Real Estate Returns in Context
Private commercial real estate has historically served a number of purposes for investors, including current income generation, tax optimization, and inflation hedging. But top of the list has almost certainly been the ability to generate attractive risk-adjusted returns (see chart below).
20-Year Risk vs. Return by Asset Class
Since the financial crisis, this feature of US real estate investing has been particularly rewarding: rapidly improving fundamentals and compressing yields combined to produce abnormally high returns. The median closed-end real estate fund started after 2009 has generated approximately 15% annually to investors, with the top quartile achieving 20%+ returns.²
Today, we believe the real estate risk premium, or the excess return investors receive for owning real estate in comparison to “risk-free” assets, remains compelling.³ However, as we noted in a previous investor letter, that premium is in the context of a low-yield environment where future returns in real estate can’t remain at abnormally high levels forever. As detailed in that letter:
“While we do not believe the conditions exist for a sharp downturn, we do believe the overall US real estate market is poised for lower growth and returns than have been enjoyed over the past several years. Importantly, we view this dynamic as consistent with most other asset classes. And within that reality of a lower-return environment, we believe that certain real estate strategies offer the potential to achieve a materially better risk-adjusted return than is broadly available in most markets today.”
To put numbers behind “lower return environment,” we believe a smart strategy with a responsible risk profile can generate between a 10% — 14% net levered return, with a mid-to-high single digit net cash yield.⁴ This approach guides us to typically target “value-add” (defined below) transactions. Recently, several of our investors have noted that this return profile feels low relative to what they have been promised by other real estate investment managers and platforms advertising “value-add” risk. We at Cadre are firm believers in a good manager’s ability to generate alpha in an asset class that remains relatively inefficient. However, we do not believe today’s market provides investors the opportunity to consistently achieve 15%+ net returns, without taking significant risk. This skepticism stems from two key factors:
- At a macro level, a competitive capital markets environment suggests that while investing in real estate remains appealing, the return for doing so has decreased
- At a more granular level, we have found that specific transactions and funds marketing high returns appear overly aggressive on key assumptions, particularly income growth and exit pricing
A Refresher on Risk
A discussion of returns wouldn’t be complete without a quick refresher on risk. The risk spectrum in real estate is typically divided into four segments: core, core-plus, value-add and opportunistic. As you move from core to opportunistic, the level of risk (operational, market, etc.) increases. Leverage also typically increases along that spectrum, which further amplifies the potential risk. The one key element this risk spectrum doesn’t capture is the price of the real estate. Overpaying for a core deal dramatically increases the risk associated with achieving your desired return. Conversely, buying an opportunistic deal at a bargain price with low leverage can significantly de-risk the otherwise “risky” profile of that deal.
Return expectations within each of these buckets can shift over time based on the overall market environment and movements in the risk-free interest rate. The below ranges and descriptions provide a rough current framework:⁵
Real Estate Risk Spectrum
Comparing a core deal with an opportunistic deal is not dissimilar to weighing a United States Treasury Bill against a high-yield bond: the relative merits of the two should never focus on just reward. This is easier said than done, mainly because potential returns in real estate are much easier to quantify than potential risk. This can lead to a tendency to opt for higher returns without appropriately judging the risk associated with those returns. We recently came across a relevant investor survey that showed investors focus on “quality” when making investment decisions. While this seemed sensible, a surprising percentage of investors went on to define quality as deals projecting internal rates of return in excess of 20%. This logic conflates quality with the promise of high returns, entirely ignoring the risk (and the validity) of those projections.
The Current Landscape
The Economic Cycle
So where is the world today? Depending on the stage of a real estate or economic cycle, both the quantity and appeal of deals within a particular risk profile fluctuates. Coming out of an economic downturn, opportunistic deals are typically easier to come by. Lingering distress in the system creates high-risk / high-reward transactions and lower pricing can make this higher risk profile particularly attractive. As the economy stabilizes, real estate vacancies and rents tend to stabilize as well, and the number of truly opportunistic deals declines. In fact, a single property might trade hands two or three times with an increasingly stable profile as new owners improve and resell the asset. In the midst of a nine-year economic upswing, that is exactly where the market finds itself today.
Consider the behavior of some of the largest and most respected real estate managers. Starwood, Carlyle, and Brookfield (to name a few), historically known for higher-octane, opportunistic real estate investments, have all launched core-plus funds in recent years.⁷ With respect to LPs, Preqin data shows that between 2016 and 2017, the percentage of LPs targeting core-plus strategies jumped by nearly 50%.⁸ Through these actions, industry participants are acknowledging the difficulty of consistently identifying higher return opportunities in today’s market.
