Before starting into this month’s Insight, I would like to remember two American icon’s that passed away this week at 99 and 100, being Charlie Munger and Henry Kissinger, respectively. Their impact on America is unquestioned. While we will miss their wit and wisdom, what I think society will miss even more is their memories and experiences of hard times and war. As their generation passes, so fades our collective remembrance of the difficulties of the Great Depression, the horrors of WW2, and the constant anxiety of the Cold War. The passing of years and the cycle of life is inevitable. Only time will tell if in our day, the cycles of history can be broken. Maybe that is a topic for another Insight.
I have bad news. If you have investment real estate (i.e. anything other than single family homes) on your balance sheet – and that is probably nearly everyone on the Altus Insight distribution list, you have almost certainly experienced losses. At least on paper. Prices across most real estate types and most geographies have been negatively impacted by the increase in interest rates. Some real estate classes, like industrial, have largely offset the negative impact of the rate increases through lease rate increases. Others, like office and hospitality…not so much.
But most of us don’t hold real estate simply for capital appreciation. We hold it for the spending power it can provide, either in current or future cash flow. Outside of a large portion of the office market, if your investment doesn’t have a loan losing its rate lock or requiring repayment, you probably haven’t been impacted (other than psychologically). I would love to think we are like Warren Buffet, and swings in market valuation don’t bother us. But most of us, and if I am being honest myself included, are mentally impacted by the negative news around us. If we like a company (or a piece of real estate, or a bond, etc.) at “x” per share, shouldn’t we like it better at “x-y” per share? The logical answer is, of course! The fundamentals of any business/investment purchase, all other things being equal improve through a purchase price reduction. The larger the price drop, the greater the increase in the fundamental value of the investment. In action, we often don’t act as if this is so.
But in front of us, we have an opportunity to put aside our fears and buy on the cheap. For most real estate types and segments, the operational fundamentals are still strong. But the word “strong” itself can be a red herring, because if we are stuck on comparing the operational performance of an investment to its historical performance, we will miss a second highly important input – price. What is important is not just the operational performance, but rather, the comparative operational performance versus the price (implicit in “price” for this discussion are the terms of debt to be used, because leverage and cost of leverage can have a massive impact on the profitability of an investment). Would you rather buy an industrial building at $100/ft. with $10/ft. rents, or buy the same building for $70/ft. with $8.5/ft. rents? When written in this manner, the answer is obvious. The second provides a 12% purchase cap rate while the first offers a 10% purchase cap (also called “Yield on Cost”). While only a 2% difference in cap rate, it is an incredible 20% increase in returns, assuming NO leverage (leverage should improve the margin), AND provides $30/ft. greater upside on an intrinsic value. Skeptical readers are rolling their eyes, “there is no way that sort of comparison is realistic.” No?
Multifamily prices fell over 40% during the GFC (Great Financial Crisis) but rents certainly did not. That was then. This is now. Ignoring properties with assumable debt, multifamily prices are estimated to have fallen over 20% from the peak. Rents nationally are basically flat. Operating costs have increased, but not enough to negatively impact NOI to the tune of 20%. What has changed is the value that buyers are putting on each dollar of income has decreased – otherwise captured as an increase in the purchase cap rate. All signs point to this continuing for some distance into the future.
More examples needed? We have an accepted letter of intent for the purchase of a 400,000 square foot industrial property for $10/ft. We won’t pretend this building is a fancy shiny new tilt wall building like what we are building at other locations, but we do expect rents to be around $3/ft. NNN, and so we are underwriting to $2/ft. Once leased, that is a ridiculous 20% estimated yield on cost. Elsewhere, we have a broker begging us to make an offer on a multifamily property at below 50% of the existing loan amount!
As a result of the current and impending market, Altus is rolling out an investment fund (two different ones actually) for the first time in nine years. Our last fund is still in operation, and has done extraordinarily well with consistent distributions above an 18% yield for several years in a row, accompanied by a 5x increase in net investment value. If it has performed so well over the last 9 years, why haven’t we done more of the same? For the past several (8) years, we didn’t feel like we could provide a clear enough strategy to incorporate into a fund structure, so instead, we did individual single purpose entities (SPEs). Financing was relatively easy to come by and most transactions were not distressed, therefore didn’t require extremely short close times on the purchase.
That has all changed now. Broadly speaking, the opportunity in the marketplace now, and for the next who knows how long, is far greater than it has been over the past ten plus years. This is the equivalent of a going out of business sale. Everything must go, and it doesn’t matter the price. This is hyperbole, but not as much as you might think.
A fund structure allows us as the manager to do a number of different things that aren’t generally available outside of a fund. And while investing through a fund is by no means a perfect structure compared to any other, there are benefits that exist beyond taking advantage of distressed opportunities:
- In times of distress, sellers, or those tasked with facilitating sales, want 100% assurance of a buyer’s ability to close. Reputation goes a long way, but cash in the bank goes a lot further. The industry term is “proof funds.” A fund allows us as a buyer to do this. It is much harder within SPE structures.
