Risk-On, Risk-Off

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For what it is worth, my opinion is that the current market is undervaluing income and overvaluing growth. Historically, this is not a common occurrence but continued competition in the space has caused this trend since late 2018.

“Frankly, there’s no substitute for limited competition. You can be a genius, but if there’s a lot of competition it won’t matter.” — Sam Zell

Discussed in my previous article “My Thoughts on the Current Real Estate Market”, bidding wars have exacerbated prices most commonly seen in the core-plus and value-add products. By the nature of these strategies, core-plus investments should traditionally yield lower on an unlevered basis than value-add because it is viewed as as a more stable asset. As an example, let’s say that a core-plus is producing an 10% IRR versus a value-add is at 14%. In a vacuum, this “risk curve” where the projected returns are positively correlated to the grade of the asset, puts investors in a difficult position. This means that in order to realize these opportunistic returns private funds are looking for, you must pursue rather aggressive value-add opportunities to get returns not typically seen in the public markets. However, over the past 2–3 years a blend of asset classes (A-,B,C+) have been trading at increasingly correlated cap rates moving forward.

Using this example, we can break down how the risk curve is affected. Let’s say demand for value-add is strong, decreasing projected returns to 12% from 14% previously. Conversely, if core-plus falls out of favor, the prospective return could increase to 12%. With this, the risk curve is completely flattened, creating essentially the same returns for both core-plus and value-add while the latter is taking on significantly more risk from a business plan execution standpoint. As a side note, I do believe the market is starting to decouple these assets with a more risk-off approach in response to lower in-place DSCR (debt service coverage ratios) in a rising rate environment. In a situation like this, the irrational investor who is seeking upside exposes themselves to potential capital calls and inheriting more risk to make up for yield compression.

I personally think many investors were trying to capitalize on “missed opportunity” while witnessing record rent growth and record appreciation rates across almost all primary, secondary, and tertiary markets. With compressed returns being the normal, investors with an investment strategy of purchasing low yielding properties relative to their purchase price are going to face many challenges moving forward. The vanilla strategy of cosmetic rehabs and pushing rents while providing minimal value to tenants in return will work until it doesn’t. Compare that with a similar yielding core-plus property, the investment thesis of creating attractive, stable cash flows over long periods of time can reduce your downside risk when projecting conservative income growth estimates for the asset. A critical component in order to exceed your return benchmarks is there must be a positive spread between the operating cap rate and the cost of debt. Historically, in a healthy market investors and lenders prefer to underwrite an in-place 250 basis point spread which has become increasingly hard to achieve on a fixed-rate basis (spreads can differ, even if the spread is the same but at a lower cap rate, the levered return is slightly lower).

When analyzing cash flow and spreads, an important factor to keep in mind is amortization. The amortization period can heavily change your projected returns depending on the structure. IO (interest only) periods which are initialized at the inception of the loan can create false cash flow since they don’t take into account the full debt service. In conclusion, we continue to stay diligent on executing a properly risk-adjusted investment strategy when examining potential opportunities. The market is starting to shift where the person with the cash is in control, which was not previously the case.