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Optimal Deal Flow Management for Direct Real Estate Investments Northfield Information Services Research

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Optimal Deal Flow Management for Direct Real Estate Investments Northfield Information Services Research August 2015 Optimal Deal Flow Management for Direct Real Estate Investments Northfield Information Services Research Emilian Belev, CFA Richard B. Gold Introduction This paper proposes an innovative practical solution to a unique problem confronting direct real estate investments. The problem is rooted in a question as old as investing itself: what to buy and when to sell in order to maximize profit while minimizing risk. The solution to this problem for illiquid investments, such as private equity real estate, however, cannot be the same as publicly traded investments since illiquid assets do not operate under the same conditions as public assets. The proposed solution is a cohesive amalgamation of the benefits of quantitative and fundamental analysis that is both theoretically rigorous and immediately practical. It also assists investors in making incremental investment decisions which are in turn transparent and intuitive to all relevant stakeholders. Furthermore, the marriage of real estate and publicly traded assets under the parameters of Modern Portfolio Theory has historically been more “War of the Roses” than “When Harry Met Sally”. This has presented a major challenge to those wishing to include real estate on an equal footing with other asset classes in their portfolio analytics. The approach described in this paper is designed in such a way to rectify this conflict. Background Directly-owned commercial real estate is an essential part of the typical institution portfolio. It comprises a significant percentage of the portfolios of some of the world’s largest investment institutions such as pension funds, sovereign wealth funds, insurance companies, and family offices. It is not unusual for illiquid assets (real estate, infrastructure, and private equity) to be upwards of 30-35 percent of an institution’s holdings, with real estate typically one third to a half of an investor’s illiquid holdings. The allocation to direct real estate varies from5 to 40 per cent of an investor’s portfolio asset value, with the highest proportion of cases in the 10-20 proportion range.1 1See: Nesbitt, S.L.,”Trends in State Pension Asset Allocation and Performance”: Cliffwater LLC, 2012. 1 www.northinfo.com Optimal Deal Flow Management for Direct Real Estate Investments There have been a number of reasons that made real estate attractive. Historically real estate was added to the typical investment portfolio because it was thought to be a diversifier.2 Its perceived low correlation with other asset classes and stable yields made it lucrative given the diversification algebra of Modern Portfolio Theory, despite the fact that appraisal-bias leaves this conclusion in doubt.3 The period following the Great Recession entrusted real estate with an additional role in the enterprise portfolios of long-term investors. That is the role of a yield provider, in an environment where other asset classes’ low yield and returns were predominant. Finally, one of the most desirable features of a typical real estate investment has been its clear, understandable, and consistent business model, which is unlike the businesses that underlie most other equity investments, and derivative financial claims in such businesses, like fixed income investments, or outright financial derivatives. Besides sheer attractiveness, real estate has warranted serious attention by analysts for other reasons. By virtue of large size and indivisible nature compared to other asset classes each incremental deal introduces a high level of idiosyncratic, or non-diversifiable, risk to the portfolio. Due to its “lumpiness”, real estate deals are also highly illiquid which requires that the investor assumes idiosyncratic risks for much longer periods compared to other asset classes. Hence the nature of this “investment marriage” requires a high level of scrutiny of the impact of each investment deal that is about to enter the portfolio. In contrast, stock portfolios exhibit a level of divisibility, liquidity, and turnover that is incomparably higher than almost any real estate deal (with the exception of REITs). Stocks are bought and sold in multiple numbers and types, every day, hour, minute, second, or even fraction of a second, freeing the investor almost entirely from the burden of monitoring idiosyncratic risks which are easily diversifiable as long as a large basket of stocks is held. Another distinctive feature of real estate investing is its toolset. The majority of the financial theories and applied research have been entirely related to issues of the public stock markets, with only a tiny fraction of work being dedicated to directly owned real estate, despite its major role and standing in institutional portfolios. Portfolio management theories like CAPM and APT do not explicitly describe how real estate should be treated as an investible asset class because of the heterogeneous nature of the underlying investment deals, and the non- arbitrage free nature