Undoubtedly, we have been in a low return world for quite some time. More specifically, yields have become increasingly smaller which has led to higher valuations. To exacerbate the situation, risk-free or benchmark rates (10-year treasury yield) are near historical lows and the cap rate spreads above these already low yields, have shrunk significantly. On the other hand, NOI has kept up with valuations throughout most of this cycle. Nonetheless, this upward rise in prices may convince some investors to not heed the warning of low yields and continue to invest based on the assumption of appreciation. However, this is not always possible nor attractive for cash flow investors, institutions with actuarial assumptions, or those who are realistic about the future outlook of growth and values.
We are at a point where it is difficult to argue that yields could compress further, meaning that all price increases must come from NOI growth. This obviously calls for value-add business plans but this space has been inundated with capital, thus driving down projected returns to the point where the spread between core and value add is near an all-time low. According to Howard Marks, there are six ways to invest in a low return world; some of them are more realistic while other are unlikely or facetious.
1. Invest as you always have and assume you will achieve the same returns as before.
2. Increase your risk profile so your projectedreturns are the same as before.
3. Invest as you always have and accept a lower projected return.
4. Decrease your risk profile and accept even lower projected returns.
5. Go to cash (or liquid, risk-free assets)
6. Focus on niche asset classes and strategies as well as managers with unique abilities.
As you can see, there are multiple approaches an investment company or individual can take based on their needs.
Option One – Invest as you always have and assume you will achieve the same returns as before.
This option is included partially for comedic effect. While you aren’t exposing yourself to more risk (aside from mismanaging investor expectations if you are a manager), this is not really a logical option. This option is most similar to option 3 which is a valid approach to navigating through a low return world.
Option Two – Increase your risk profile so your projected returns are the same as before.
Most market participants have increased their risk profile in order to get deals to underwrite to the same projected returns as before when good, value-add B class property could be bought for a 6% cap or better. Buyers who previously were content with core-plus returns, incorporating modest value-add, and permanent financing are now pursuing messy C class property with bridge debt. In my opinion, taking on higher levels of risk at a time when the market is not paying you an incrementally higher risk premium is simply not worth it. At the top of the cycle (now), the incremental increase in projected returns per unit of risk is smaller. This line of thinking removes option number two for me since you are not adequately compensated for the added risk at a time when things are already most risky (top of the cycle). Markets do have their own idiosyncratic cycles relating to rent growth, vacancy, and new supply which is why we are focusing on Houston which currently shows favorable supply demand dynamics and is the only market in its recovery phase, according to Integra Realty Resources. Nonetheless, the general market, influenced by national and global investor demand and the capital markets, has a much stronger effect on valuations.
Option Three – Invest as you always have and accept a lower projected return.
This option is extremely logical and one that I am in favor of. To assume/project the same returns as in earlier parts of the cycle is foolish at best and disingenuous at worst. Keeping your risk profile and strategy the same will mitigate risk due to expertise.
Option Four – Decrease your risk profile and accept even lower projected returns.
At the top of the cycle, much of the smart money is doing exactly this. Conservative investors are buying higher quality assets than before and taking on less execution risk. This isn’t easy for most since there is nothing compelling about sub-5% cash on cash returns and 10% IRR. However, this strategy is more realistic and more robust in a recession. A caveat is that class A multifamily, which is typically considered less risky than class B/C, may prove to be riskier in a downturn as the class’ basis is extremely high and NOI may suffer more than B/C class assets. The main concerns are stability of income and debt service coverage ratios. You can’t lose with stable income and high DSCR.
Option Five – Go to cash (or liquid, risk-free assets)
This option is unrealistic for most and is not likely to produce the best results. Furthermore, not making investments as a manager while the market remains sanguine is an easy way to look like a heretic, preaching that the next recession is coming next year, every year. Howard Marks, an extremely conservative investor, has been preaching that the investing markets of the world are potentially a dangerous place since 2015. Nonetheless, he claims his $130B firm is buying every day and attempts to remain fully invested.
Option Six – Focus on niche asset classes and strategies as well as managers with unique abilities.
Many investors at the top of the market start to look for creative solutions to their low return problems. They are looking for a silver bullet or a magical strategy that will provide them alpha. This idea isn’t completely without merit. There are adjustments one can make to his or her strategy in order to find good returns. However, this comes with a warning: Investing in a strategy that is new to you adds a layer of risk which cannot be overlooked. For example, many multifamily investors are currently being wooed by the ostensible stability and higher cash flows of mobile home parks. Historically, mobile homes have proven to be an overlooked and resilient asset class that has fared well through recessions. However, their operations are very different and just like anything else, require expertise. An additional problem with turning to niche strategies is that there is likely a flood of capital joining you in this flight to alternative investment. The nature of an alternative or niche asset class or strategy is that it is small and thus cannot handle large capital inflows. This means that it is much easier to drive projected returns down for niche investments through capital inflows than it is in the stock market. The stock market (and other large asset classes) are capable of absorbing billions of dollars without pushing up valuations. We are exploring unique strategies but remain cautious, as Howard Marks says, “when there is nothing creative to do, the worst thing you can be is creative”.
What Works for Us
We have largely kept our risk profile the same and continue to underwrite deals realistically, which reflects in lower projected returns. The market has its uncertainties but I don’t think it is warranted to lower the amount of risk we are taking. We remain comfortable with bridge debt as it is the best and sometimes only way to implement a comprehensive value-add business plan. We are exploring unique strategies such as ground lease execution, tokenization and HUD financing in order to increase our risk-adjusted returns.
What option have you been taking for the last few years?