12 Jul Opportunities in Real Estate
Thinking Man Series #5
In light of questions about the real estate recovery, an inside look at our how BigSur approaches real estate investing
Since the summer of 2012, there have been positive headlines about the housing recovery in the US. Prices in single family homes have risen steadily; there have been increases in sales and mortgage applications; and fewer real estate related write-downs from the US banks. A similar trend has taken place in commercial real estate, and with the market generally bullish again, we see many investors feeling it is “safe again” to invest, wanting to put money to work quickly before prices appreciate much further. This mindset has led to inquiries about our views and what deals we have currently in the pipeline, so investors can participate while the market is starting to “get hot.”
This mindset or approach is based upon price appreciation- investors wanting to purchase properties at reasonable prices in hopes that their values will appreciate quickly. While price is an important variable in our investment approach- we also take other factors into consideration when evaluating an asset purchase. Both the replacement cost of a real estate asset as well as the cash yield are important considerations, not solely the potential future upside. Given that our clients investment profiles are generally focused on income generation, an important objective in holding real estate investments has been to generate a steady cash flow on a high quality assets, providing an alternative source of yield to our client portfolios.
There are many different approaches to real estate investing- from buying a property leased to a single owner to investing in an office space in a top tier market or investing in a real estate fund, etc. As the real estate recovery has been a popular topic, we thought we would take the opportunity in this month’s Thinking Man’s Approach to provide a brief overview of BigSur’s approach to real estate investing. We will highlight the following topics:
- Why real estate?
- What types of real investments are we focused on?
- How does a private client get access to direct investing?
1. Why real estate?
In today’s low rate environment, we use commercial real estate for the yields it provides investors and are aiming to take advantage of the cheap long term fixed financing.
We’ve been living in a low-rate environment for the past couple of years, and stable investments which provide an attractive yield have been scarce. High quality fixed income paper, like the 10 year treasury yields 1.7%, and the 10 year German bund yields 1.3%. To find yield in traditional fixed income investments, investors have had to give up the quality of the asset- for example looking to junk bonds to secure a yield of 6%. To find yield in high quality assets, investors have had to look beyond traditional fixed income opportunities. This led us to real estate in 2009, when we found opportunities in core real estate properties (which are characterized by high quality buildings which are significantly leased) to secure income streams and current yield from a quality asset.
An additional factor making direct real estate investments attractive today is the cheap long-term fixed financing we have secured. The key term here is fixed; we have been recently able to secure 10 year fixed rates at or below 4%. We believe that securing fixed financing for our real estate investments makes these investments a hedge on inflation in the long-term.
Direct commercial real estate opportunities also provide an additional benefit to a client portfolio: an inflation hedge and diversification.
While today we are not in an inflationary environment, and do not see inflation being an issue in the immediate future, inflation will likely be a factor in the coming years. Commercial real estate has traditionally been used in a portfolio to provide a hedge against inflation. In times of increased inflation, lease rates can be adjusted frequently and increased expenses can be passed through, protecting income return. Valuations also rise when there is an expectation of increased inflation: risk premiums of real estate are typically reduced. Additionally, replacement costs increase with inflation (for example, the costs of constructing a new building, which may be a competitor, rise), helping boost valuations.
As an asset class, commercial real estate has shown very low correlation with stocks or bonds over time. Over the past 25 years, the NCREIF Office Index, a leading index of total return of individual commercial real estate office properties, had a ‐0.03 correlation with US stocks and a -0.16 correlation with high grade developed bonds. When added as a part of a portfolio, commercial real estate acts as a diversifier and reduces risk because of its distinct market behavior from other asset classes. It is important to note- this refers to direct commercial real estate properties, and not other vehicles such as REITs, which are highly correlated to stock markets (over the same time period, REITs had a correlation of 0.55 with the US stock markets).
We’ve identified key qualities BigSur is looking for in a real estate investment: a high quality asset providing a steady source of income; a potential inflation hedge and diversifying asset to a portfolio. Keeping these qualities in mind, we determine what types of real estate investments to focus upon and the best vehicles to invest in.
What are the types of real estate investments we focus on?
Real estate investments are classified into three different segments: core, value-add, and opportunistic. See the below chart which highlights each of these segments and their risk/return profile.
As our focus for investors is to earn a steady income backed by a high quality asset, it is natural that we target core properties. We’ve been focused on purchasing properties at a reasonable price with good cash flows – we are not targeting high risk/high return properties which may require long-term strategic planning and changes, or holding the asset for a significant amount of time before an investor realizes any value.
There are a variety of ways to invest in real estate- through a Real Estate Investment Trust (REIT) which is traded on a public stock exchange; a Private Equity Real Estate Fund; or a direct investment. Even though each of these vehicles is trying to capture exposure to the same underlying asset class – each exhibits its own different investment characteristics, as highlighted by the below graphic.
