Over the last eight years private equity real estate has witnessed some of the best total returns in its history. This has also coincided with the longest stock bull market in U.S. history. Some investors feel as if the current expansion can continue unabated. More disturbingly than that, and perhaps spoiled by the astounding returns in this cycle, many investors are still reaching for IRRs they achieved in the near past, blithely ignorant of the fact that most of the appreciation was the result of mean reversion and record low interest rates. Investors remain aggressive today when they should be defensive.
Extended cycle. Because of the muted recovery and the cautionary mood of corporations, the current expansion has been protracted, lulling some investors into a false sense of security. Two years ago, I said that this would be a longer cycle than usual and we still had some room to run and felt that we had about two or three years left in the cycle. I felt that the current cycle would be more protracted because of the slow, muted nature of the recovery. This has proven accurate. Nevertheless, I think we are beginning a period where I believe investors should be cautious and shift to less risky strategies that are less sensitive to downturns and recessionary periods. In a perfect world, I would advocate a hiatus from real estate investing; however, not all investors have this luxury. Many, including pension funds, must continually invest to meet liabilities of current income.
I generally see real estate investors rationalizing their decisions to invest in riskier and riskier deals to increase their returns at exactly the wrong time in the cycle. In most cases, investors are defensive soon after a correction or recession, biased by their recent losses and the ubiquity of negative sentiment. This is the time when, in fact, they should be aggressive. Conversely, investors tend to be aggressive at the end of a cycle or expansion, when they should be defensive. Why do I sound negative and critical when conditions are, in many ways, very positive for the economy and commercial real estate?
While there are many positives in the economy and the sector, they serve to mask the risk to real estate investors and induce them to continue to pay record prices for diminished prospective returns. Let’s review both the positives and negatives of the current investment milieu.
Positives. The U.S. economy continues to grow steadily and the recovery that began in 2009 has become one of the longest in history (108 months old at this point). Moreover, the world is enjoying synchronous and sustained growth. There have not been excesses with respect to lending and underwriting standards have not deteriorated significantly. Loan-to-value rations (LTVs), for example, have not risen to pre-recession levels. The current administration is pro-business and has improved the confidence level and resulted in positive business sentiment, leading to, among other things, higher capital spending and hiring. The recent tax law change has put money back onto the balance sheets of U.S. corporations. Large amounts of capital could be repatriated from abroad. Though unemployment is low, there does not seem to be significant pressure on wages, perhaps because many workers still remain under-employed or have dropped out of the system entirely. Inflation remains low, taking the pressure off the Fed to raise rates appreciably. Thus rates, while rising gradually, are still incredibly low by historical standards. There do not appear to be obvious factors that would lead to a market downturn, except perhaps an asset pricing bubble bursting. Real estate fundamentals are generally strong and improving. There are only small pockets of oversupply in a few markets.
Negatives. The U.S. economy and most industrialized economies seem stuck in a low growth and high indebtedness state, with most of the high growth shifting to emerging market countries. Interest rates are rising and are likely continue to rise in the U.S. and most countries. Valuations in real estate are perhaps the highest ever, with cap rates at all-time lows and peak pricing levels exceeded across all real estate asset classes in virtually all markets. In the past, levels like these were followed by downturns or reversions to the mean. Many real estate investors are reaching for returns they achieved recently in the market recovery, causing them to pursue risky value-add investments, taking on more risk at exactly the wrong end of the cycle. Many institutional investors seeing the high returns achieved by others are arriving late to the party and are overpaying, especially for core properties in the “global gateway markets.” Many investment decisions are being rationalized on the basis of relative low returns, particularly forward-looking yield and total returns of core real estate, creating a race to the bottom. Investors are not pricing on the basis of absolute returns or intrinsic or replacement value.
Risk-seeking at the worst time. Given today’s scarcity of high returns at the low-risk end of the spectrum and the deals being hawked at the high-risk end of the spectrum, many investors are moving capital to riskier investment (such as value-add and development) just when the returns on those prospective investments are the lowest they have ever been. They are jumping at investments today that they rejected in the past when projected returns were higher. Everyone seems to be embracing riskier investments at the same time. This usually does not end well. Investors should be ready to seek safer, less speculative and more income-oriented investments. Combined with the global glut of liquidity, less concern about risk and low prospective returns, I think it is prudent to be cautious early and perhaps underperform the market rather than too late, after the deterioration of the market has begun, making it hard to minimize losses and exit.
Long-term investment horizon. It seems as if most people are investing on the basis of relative returns. They buy at record low cap rates because everybody else is doing it. Most investors know that the good times will end, but they feel like they must be in the dance and they rationalize their decisions on the basis of “everybody else is doing it.” Going forward, I believe the rate of capital appreciation will be roughly average to below average. Therefore, real estate investment should revert to a focus on long-term fundamentals of actively managing properties including improving NOI and creating value, with the bulk of the returns coming from income and not appreciation.
Investors should not expect a quick in-and-out profit with a huge capital return, but rather take a more traditional long-term approach to investing. Investors should not be in real estate for speculating on return and timing the cycle. Speculative investors have been a significant component of transactions in recent years. The speculative phase has come to and end with pricing surpassing previous all-time peaks and cap rates hitting new lows and interest rates rising. The music has stopped. Most of the easy money has been made. From here on out, it is about (or should be) fundamental, long-term value investing in real estate. Investors should choose their risk posture based on absolute return, absolute risk, and thus, risk–adjusted returns.
I am not making any predictions. No one can predict the exact bottom or top of the market. I do believe that where we are in the cycle indicates a great deal about investors’ tendencies. It feels to me like we are in extra innings, running on borrowed time. The case for stable income-oriented real estate investment is stronger now than since the end of the last cycle. As I said previously, risk is high and prospective returns are low on safe investments, pushing investors into taking more risk at a time when the reward for doing so is low. When real estate outperforms for too long—when appreciation returns far exceed NOI growth and when short-term returns are far better than long-term returns, it usually means that the market is overpriced and it will correct. I think we are overdue for a correction.
David Lynn, Ph.D., is CEO and founder of Everest Healthcare Properties. He has been an advisor to global institutional investors for over 25 years. During the course of his career, he has invested in more than 200 transactions totaling over $20 billion.