Earlier this week I was speaking with an Altus investor that asked a question that resonated as a topic of discussion worthy of an Altus Insight. While the question was particular in nature to Altus Equity Group (and even more particular to the Altus Opportunity Fund), the topic can be more broadly discussed across the entirety of the real estate investment world. How do you produce alpha?
As a quick refresher for those not familiar with the term, alpha refers to an investment’s outperformance versus “average” performance of similar investments with the same amount of risk. Or said another way, it is a measurement of an investment’s ability to “beat the market”. In the public securities market risk is measured by volatility. Volatility is a hugely inept measurement of risk, but hey, it is a way to measure risk! Quantitatively measuring risk within the world of real estate investing is much, much more difficult, if not impossible.
Another way risk is assessed by many public market participants is liquidity, or how quickly an investment can be converted to cash. My opinion of this measurement of risk is even lower than my judgement of volatility. Many of the safest investments in the world, by their very nature, aren’t very liquid. As an example, there are various types of annuities that can be purchased by conservative investors. Transferability on some of those investments is very low, but the dependability of the cash flow is unsurpassed. In our world, low leverage first position private debt could be such an investment. Because it holds security against real assets, if done at appropriate leverage points, the chance of loss is close to zero, and I would argue lower risk than high grade corporate bonds (and possibility even comparable to government debt). Private debt may take a couple weeks to sell (if you know where to go), which is considerably less liquid than being able to sell corporate bonds almost instantaneously through a brokerage account. For that reduced liquidity, a substantial return premium can be obtained by an investor. This is all part of the nuances of successful investing.
For someone that needs to be able to access cash quickly because they are trying to buy a house, then liquidity is important. For someone that has a couple years of living expenses already set aside in a cash equivalent, a twelve-month private note term is not at all a liquidity concern. After all, some folks tie up their money into CDs for months or years and give up that same liquidity, but for far reduced returns.
Another real estate specific example is the use of long-term assumable debt. If we only focused on liquidity, then long-term assumable debt is either a reduction in liquidity (because assumptions move painfully slow) or an almost certain reduction in sales proceeds because of prepayment penalties. However, that same instrument that is reducing liquidity is also providing a huge risk reducing hedge against upward movements in interest rates. We have mentioned this several times on investor calls over the past year, but our portfolio’s preponderance of long-term fixed rate debt has allowed us to not only avoid much of the catastrophic issues facing many investment real estate market participants today, but long-term debt has also acted as a value add for buyers, offsetting a chunk of the market’s broader price erosion.
There are also those that will say leverage is associated with risk, as higher leverage is often assumed to equal higher risk. But this contains many levels of intricacies that most never consider. Assuming identical costs of financing, we can probably say there is a higher likelihood of servicing debt payments with lower levels of debt (lower debt should equal smaller debt payments), but there is risk associated with investing in real estate besides just the servicing of the debt. Let us consider for explanation a property purchased to be developed to a higher and better use (Note: Altus does not consider itself a developer. See the footnote below for more explanation)[1]. We will assume there is a 50% chance of success in getting the approvals (entitlements) needed. The seller is savvy enough to understand the investment returns associated with capturing that upsize through obtaining the entitlements, and the corresponding risk of loss if the entitlements are not obtained. So long as the opportunity for upside is greater than the possibility of loss, game theory tells us the seller will require a sales price higher than the market value of the property, absent the potential upside through the change in use.
Putting numbers to it, let’s assume the property can be purchased for $10 million, will require $1 million in additional investment to obtain the entitlements, will be worth $20 million if entitlements are obtained, is worth $8 million in is current state (without possibility of the change of use), and the change in use has a 50% chance of being successful.
The expected value of that investment is $14 million (50% * $20 million + 50% * $8 million) against a total cost of $11 million ($10 million purchase plus $1 million in costs). Now, this investment could be pursued with no leverage, with an expected return of 27% (($14 million – $11 million)/$11 million). Not a bad return but inclusive of a 50% likelihood of the same 27% loss (($11 million – $8 million)/$11 million). However, note that there is zero percent likelihood of actually achieving a 27% return, because that return is calculated across two possible outcomes to the investment. In reality there will either be a $3 million loss, or a $9 million gain.
