acknowledging that I previously used this same data point as a reason why real estate is overpriced, low interest rates can also be a great reason to invest in real estate right now despite the general high priced nature of the market. If a person is a long term investor, especially a long term investor with belief in the possibility of inflation and ongoing housing shortages, how great is it to be able to lock in low interest rates for many years into the future while benefiting from rent increases along the way? This is the perfect inflation hedge while still providing current return on the investment.
- In Alternatives, people do business with people they like. Unlike pushing a button on a computer that results in the purchase of a security from a faceless, nameless seller, alternative transactions involve real people with real personalities and often considerations other than purely price. This month we closed on the purchase of a complex in Modesto that we feel we were able to purchase well below market price. The property was never listed for sale. A loan broker we know that works very closely with an extremely deep pocketed client called us as soon as he knew the client wanted to sell. The client was more concerned about minimizing the impact on the tenants and not having to go through the traditional process of listing and selling a property. The contact between us and the seller has done business with us on multiple occasions and knew we would get it done. The seller won because they got what they wanted, the broker won because he was able to perform quickly for his client, and we won because we got a great buy simply because we were easy to work with and do what we say we will do. The power of a network at work.
The days of real estate as a broad class being a great investment are long gone, but this doesn’t mean there isn’t still opportunity in handpicked properties. And where else am I going to invest my money? With most investment classes being at the high end of their historical valuation ranges there aren’t a lot of options. Oil? Speculative and hard to find ways to invest. Precious metals? Zero return on investment during the holding period and only a store of value. Commodities? A guess on economic growth and the strength of the dollar. Stock and bond markets? As discussed in May, while a crash may not be imminent, chances are that prices will fall below where they are now in the future. So Real Estate? We discuss it often, and thus far the conclusion continues to be that it is the best place for us to focus; current returns, strategies that minimize the effects of volatility, and entrepreneurial profits offsetting possible market declines. That being said, taking into consideration the level of current market prices, we are being highly selective in our search for new opportunities and are focusing on structuring the investment and debt with an eye minimizing medium term market exposure.
About the Author: Forrest Jinks is a managing director of Altus Equity Group, LP and licensed real estate broker. Forrest has many years of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start up (online marketing and site retail). He can be reached at email@example.com.