Something to keep in mind is that any indirect method of investing in real estate will not be a “pure play” upon the asset. Investing through a vehicle and not directly in the real estate asset itself will bring exposure to the managers of that vehicle and any other costs. Avoiding paying fund manager fees is an important savings of direct investing. Direct investing also allows for full transparency versus being under the structure of a fund. As the graphic depicts, we like direct investing based on the low correlation to equity markets; generation of income, avoidance of management fees, and control over the asset.
How does a private client get access to direct investing?
We believe direct investments offer investors the most value. The issue that private investors face with this option is the issue of size. Typically in order to access direct institutional commercial real estate deals, a single investor required to invest somewhere north of $5 million per deal- making it difficult for many private investors to build a diversified portfolio of direct investments.
One of our key values at BigSur is to innovate ways for clients bring themselves to a higher level of investment execution. One way we have approached this is by creating the Club of Investors, where we pool the money of our clients together and participate in institutional investments alongside other major institutional investors. The participants in BigSur’s Club of Investors are given access to large deals which they wouldn’t be able to invest in as a typical private investor. We’ve used this approach to give our clients access to real estate. The BigSur Club of Investors has participated in six commercial real estate investments.
Making direct investments in real estate requires heavy quantitative and qualitative analysis, as well as tenured experience in the field. Our philosophy on real estate investing is consistent with our firm philosophy on working with the best specialists in every area. We position ourselves as generalists, always involved in every real estate transaction and applying our own analysis to each deal, but we partner with firms whose sole focus is on direct real estate investing.
An important issue is selecting the right partners- we aim to partner with the “best in class” institutional players. There are many qualified and not so qualified people out there calling themselves real estate experts. Through referrals and due diligence, we have found extremely professional partners with solid track records and reputations to work with. Also consistent with our firm philosophy, we have structured our partnerships with these firms to align our client’s interests with those of the General Partners. A key benefit from choosing a professional and institutional General Partner or property manager versus a small unknown firm is that of know-how and scalability (example: negotiate insurances in bulk). When General Partners bring ideas and plans, we have control on important decisions, typically: financing, buy/sell, budget approval. We ask for the inputs of the General Partners whose expertise can often be helpful in mitigating downside risk. We also have the hiring/firing of the General Partner, protecting us from any issues or unsatisfactory performance.
It is also important for investors to realize that no one has the crystal ball, and although we feel comfortable investing in real estate for all of the reasons this note highlights, there is a possibility that the market has not yet bottomed, and the positive movement real estate is experiencing is not a sustained recovery. We don’t see this as the base case, but for those readers interested, there is a recent New York Time’s article by Robert Shiller, an expert in housing markets and bubbles, which puts today’s housing recovery in context with historical bubbles. The article follows this piece.
We will continue to look for reasonably priced assets, focusing upon two segments of the market: second tier primary markets for office space and Texas for multi family housing. The office space in top tier metropolitan markets such as New York, San Francisco, and Washington, DC is already richly valued- reasonably priced assets are scarce, and there are few opportunities for attractive investments. Our focus has been upon markets a step below these primary top tier markets- cities such as Pittsburgh, Pennsylvania or Austin, Texas. We are targeting cities that are experiencing a significant transformation, usually related to a change of industry (for example, Pittsburgh, which has for the last few years positioned itself to become a leading health care services city from a manufacturing and steel city). We like to find this dynamic in the cities we invest in- strong fundamental drivers propelling growth. We are focusing on Texas for multi family housing; key factors to consider when evaluating multi-family housing are population, job and economic growth. Texas leads the way in all three categories in the US- in 2012, the population growth rate in Texas cities (Austin: 2.8%; Dallas: 2.2%; Houston: 2.0%;) were more than double that of the average US city (0.7%).1 Forbes forecasted the economic growth rate of cities in Texas to be above 5% for 2011-2016 (Austin: 6.1%; Dallas: 5.0%; Houston 6.1%).2
We will take advantage of the low interest rate environment to lock in low financing rates for as long as we can- and we believe that these conditions of low valuations and low rates will not last forever. While the window of opportunity remains open we will be helping our clients to build a balanced real estate portfolio of investments that will yield relatively higher than other assets for the next few years.
This material is distributed for informational purposes only. The discussions and opinions in this article are for general information only, and are not intended to provide investment advice. While taken from sources deemed to be accurate, BigSur Wealth Management, LLC (“BigSur” or the “Adviser”) makes no representations about the accuracy of the information in the article or its appropriateness for any given situation. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements. BigSur shall not be responsible for the consequences of reliance upon any opinion or statements contained herein, and expressly disclaim any liability, including incidental or consequential damages, arising from any errors or omissions.
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BigSur Wealth Management, LLC
1441 Brickell Avenue, Suite 1410
Miami, FL 33131
Office (Main): 305-740-6777 ext. 8006