In a second scenario, the seller agrees to provide seller financing of $10 million for an increase in purchase price of $1 million. With the same $1 million required in costs to (try and) obtain the entitlements, the total cost is now $12 million. The calculated expected return at the project level is reduced to $2 million, but the expected investment return percentage increases to 100%. Why? The $2 million in expected return is now divided by only a $2 million investment denominator, but more importantly, the catastrophic outcome (which we are saying has a 50% likelihood of occurring) results in only a $2 million loss to the investor versus the $3 million loss in the non-leveraged scenario. In this case, the increase in leverage DECREASED the risk associated with the investment. At least to the investor. The seller increased their risk in exchange for the extra $1 million in sales proceeds. To be clear, this logic can’t and shouldn’t be applied across all real estate investment structures; but it is more common than people might think.
This detour into discussing risk is really only to magnify how difficult it is to measure alpha within the real estate investment world. Someday maybe we will figure out how to do it (and we will continue to try), but for now the analysis of alpha requires non definitive analysis skills on the part of the investor. There are many ways to make comparisons, with each investor’s individual situation having to play into the analysis. The following are ways that alpha can be created:
- Deal (purchase/sale) Structure: Little things can make a big difference on total profitability. And having the awareness and technical know-how to help solve problems for the opposite party (as buyer or seller) can also result in better returns. A correct deal structure, through the reams of legal documents involved, should be able to reduce risk, in effect creating alpha if there is not a corresponding reduction in returns for that risk mitigation.
- Investment Structure: While most specific to a passive investors’ investment into an opportunity, and how the risk and returns are allocated within the passive/non-passive investment structure (generally referred to as LP/GP), this also can relate to the broader capital stack (including debt), which brings into discussion the points shared above about risk. The investment structure is essentially the assignment of risk between all the parties involved (debt and equity).
- Strength of Buyer/Borrower: The more dependable a party, the more likely other parties will want to transact with them (see more detail in the “network/relationship” section below). The stronger a party is financially, the better pricing they will obtain, either from sellers (through increased confidence in closing) or from lenders. Lower purchase prices and lower cost of funds both are accreditive to the returns on an investment versus other parties that don’t have those strengths. Likewise, a seller avoiding “having” to sell will increase returns, while selling under distress will decrease returns. Having or not having to sell is often tied to financial strength of a property owner.
- Blood, Sweat and Tears: Unlike traded securities, real estate is still a highly imperfect market from an information perspective. Information is becoming more ubiquitous but at least so far is still asymmetric. People that are willing to dig in deep, learn the details, turn over the rocks, make the extra phone calls, and stay disciplined (see below) will beat those that aren’t willing to put in the effort.
- Discipline in thought, psychology, and action: The power of this item cannot be overstated. Like the stock market, real estate is subject to the whims and emotions of investors. The value-add apartment syndication craze of 2019 – 2021 is a perfect example of this. Discipline is required to manage over the psychological impacts that afflict us all. Further, discipline action ties into blood, sweat, and tears and adds structure to actions being taken.
- Knowledge: There are so many moving parts in any real estate transaction or project that are very difficult to know. There are some individuals or companies that know a lot more than others. Some of this is through time and exposure. Considerably more is through the blood, sweat, and tears referenced above.
- Execution: As information within the world of real estate investing becomes less asymmetric, execution becomes more important, and will continue to grow in importance in the coming years. This is execution in acquisition processes. This is execution in purchase and sale transactions. This is execution in due diligence. It is execution in business plan (new construction/redevelopment/lease up/etc.). And especially when it comes to hospitality and multifamily, it is execution of the management of the property. If a multifamily property can outperform the market by even 5% a year at the top line, it works out to a ~10% increase in NOI per year, which works out to a 50% increase in cash flow (at a 1.25 DSCR). That is MASSIVE. Additionally, that 5% increase in revenue increased the property value by a factor of nearly 17x the 5% increase in revenue (at a 6 cap). Also MASSIVE.