Just as supply and demand dictate market rents, the supply and demand for investment opportunities dictate pricing and potential returns. When there is a lot of uninvested capital looking for deals, prices rise and returns compress. We see this dynamic playing out today across asset classes, with real estate being no exception.
Uninvested Capital — Closed-End Private Real Estate Funds⁹
On one hand, the wave of capital waiting to be invested is validation that investors see the appeal of allocating toward real estate. But it also means heightened competition for deals. While we push to find opportunities on an off-market basis (over 60% of our closed deals have been sourced off-market), even off-market sellers aren’t irrational. They may be willing to transact at a slightly reduced price, either for the opportunity to do future business or for certainty of execution, but off-market does not mean selling at a price that will generate clear outsized return to the next buyer.
But are we seeing the “best” deals in order to make these judgments? We believe so. We have built a differentiated, high-quality sourcing engine that gives us a strong pulse on real estate capital markets across the US. Through our network of operating partners, we have the opportunity to transact wherever we think capital markets participants don’t fully appreciate underlying market strength (or steer clear where capital markets seem too optimistic). We have reviewed over 400 deals over the past 12 months. And while returns are always subject to the assumptions that drive them, almost all of these realistically underwrote to between an 8%-14% net IRR. Some will ultimately do better, and some worse, but we are skeptical that a material percentage will consistently outperform that range, as some of our peers’ underwriting suggests. To that point, the next section looks more closely at the assumptions that actually drive returns.
“Solving for Return”
The Components of Return
At the risk of oversimplifying, we think about returns as a function of three key components: (i) the cap rate (yield) you buy into, (ii) the increase in income generated by the property during the hold, and (iii) the cap rate or yield you can sell for. While one might argue a fourth component is the attractiveness of available debt, we view leverage as an amplifier of return or loss as opposed to a key driver.
Real estate is not perfectly efficient, so certain deals do present below-market pricing on the margin (this relates to key component #1). However, consistently buying at steep discounts to fair value is a far-fetched notion, especially given today’s capital markets backdrop. And we don’t believe investors are generally being promised stellar returns based on the notion of buying assets for pennies on the dollar. Instead, we have noticed a propensity for certain managers and operators to make highly optimistic assumptions around the “unknowns” of income growth and exit pricing (components #2 and #3).
Last year we identified Houston as having one of the most favorable apartment supply / demand dynamics across major markets. We subsequently closed on three assets in Houston representing 1,300 units (while passing on 19 other opportunities in the same market). The assets were built in the late 1990s / early 2000s and purchased at a high 5% initial yield with a value-add plan to renovate units. We underwrote both of these transactions to a ~12% target net levered return and a ~5% net cash yield, slightly better than where we think most assets with this risk profile are pricing today.
Recently, we encountered an asset in the same market (older asset but slightly better location) with a similar value-add risk profile that was being offered by another manager at an 18% target net return despite a low 4% initial yield. First off, we acknowledge we do not have a crystal ball, nor do we think we cornered the only attractive transactions in Houston. That said, we would argue an 18% return based on a sub-5% initial acquisition yield likely overpromises on two of the key return components we reference above: income growth and exit pricing. The goal here is not to compare the relative merits of specific deals, but rather to illustrate the ease of “solving for return” through aggressive assumptions in order to attract investor interest.
Let’s address income growth first. The manager assumes net operating income grows by an average of 15% annually for 5 years! We too are believers in Houston’s potential to materially outperform other US markets, but 15% annual growth is 3x our assumption, and through compounding, leaves you with 5-year total growth of 104% vs. 30% in our underwriting. More specifically, this growth assumes the asset can achieve material 6.5% annual rent increases in parallel with raising economic occupancy from 72% to 88% and reducing expenses by ~20%.
The manager then assumes a 5% exit cap rate (yield on the property’s operating income), which implies a price of ~$170k per unit. Without getting into too detailed of a discussion on cap rates, we focus on future interest rates, stabilized yields and replacement cost when evaluating exit pricing. We take the market view that we are in a generally rising interest rate environment, which should imply higher exit yields in the future. At first glance, assuming a 5% cap rate on exit might seem reasonable when compared to a low 4% initial yield. However, in the context of stabilized yields and replacement cost, the 5% cap rate is hard to defend. Specifically, buyers of recently renovated assets with less future upside will want to pay higher cap rates because there is less ability to create future income and yield growth.¹⁰ In this case, according to underwriting, the next buyer will be inheriting a well-managed, 95% occupied asset with rents at market. We underwrote a similar value-add business plan, and with the concept of stabilized yield in mind, we underwrote exiting our assets at a 6% cap rate and ~$136k per unit.
