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Quality Asset ≠ Quality Investment
January 19, 2020
Within the last month or so I went back and read all of Howard Marks’ investment memos dating back to 1990 and while Howard and Oaktree Capital focus on distressed debt and high yield bonds, I feel his lessons are highly transferable to all forms of investment and even life itself.
Is a High-Quality Asset a Great Investment?
A common misconception that Howard Marks frequently addresses in his memos is the idea that a high-quality asset must be a great investment. For example, in the bond markets a AAA bond must be a great investment or at the very least, be the least risky. Similarly, a B-grade bond is a “bad investment” as the rating agencies describe them as “generally lacking the qualities of an attractive investment”. Howard goes on to ask if a B grade bond could possibly be an attractive investment at a low enough price. Conversely, is there a high enough price that would make a 10-year US Treasury bond a poor investment? This introduces the concept that a great investment cannot only be based on the quality of the asset nor solely the price, but rather that quality and price are inextricably connected when determining value. “For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.” (“The Most Important Thing”, Marks 2003). This may seem rudimentary but many investors seem to overlook this very important connection.
In real estate, many investors lean towards the newest and nicest assets as the best investments. For example, they view a beautiful, newly-constructed high-rise apartment building in a city center as their ideal investment. The investor can see themselves living in this class A, luxury complex and believe that since it’s such a desirable property, demand must always be high, making it a very low risk investment. Further, these investors believe the tenant profile of class A apartments is much higher (confusing this with less risky). This type of investor (family offices, foreign capital, high net worth individuals) is willing to pay any price in order to outbid the competition for these highly-coveted assets.
There’s a saying, “any bond can become AAA at a certain price”. Real estate is no different. While traditional wisdom holds that buying a class B/C asset bears more risk than buying a class A asset, I believe there are ways to find better value(read: risk-adjusted return). However, I would like to posit that buying a class A urban high-rise with a 1.20x debt service coverage ratio is riskier than buying a class C apartment community in the same market at an 8% cap rate, at least from a credit default perspective.
Here are common objections as to why class B/C multifamily assets are commonly perceived as bad or risky investments:
- Older properties will invariably have higher deferred maintenance costs.
- Unappealing neighborhood, community, and apartment to live in (based on who’s lofty standards?).
- Higher instance of evictions and unpaid debt leading to write-offs.
Here are a few reasons why I believe class B/C multifamily product on average offer better risk-adjusted returns than class A assets:
- Global liquidity and low interest rates have driven and are continuing to drive foreign (and domestic) buyers into the US real estate market. Foreign investors and others being pushed into the US real estate market typically invest in class A assets and are not interested in learning the intricacies of a market in order to find good class B/C deals. This approach makes sense for buyers who are not familiar with a market or if real estate is not their main business as this is perceived as the safe route.
- Class B/C multifamily product is perceived to be higher risk and thus trade at higher cap rates. However, some of these aged or non-trophy assets have overstated risk profiles.
- Class B/C assets often offer a value-add proposition through renovations, addressing deferred maintenance, improving management, and sometimes complete marketing rebranding.
- Value-add has become somewhat of a meaningless buzzword these days as it is gratuitously slapped on to the description of almost every multifamily deal (“off-market” is grossly misused as well). However, true value-add opportunities are still one of the best ways to achieve outsized returns while mitigating risk by forcing appreciation through the implementation of a judicious business plan.
- Class A assets garner the highest rents and are therefore the first (and sometimes only class) to experience concessions, softening in rents, and see an increased vacancy when market conditions weaken. Conversely, affordable housing is more stable because the tenant profile for these assets are renters by necessity rather than choice. While rents may not be escalated as aggressively in affordable properties in boom times as they can be in class A properties, class B/C properties experience less fluctuations in occupancy simply because people do not have many options when it comes to affordable housing and will always need a place to sleep.
- Lastly, by the nature of class B/C being at least 15 years old, it is impossible to build more of it. Further exacerbating the issue, building costs have risen dramatically within the last decade (article), meaning developers are forced to build luxury properties in order to achieve their desired returns on their costs. The demand for affordable housing is rapidly growing while supply remains relatively stagnant if not shrinking.
I recently read a great article on www.nreionline.com addressing many of these points in detail. Here is a quote from the article I thought summed up the discussion well:
“Affordable housing properties tend to produce consistent, steady income from rents. In many markets, they are fully-occupied, dependable performers and can often be safer investments than conventional, class-A apartment buildings.”