of real estate values as embedded appraisal-based valuations.4 Even when a major theory refers to “complete” asset markets, the available estimation methodologies, like regression/time-series econometric analysis, render their use with real estate impractical due to the lack of observable pricing history, as one of the corollaries of being an illiquid asset class. For all of the above reasons, unlike equity analysis where the quantitative aspect of investment analysis is just as dominant as fundamental analysis, real estate investment deal making has evolved to be almost exclusively based on fundamental investment studies and techniques. The elaborate review of coverage, leverage, and profitability 2 See: Hoesli, M., Lekander, and J, Witkiewicz, W, “International Evidence on Real Estate as a Portfolio Diversifier”: Journal of Real Estate Research, 2004, 26: 2, 161 – 206. 3See Northfield Information Services’ March 2014 Newsletter article (http://northinfo.com/Documents/589.pdf) entitled, “The Pitfalls of an Index-Based Approach to Managing Real Estate Investment Risk” by Emilian Belev, CFA and Richard B. Gold for a more complete discussion of these issues and the implications for investors. 4Appraisal smoothing has long been recognized as an issue in private equity real estate. See: Geltner, D.M., “Smoothing in Appraisal-Based Returns”: Journal of Real Estate Finance and Economics, 1991, 4, 327 – 345. 2 www.northinfo.com Optimal Deal Flow Management for Direct Real Estate Investments ratios, tenant turnover, vacancy, and others variables can occasionally be supplemented by econometric studies of inputs that determine demand and supply, but essentially the estimation procedures result in the figures that rest on first moment (central tendency) in a distributional sense. Where such work stretches to estimation of the uncertainty around the central tendency estimate (e.g. standard deviation of projected return), eventually it cannot connect to the impact on the overall portfolio, or even to other such estimates within the real estate portfolio but from different geographic or property type markets, due to differences in the employed risk factor set.5 Notwithstanding all these seemingly practical contradictions, there are reasons for optimism. First, as already mentioned, portfolio theory, abstract as it might be, does refer to “complete” markets, encompassing all asset classes. Second, risk models do exist, that span real estate markets while simultaneously measure real estate risk with the same yard stick as other asset classes. Finally, the high quality of the in-depth fundamental analysis by real estate practitioners is an excellent source of information with respect to the asset class’ “profitability”, which in turn plays a central role even in the most involved of “quant” methodologies The Real Estate Investment Process Every asset owner has a particular deal allocation process that is guided by some general fixed investment principles but takes a distinct practical form. For example, smaller asset owners, with only one fund or portfolio, may be highly selective and have specific filters by land use, deal size, location, quality, expected return, and leverage to quickly determine their level of interest in a particular deal package. Larger firms, with multiple funds and separate accounts, may have a formal allocation process by which they allocate deals. If there are several bidders for a particular property, a second screening process is likely to determine who will be the “winner”. Often it is as simple as which fund is the next in line but often it may involve some heuristic “goodness of fit” metric. The number of deal packages any investor receives in any given time period is a function of a number of factors, some of which are not under the investor’s control. The factors include, but are not limited to, the size of the firm, its reputation, and how active it has recently been in the market. Even more important in determining deal flow are both available space and capital market conditions. There are times when even the most active and largest investors may see few, if any deals, go over the transom. For example, during the “Great Recession” transactions levels were constrained because there were few sellers willing to take the necessary valuation haircut to bring a property to market. Even when markets are their most fluid, unlike equity markets, not every building is for sale, and even fewer properties that meet a specific asset owner’s investment criteria are for sale. Finally, as a byproduct of the heterogeneity of deals, the bidding against a single property suggests that bidders face an additional risk. That is, with multiple candidates, a bidding war is likely to break out and in the absence of a rigorous and clear price limit, a buyer may end up paying more than they initially expected. For unsuccessful bidders 5 Real estate indices currently available to investors are not “actual” in the sense that they are appraisal-based and do not use transactions of the specific asset. Even transaction-based indices are not truly real time in the sense that they require hedonic estimates to fill in gaps, have small sample sizes, and have other shortcomings.
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