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Managing Risk and Adding Value for HNW Real Estate Investors

A compelling case is made for investing in secondary and suburban markets, which remain below peak valuation and present protection against a possible market correction.

Ultra-high net worth (HNW) investors and family offices remain challenged to achieve acceptable risk-adjusted returns amid the current robust economic cycle. U.S. commercial property prices have broadly surpassed the previous peak, impacting yields on core, core plus and value-add assets, especially in primary markets.

Trends in capital flows and property fundamentals suggest strong support for this pricing. Looking deeper into the post-recession recovery reveals that all markets are not created equally; appreciation has been uneven.

A compelling case is made for investing in secondary and suburban markets, which remain below peak valuation, offer room for rent growth and present favorable protection against a possible market correction. Assets in these markets that have healthy supply/demand characteristics and opportunities to add value can deliver risk-adjusted returns that align with investment portfolio goals.

Enhanced value-add yields in secondary markets

An arbitrage opportunity exists for HNW investors in non-major markets and in non-core properties. Safety-minded institutional investors flock together and drive up prices for trophy assets in the early stages of recovery, then grow dissatisfied with the resultant low yields as economic and property fundamentals strengthen. As the institutions branch out to secondary markets in search of higher returns, savvy HNW investors can reap the benefits.

The positive influence of these capital flows can be augmented if non-core properties can be repositioned into the core investment channel. Repositioning value-add activities in this case may include lease-up, renovation, portfolio aggregation, re-tenanting, rebranding and other actions that increase cash flows and diminish risk. These activities can enable investors to realize a “double lift” in yield from value-add properties in secondary markets.

Middle-market inefficiency, investor opportunity

Segmenting the market based upon asset size also contributes to strong risk-adjusted returns. A disproportionate share of capital has been raised in the post-recession cycle by billion dollar “mega-funds.” These funds symbolize institutional investors’ desires to invest with the largest managers, effectivelyconsolidating more capital with fewer managers.

This concentration of capital has manifested itself in the rapid appreciation of the highest-value core U.S. properties. With so much capital to deploy, these mega-funds skew capital flows toward $100-million-plus properties. Foreign investors share a similar bias for investments of this size. The outgrowth of this larger-is-better trend is comparatively less capital seeking assets valued below $75 million, thus creating opportunistic pricing inefficiencies.

Follow the jobs

Another primary driver favoring secondary markets is employment. Non-gateway cities have outpaced gateway markets markedly in terms of percentage job growth, with the primary exception being the San Francisco Bay Area, where prices are at all-time highs. Notably, many of these second-tier cities also boast strong job growth in absolute numbers (e.g., Dallas, Atlanta, Phoenix and San Diego).

Citing the Bureau of Labor Statistics, job growth from the third quarter of 2015 to the third quarter of 2016 was fastest in the lower-density suburbs of large metropolitan areas, with populations over one million. Employment grew 2.2 percent in those counties, slightly ahead of growth in higher-density suburban counties (2.1 percent) and in urban counties (2.0 percent) of large metropolitan areas. Concurrent with this shift is slightly higher population growth in the suburbs as well.

Conclusion

We believe commercial property fundamentals are solid and are projected to remain so for some time. Barring unforeseen exigent events that could shake up the U.S. economy, supply and demand should remain well-balanced, leading to steady occupancy and rental gains over the next several years.

Employment factors, domestic capital flows (both debt and equity) and the inflow of foreign capital are projected to buoy asset values and keep a lid on cap rates. Within this environment, we believe premium risk-adjusted returns can be realized over the next several years by playing to the edges.

Appreciation of larger properties in gateway cities has been so dramatic that they may carry more risk of price declines than under-appreciated assets that tend to be smaller properties in secondary markets and submarkets. These smaller assets, mostly suburban office buildings, generally offer strong yields to investors, are comparatively insulated from supply risk and present compelling rental economics to tenants. Investors in these middle market properties may find less competition on the buy side today and are likely to benefit from capital flows trending towards these secondary cities down the road. Those who reposition non-core assets in secondary markets into core-quality investments may also realize a “double lift” by combining income gains with increasing buyer demand.

Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on value-add investing by providing debt and equity capital to owners and operators of commercial real estate, as well as buying direct investment for its own account.

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