- Need for speed. The second requirement in most distressed sales is getting the transaction done quickly. Much, much more quickly than in a normal market. Thirty-day due diligence? Forget it. You have five. Sixty-day close? Forget it. You have thirty. Getting through due diligence quickly requires all hands on deck. There isn’t time to get private placement memorandums in place and put together shiny slide decks. The focus has to be on the real estate. And sometimes the required speed of the closing means purchase debt is not feasible. Other options are to pay cash, or to have financing proactively arranged, often secured by other assets owned by the buyer. These are things a fund can provide that are much more difficult in non-fund structures.
- Part of being a buyer of distressed property (or rather, buying from distressed sellers), is building in really fat contingencies and being super conservative in assumptions. These situations simply do not allow for the level of precision that can be expected with much longer due diligence periods with cleaner books and disclosures by a seller. Generally, this works out in the buyer’s favor because those fat contingencies and conservative assumptions usually end up overly conservative, and accreditive to the bottom line. But, once in a while, something of consequence will get missed. If an investor is only investing in one property, that miss can be really painful, but across a broader portfolio of investments, the realization and acknowledgment of occasional underperforming investments is built into the assumptions of the fund. Shoot, in our non-performing notes fund, we include assumptions that there will be some notes purchased within portfolios that will have a zero recovery rate. This spread of risk is not just useful in times of greater opportunity such as these. This is a benefit across the entirety of the real estate and economic cycle, though the efficacy of the risk dispersion can be enhanced or diminished by actions taken within a fund. For example, if a fund only purchased Triple Net Leased Rite Aids, there isn’t a lot of risk dispersion, and buyers of the Rite Aids are now feeling the impact. But if a fund buys several different asset classes across a variety of geographies and a mix of products (new construction, stabilized, lease up, etc.) then there is considerable risk mitigation. This is true from both minimizing the possibility of catastrophic loss, and also reduces the risk of any loss at all. In many cases losses in real estate are not due to something inherently wrong with the real estate itself. It is nearly always the timing of the execution of a particular business strategy not being aligned with the expectations or financing secured to execute that business strategy. By having other sources of cash flow and equity, surprises can be mitigated, and recovery obtained.
- Less investor effort: Maybe it is just me, but it feels like a lot of work every time I make an investment into a specific real estate project or private business (I do very little in the public markets). Not only do I need to do due diligence on the specific investment, but there are timing issues (I don’t want to be sitting on cash), coupled with the friction around physically making the investment – paperwork, verifications, moving money, etc. Also, I don’t want to put all my money into a single deal, so I have to do this over and over again. A fund makes it much easier. My due diligence is on the strategy and the sponsor, which I only have to do once. Also, I can make a much larger investment knowing that I will still obtain a diffusion of my investment because the fund will be purchasing a variety of assets. Then of course, it is only one set of legal documents, accreditation, etc.
- Many, if not most, funds are open to take investment for several months. One of the difficulties of SPE investing is the speed at which the investment dollars are often required. The slower roll out of a fund allows for other components in a broader investment portfolio to be handled in a more efficient manner while the cash is accumulated for investment. In many cases, the investment is not required all at once, and smaller investments can be made over a several month period. In the case of the Altus funds, we have a full year to accept investment.
There are some drawbacks of course:
- When investing in a fund, an investor does not have the ability to underwrite every single investment. Is this a feature or bug? It depends. See number #4 above.
- As an investor, it may be a little harder to understand what is going on inside of a fund versus a single asset investment. Our quarterly commentary for our remaining legacy fund runs several pages so all the assets can be discussed, often without a ton of detail on each individual investment inside the fund. Conversely, the quarterly commentary for our SPEs rarely exceeds a single page.
- As with any private investment, there is sponsor risk. Who is responsible for executing on my investment? With whom are you investing? Do they have a reputable track record? Do they have controls in place? Do they have a team that can continue to run if one key person becomes ill? I need a legitimate company that can handle the changes of life and keep moving forward.
What does this mean in summary?
- If you want real estate in your investment portfolio, now is a great time to invest. As Warren Buffet has said on many occasions, “Buy when others are fearful.”
- If you believe the above bullet point to be true, a fund structure is almost certainly the way to do it. Buyers that can move fast and aggressively are going to be able to consistently outperform buyers that cannot. Buyers that cannot compete with offer strength and speed will have to instead compete on price. A higher price, by definition, means lower profits on any specific investment. Does that mean there won’t be great investments made outside of funds? Of course not. The world of real estate is huge; and in nearly all parts of the market cycle there is opportunity. It is just going to be less prevalent and harder to find.
Pertaining to Altus specifically, we cannot say with any amount of certainty how we will structure investment opportunities in the future. Maybe a couple years down the road we revert back to individual SPE structures. But I know for the time being, outside of 1031 reinvestments that require fee simple ownership, our entire focus will be through funds.
Of note, Altus Capital Group will continue to offer debt investment opportunities on a one-off basis.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.