Another article from www.nreionline.com covers the recent softening or even declines in rent for class A apartments, especially in primary markets. While I don’t want to get into a discussion about primary vs secondary vs tertiary markets, let’s just say I think there’s a healthy risk-adjusted return for investors who are willing to venture outside of your typical New York City, San Francisco, Los Angeles sandbox. Investors in the 1970s rushed to buy the famous nifty fifty stocks regardless of price because they were the best companies in America. Investors were not concerned about the price they were paying and instead were more concerned with not missing out or looking like an idiot for not betting on a “sure thing”. Of course, many of these stocks had P/E multiples over 60 (Polaroid had a 91 P/E multiple, McDonalds’ was 86) and consequently lost 90% of their value when reality set in. Today, real estate investors also are justifying extremely low cap rates in order to buy into the best markets and to own the “best assets”. Investors are willing to collect meager cash flows (or even negative cash flows) in hopes of owning an appreciating asset. While this strategy may work well over the long term, the markets do have a habit of shaking out these types of investors in times of volatility or economic downturns.
Inefficiency Presents Opportunity
Another salient point Howard Marks likes to make is the importance of exploiting inefficient markets and leave the efficient markets to the clairvoyants. If you received an MBA and learned about Modern Portfolio Theory (like I didn’t), then you were taught that the stock market is efficient, meaning every buyer and seller has roughly the same (legal) access to information and thus the sentiment of every buyer and seller is instantaneously reflected in the price. This efficiency leaves no bargains to be taken advantage of just as everyone on the freeway switching into the fast lane, makes it the slow lane. I like to say, “if it’s in the paper, it’s in the price”. This makes it very difficult to gain an edge in the stock market. Howard Marks takes great pains to explain that in order to make money in an efficient market like the stock market, one must take a contrarian position against the consensus. This is dubious for numerous reasons:
1) The consensus represents the aggregate position of all of the brightest minds (I like to think the stock market is a more competitive game than any other) in the world. Are you willing to bet against that?
2) Because the consensus will be right most of the time and the consensus is reflected in the price, there is no alpha in betting with the market.
3) Even if you do manage to develop a contrarian investment thesis, are you willing to hold that position for weeks, months, or years until it might finally prove right. Ray Dalio has said being too early is the same as being wrong.
So back to inefficiency. Markets that show signs of inefficiency present skilled operators opportunities to profit and generate returns in excess of their benchmark. Real estate is an exemplary inefficient market and while I have employed the use of multiple bullet and numbered lists thus far, I believe we can do with one more:
- Commercial real estate is illiquid (especially classes that are out of favor). Liquidity is almost a definition of an efficient market and thus real estate is nearly the opposite of the stock market in that sense.
- Real estate markets are decentralized. This means that a transaction in Mumbai, India scarcely impacts a transaction in London, England.
- Information is not widely available thus efforts can be made to create bargain buying opportunities. Conversely, there is no such thing as an off-market stock purchase. A great example of this is that Texas is a non-disclosure state meaning you are not obligated to tell the state the price you paid for a property, furthering the opaque nature of the information in the real estate market.
- Real estate involves emotions. People are willing to pay more or less based on things that have little to do with the income statement or overall investment.
While there are more reasons why real estate is an inefficient market, I’d rather spend time discussing how to directly profit from it. Multifamily already presents a very attractive risk-adjusted return especially when including the tax benefits and when compared to other popular investments, such as stocks and bonds. However, to get an even higher return without adding commensurate risk or even lowering risk, one must exploit inefficiencies in the market. The most common way to do this is to purchase a property below its market value. There are many ways to do this including finding an off-market opportunity (your friend’s cousin sells to you cheap because you are such a nice guy). Another way would be to purchase a portfolio of properties which is trading for less than its NAV (net asset value). See Blackstone’s acquisition of Equity Office Properties Trust for $39 billion (long analysis) as a prime example of this. Lastly, the market could be assigning a value to a property based on it being an extended stay hotel, but what would the value be if the property were repositioned to a multifamily complex? Repositioning, rebranding, and moderate to extensive value-add business plans are other ways to effectively buy an asset below its fair market value.
Today, we discussed how and why many investors misconstrue asset quality for investment quality. Pricing and performance are just as important as rating and quality. I’m hoping if I asked if you wanted to buy a Ferrari from me (I don’t have one yet), the first thing you would ask me is “how much?”. Lastly, we went over the advantages of operating in an inefficient market where bargains are possible through knowledge and skill.