Several years ago, I began writing a series of regular blogs, more like short articles really, about various aspects of what I then called Small Balance Real Estate (or SBRE). The blogs were generally well received I think because I tried to write about real, bona fide, challenging issues that mattered to both sides of what is truly a dual sided market – namely managers/sponsors on the one side and investors (high net worth, family offices, and institutional) on the other. I wrote nearly 150 blogs over a three-and-a-half-year span and enjoyed doing it both because I enjoy writing and more importantly because of the actual value people involved in the industry got from the content. That writing has tapered off (in fact dwindled to nothing) in recent years as Fairway America has grown, but the issues people face on both sides of the aisle are more important than ever. So now, with even more scar tissue than I already had living and breathing in the trenches of what I now am referring to as the “middle market real estate” space, I am resuming production and distribution of this blog. I hope that at least some of you find it useful in your efforts in this fascinating and underappreciated segment of the real estate investment world.
One of the most prevalent topics of conversation with sponsors and investors I encounter is about current market conditions and what happens in a downturn. Everyone knows that we are deep in a favorable economic cycle that has gone on for about as long as anyone can remember. These tailwinds have made real estate investing in the United States look relatively easy as just about everything has performed well for nearly a decade and intelligent people are rightly concerned about an inevitable downturn. ”What is likely to happen to real estate assets when that time comes?” people ask me. “Are there any opportunities left in real estate?” Anyone who is active in real estate asset-based investing knows that competition today for origination and acquisition is fierce. Broadly speaking, property is expensive, construction, labor, and material costs are up, debt is plentiful and cheap, and capital is having a hard time finding yield in the current environment. So, I respond to people that yes, in my view, this is a time to be very careful and disciplined enough to adhere to the principles of value investing (as applied to real estate), which I see many ignoring in the chase to simply “close deals.” But I don’t think that it means that there are no opportunities in real estate. Instead it means being patient and sticking to fundamentals.
The relationship between price and value goes to the heart of value investing. The concept first articulated by Benjamin Graham and David Dodd, and made famous by Warren Buffett, has direct application to successfully investing in a variety of real estate-based asset types. Buying real estate at less than its intrinsic value (or providing or acquiring debt secured by real estate whose value is substantially greater than the amount of that debt) creates a “margin of safety” that helps to shield investors from the unavoidable challenges, issues and market forces that impact operations, cash flow, and ultimately performance of any given real estate asset. In today’s environment, being able to procure assets at less than intrinsic value is difficult. There are so many people with a surplus of capital who are willing to pay more than a disciplined investor who adheres to these principles.
Savvy investors realize this.
How they react to it and what they choose to do and not do about it is what I find most interesting. It is also the subject of this article (and ultimately our entire investment thesis at Fairway America). Not-so-savvy investors chase yield and ignore (or are ignorant of) the underlying assumptions that produce whatever attractive return figures the sponsor’s spreadsheet reflects. Aware investors choose one of several paths. One is to do nothing now and simply avoid real estate investments altogether at this stage of the cycle. This is, of course, a viable path, but it leads to the question of what other asset types do they pursue with that capital and whether they are also overpriced, a question beyond the scope of this article. For our purposes, I can respect the decision to simply sit on the sidelines at this stage for people whose financial situation and perspective allow for it.
Many other investors, including particularly large institutional and family office investors, may choose the path of a “flight to safety” by moving into what they believe to be “core” assets in “gateway” cities and “primary” markets. Given the minimum ticket sizes of their investment capability and the limited number of markets and assets that meet these multiple criteria, this necessarily confines the universe of options to a finite number of possibilities and increases the competitive pressure on the price (but not necessarily the intrinsic value) of those assets. The theory is that in a downturn or recession, these markets and these assets will withstand negative market forces better than secondary or tertiary markets and thus are “safer.”
I will not argue that New York City is less likely to perform better over the long haul than Toledo, Ohio, Boise, Idaho or St. Louis, Missouri. (We have invested, by the way, in all four of those markets, all successfully to-date.) However, I do not believe that paying today’s prices (given the dynamics of competitive pressures) for core assets just because they are located in New York City is necessarily or automatically a safer play than buying well-considered and underwritten assets in Toledo or Boise or St. Louis or any one of hundreds of smaller but very viable cities and towns across America. It comes down to the price being paid for those assets vs. their intrinsic value. Location clearly plays a key role in real estate (hence the mantra “location, location, location”), but choosing markets regardless of the price vs. value assessment is not, in my view, any safer or smarter than investing intelligently and selectively into secondary and tertiary, but perfectly practical and sustainable markets.
This is why I love investing in middle market real estate so much. The middle market is vast and fragmented. It constitutes the overwhelming majority of real estate asset-based investments transacted in the United States (certainly by number of transactions and I believe also by cumulative dollar volume). The sheer size and fragmentation give rise to market inefficiencies and thus greater opportunities to apply value investing concepts to real estate asset-based investing, even in market conditions like those we find ourselves in today. This is our response to investors who ask us how we are dealing with the coming recession. Namely, that value investing is in our DNA, that we always try to apply its principles in every market condition, and that consistent application of those principles helps to provide margin of safety and protect against market corrections.
The middle market presents both challenges and opportunities for investors. There is a large number of real estate entrepreneurs (managers, sponsors, operators, private lenders) who are experts in their asset strategy and local markets. The hardest and generally most loathed part of their business is raising capital and reporting to investors. They love real estate, they don’t love raising capital. It is just plain hard work and time consuming. But they have collective access to tremendous opportunities that provide ample prospects for investors to deploy very large amounts of capital while still adhering to fundamental value investing principles. This is a much more defensive strategy, in my judgement, than pivoting to high priced assets for which everyone else with massive investment allocations is competing.
From an investor standpoint, I admit that it is more difficult and time-consuming to sort through the chaff to find the wheat in the middle market. This is especially true for institutional investors and large family offices whose mandate requires the placement of much larger check sizes. It is not very practical for a typical endowment or sovereign wealth fund or multifamily office to take the time to underwrite an individual sponsor who is only capable of deploying $2 or $5 or $10 million (and sometimes even $50 or $100 million). But this fact can force them into a position of only being able to consider investments with a very limited number of sponsors or managers who are all chasing the same deals in New York, Washington, and San Francisco. Buying an office tower at a 4 cap and $600 per square foot and modeling annual rent increases for the next 5-10 years in order to project to a 12% IRR is not my idea of “value investing.”
This does not mean, of course, that investing in the middle market is without risk. Different investors have different challenges with accessing the middle market. For individual high net worth investors, they often do not understand how to underwrite and evaluate opportunities and therefore to effectively differentiate one investment from another. Institutional investors generally have more capability to do this in theory (they employ analysts and professionals with the experience and knowledge needed to do so), but in practice the relatively small sizes and high fragmentation can effectively preclude them from justifying the application of those resources. Therefore, middle market real estate sponsors are left having to access capital sub-optimally and devote far more time and effort to this side of their business than they’d like. But that is a subject to another blog…