How risky is value-creation in real estate?
Real estate investment is always a tough and tricky one. Let’s take the example of two investment opportunities, one large class-A office building in Midtown Manhattan and a portfolio consisting of 10 distressed residential properties in Chester NY. The first has a low vacancy rate and quality tenants with excellent credit rating located on 666 Fifth Avenue which is a low-risk investment. The second has relatively high vacancy rate, distressed tenants in a C-location which is typically a high risk investment. Which might be the better investment in terms of risk-adjusted returns?
The above case is undoubtedly oversimplified and the right answer lies in the details. However, the examples are to outline the characteristic differences of two elusive investment approaches heavily debated both in financial literature and industry. The first approach has been traditionally considered less risky, a passive investment strategy in which the investor buys well-performing stocks, real estate or other asset classes and holds them for a long period of time – the so called ‘buy-and-hold’ strategy. The second approach is focused on undervalued assets and requires professional expertise and active management, buying low and selling when the market is near the top generating high return. On the one hand, theory suggests that greater the risk associated with a financial decision, the greater the return expected from it. At the same time, there are many actively managed funds earning abnormal returns for a long period of time, which indicates that skills and professional expertise might play an important role.
Recent research analyzing the performance of actively managed U.S equity mutual funds has shown that active management of stock portfolios yield risk-adjusted returns that can also be explained by luck. Stock markets are fairly efficient and therefore it is difficult to predict future performance based on historic and present data. Rarely actively managed funds continuously outperform markets, at least in stock markets. Research findings suggest that broad diversification in a portfolio may lead to a better possible outcome in efficient markets.[1] Through investing in various asset classes and diversifying among sectors, geographies and sizes, the risk of under-performance can be substantially reduced because different markets do not tend to move into the same direction and respond to the same shock differently. For example, the maximum loss of one investment is 100% but maximum gain from one property is not limited.
Real opportunities, however, are rather available in semi-efficient markets, for example the real estate market. The more conservative buy-and-hold strategy is about buying new, well-leased properties in core locations and hold for a long period of time. These properties will generate a solid income stream and you can eventually sell at the purchase multiple. However, the potential for value creation in the core markets is very limited and claiming that it is possible to exit at 25+ multiples, which are more and more common in prime locations, seems rather speculation. The buy-and-hold strategy has traditionally been perceived as yielding modest returns at low risk. Core investments are similar to a bond, with stable cash flows over long periods of time.
In contrast, value-added and opportunistic private equity real estate investments require a more entrepreneurial approach; buying non-core properties and carrying out capital improvements to attract new tenants. This will reduce vacancy and stabilize cash flow. These capital improvements may include upgrading facades and signage, parking lot, tenant improvement, standardization of leases and other ways of reducing operational inefficiencies. The significant amount of value creation through redevelopment and development may yield 15%+ return by transforming troubled properties to stable assets. Normally, value-added and opportunistic investments are highly leveraged; therefore they are exposed to a higher degree of risk. By utilizing leverage prudently and with sufficient market knowledge as well as operational expertise, these investments can generate higher risk-adjusted returns.
The question really is whether higher return on value-added and opportunistic private equity real estate investments is simply compensation for higher risk associated with the investments or other factors such as managerial skills. Recent studies have shown that these more entrepreneurial type investments have higher returns than core investments, and their superior returns are driven primarily by market timing and the use of cheap debt rather than by risk exposure.[2] On top, value-added and opportunistic investments undertake capital improvements, which do not in fact increase risk such as, energy efficient retrofit, restoration of some aspect of a property, enhancing management efficiency, standardization of leases etc. There is also high economic benefit when obsolete properties regain economic value. Normally, the value-added and opportunistic approach involve investments in a wide range of real estate types, including residential apartments, office buildings, retail centers and industrial properties, and geographic diversification is wider as well. The current economic environment is favorable for value-added and opportunistic investments. Because the market for core assets in top locations tend to overheat while bargain opportunities skill exist in B-locations and in specialized property segments for example logistics, food retail etc.
Beyond the theoretical justification for value-added and opportunistic investments compared with core investments, it may be worthwhile to have a look at the returns. The two figures below show the returns on different asset classes over a long period of time, there is a strong case for European opportunistic investing.[3] In both the US and Europe, real estate has delivered competitive performance relative to equities and bonds over both short and long-term periods. Opportunistic investments have performed very well both in the US and Europe. In Europe, value-added investment returns have turned around after the financial crisis following the collapse of subprime mortgages, and delivered competitive performance relative to core investments, with even greater difference in returns than before the crisis.
In the light of the above findings, Taurus Investment Holdings, an entrepreneurial real estate manager and developer with focus on value-creation, has engaged in a residential aggregation program in Harlem, NYC. The project includes the purchase of 300+ residential units between 130th street and 170th street, a core investment in Manhattan’s fastest gentrifying real estate market. The rapid development of the Harlem area has occurred because of a supply constraint and increased demand for residential housing in Manhattan. Exercising additional demand pressure, Columbia University has engaged in campus developments in Harlem as well. So, the market trends are very positive in Harlem and the residential market is poised to attract a wealthier clientele.
Local expertise is a crucial element of value-added investments. Our partner is a New York City focused real estate investment and development team with experience in the Northern Manhattan rent-regulated residential market. The plan is to complete energy efficient retrofit developments and to reduce operating costs. After increasing rental income and creating a portfolio of institutional size, we will be able to sell at a high purchase multiple.
Although it is a core location, the strategy is focused on value-creation with relatively low risk. Due to the aggregation strategy, Taurus will be able to reach the critical mass to influence market standards, enhancing operational efficiency and gain a portfolio premium at the exit. Through lease standardization, the management of the properties will become more efficient. We expect to exit with a 15% IRR for our investors The planned holding period is five years which indicates a more conservative medium-term approach. Taurus takes an unusually conservative approach to private equity real estate investment; benefitting from the market momentum and creating value by aggregation, developing and increasing operational efficiency to exploit the “hidden equity”. By achieving this, the risk associated with the portfolio will not rise.
The long held paradigm that value-added and opportunistic strategies are necessarily associated with higher risk appears to lack empirical evidence. 15%+ returns at a moderate risk are available for sophisticated investors who realize potential through value-creation. Along these lines, new research suggests that these strategies even outperform in recession times.[4]
[1] Eugene F. Fama and Kenneth R. French, Luck versus Skill in the Cross-Section of Mutual Fund Returns , The Journal of Finance Vol. LXV, 2010
[2] James D. Schilling and Charlie Wurtzebach, Is Value-Added and Opportunistic Real Estate Investing Beneficial? If So, Why?, Journal of Real Estate Research, vol. 34, 2012
[3] RREEF - The Case for European Opportunistic Investing, 2011
[4] James D. Schilling and Charlie Wurtzebach, Is Value-Added and Opportunistic Real Estate Investing Beneficial? If So, Why?, Journal of Real Estate Research, vol. 34, 2012