In the same vein, we have estimated replacement cost in this market between $150k and $165k per unit. While construction costs continue to rise, this underwriting assumes an asset built before 1970 will sell for ~$170k/unit, which is more than the cost to build a brand new asset today. How impactful is the sale price assumption? If you adjust the exit cap rate from 5.0% to 6.0% (and therefore reduce the sale price to ~$140k per unit), the net IRR falls from 18% to roughly 12% based on just one underwriting change! If you stress test additional growth assumptions, expected return falls even further.
Deal Underwriting Comparison
Again, our version of future events may turn out to be incorrect (we would be thrilled to grow our asset incomes and residual values at higher rates). And in retrospect, many conservative investors over the last few years probably wish that they had underwritten more aggressively to win more deals. But the key is balancing well-reasoned conviction with irrational exuberance. By homing in on a few key variables, like exit cap rate, and understanding the range of outcomes, investors arm themselves to ask better questions and make better decisions.
Investors today have access to a wider range of managers and platforms than ever before, which is generally a good thing. But it does complicate the task of deciding where to allocate time and dollars.
In our view, the first step is to develop a realistic set of expectations around what type of returns are broadly achievable today. As we survey both the macro landscape and the individual deals in our pipeline, we see a lower return environment that generally calls for a more defensive, yield-oriented strategy to unlock attractive risk-adjusted returns. As Prudential noted in their most recent global real estate survey, “MSCI Global All Property Returns have eased to about 7% since the start of 2016, having averaged 9% over the previous five years of the current cycle. On a relative basis, real estate returns still look compelling.”¹² Not bad compared to most asset classes, but certainly not previously expected returns.
The second step is to have a framework for comparing options. While most of us know we should be focused on the trade-off between risk and reward, actually doing so can be difficult. Without a reliable way to compare risk, it becomes easy to gravitate toward investments that promise the highest returns. We too would like our money to grow at 18% instead of 12%. Deal tags of “core-plus” and “value-add” become blunt instruments to measure risk and, unsurprisingly, investors prefer a “value-add” deal that markets an 18% return over a 12% return. Our goal in this paper has been to demonstrate that, even within a certain “risk bucket”, headline returns can be highly misleading. Thankfully, investors can quickly arm themselves by understanding the basic drivers of those returns.
Aligning with the right strategies — ones that don’t take undue risk or over-promise — is as important as ever. Our (full-time) job at Cadre is to rigorously analyze everything about a transaction, from historical rent rolls to property condition reports to market fundamentals. We also believe there’s no better way to align ourselves than investing our own money in each deal we do. Ultimately, we hope to present well-conceived opportunities in a way that empowers well-informed decisions by you, the investor.
- Source: Predex, Bloomberg and NCREIF. Standard Deviation of Returns is defined as the first standard deviation of annual variance for the 20 years ended December 31, 2016. Private commercial real estate reflects the NCREIF Open-End Diversified Core (ODCE) Index through December 31, 2016. U.S. Bonds reflects the Barclays Capital Aggregate Bond Index, which covers the U.S. taxable investment grade fixed rate bond market.
- Source: Preqin Quarterly Update: Real Estate, Q1 2018
- For real estate, the benchmark risk-free asset is typically defined as the 10-Year US Treasury Bond yield, which is ”risk-free” due to its backing by the US Government. The 10-Year Treasury yield has hovered between 2.8% and 3.0% in July 2018.
- Net cash yield is defined as annual cash flow, net of fees, divided by the total amount of cash invested.
- Returns within each profile are often quoted as “gross” IRRs, before any fees are paid to operators or investment managers. We prefer to quote net returns to investors to fully capture the impact of fees.
- Cadre’s primary focus in today’s environment is the value-add segment of the risk spectrum
- Source: Pensions & Investments, March 2017
- Source: Preqin Quarterly Update: Real Estate, Q2 2017
- Source: Preqin Quarterly Update: Real Estate Q1 2018
- This dynamic has a clear parallel in equities: when an investor pays a high earnings multiple for a young growth stock, it is because he or she believes the company will greatly increase earnings as it matures. Now imagine the company succeeds in doing so, but as expected, growth begins to slow down. Should a new investor buying that stock pay the same multiple? No, because the company has matured into more of an income stock with lower expected future growth. To tie this back to real estate, investors pay lower cap rates for value-add assets given their higher growth potential. If your business plan assumes you stabilize the asset, the next investor is going to require a higher initial yield for that asset.
- Please see Important Disclaimers
- Source: PGIM Real Estate Global Outlook, May 2018