- Relationships/Network: The more complicated a transaction, the more relationships matter. Specifically, the trust and interpersonal connection of those relationships. As it turns out, transacting real estate is far more complex than transacting stocks or bonds. The relationships that build from a transaction lead to broader and deeper relationships, which leads to more opportunities to solve problems.
- Problem Solving: In business, the more or bigger problems that can be solved, the more compensation is available for the problem solver. In real estate there are lots of problems to be solved. Often the problem a seller wants solved is who will pay the highest price. Only in rare occasions does solving this problem create alpha. But in other situations, the seller may need help with tax exposure. Or a property owner may need help progressing a project forward. Or a buyer could need assistance with their own tax situation that can result in better results to a seller, etc.
- Alignment of Interest/Participant Incentives: There is no question different market participants have different incentives. Are those incentives aligned with investors? Sometimes. And sometimes not. In one particular very large corner of the real estate world decision makers are far more incentivized to not get fired than to be outstanding investors. This leads to herd mentality, which almost by definition makes outperformance impossible. Those that benefit from profits, however, are incentivized to maximize profits; regardless of what their neighbor or fellow country club member may be doing. Those that are incentivized to maximize profits are far more likely to create alpha than those that are not.
- Niche = Rich: As a very close companion of discipline/psychology, niche investing often produces alpha for those that are experts in their niche. Most of the alpha is created in the gap between real and perceived risk, with the remainder being through the investor’s willingness to invest differently than the herd.
- Technology and Innovation: There is a lot of potential here, though so far very few owners are taking advantage of technology that truly results in better results. This will almost certainly change as time goes on and technology provides incremental improvements either to processes (resident/manager interactions) or inputs (smart climate control in office buildings).
- Market research/trend capture: It is often said you can’t beat the market through marketing timing. When looking at public markets over short times frames that is probably true. But zoom back (and forget trying to buy at the absolute top or the absolute bottom) and you might have better success. This is even more true in real estate where trends unfold over the course of years. These trends are powerful and can be a huge tailwind to returns for those willing to find and trust the data. So get on a plane to get to where the data says to go.
- Tax Efficiency: This is absolutely the unsung hero of alpha. Very few real estate sponsors pay attention to the tax situation of their investors, and instead are 100% focused on gross return numbers. Everyone’s tax situation is different, so it makes sense that investor return structures (waterfalls) are calculated off of gross returns. As the largest source of real estate investment dollars, institutional investors generally don’t care about tax structures because they too are bonused on gross returns. But at the individual investor level it can have a huge impact on net returns. The dollars that actually go into their pocket. For instance, assume you make an investment of $10 million into one of two identical projects but one is located in a QOZ. With a second assumption that all cashflow during the 10-year hold is negated by depreciation in both scenarios (not at all a stretch), the net cash flow from the QOZ project is a relative 25% higher because of the tax savings. (Note: this is calculated at a gross 15% IRR over the ten years. The relative percentage of outperformance erodes as gross returns increase, and grows as gross returns decrease). Qualified Opportunity Zones are only one of many tax efficiency tools available to real estate investors.
While any of the above can create alpha in a vacuum, true alpha is more likely created through a combination of several of these factors. Blood, sweat and tears can lead to uncovering more great relationships if people are treated right. Those relationships in turn result in more opportunities to solve problems, which benefit from deeper technical knowledge. And so on.
What is alpha in real estate? To quote Justice Potter Steward, “I know it when I see it.” If we (Altus) are good at least a few of the above, we should be able to continue to create it.
Happy Investing.
[1] Altus defines development as obtaining discretionary approvals (entitlements). We are fine taking on the risk of construction when the returns are enough to do so, because it can be quantified. But we avoid taking on the unknowns of entitlements, because unknowns are unquantifiable.
