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Why Returns are Different Today

January 19, 2020

After attending the Intelligent Investor Real Estate Conference in Marina Del Rey, California a few months ago, I had lots to think about. An interesting conversation I had was about risk and return (of course – my favorite topic). I debated over whether sponsors/investors should pick a return projection then go out to the market and find investments that match that return requirement. For example, pension funds with an 8% actuarial assumption or multifamily sponsors with 14% IRR targets. This may seem like a simple and straightforward process but this way of thinking can actually become hazardous and/or lead to underperformance. The reason being is due to the many cycles found in economics and investment – business cycle, market cycle, interest rates, and investor sentiment. In various periods of history, it has been quite easy for pension funds to achieve an 8% return from a mix of stocks, high-grade bonds, and a small allocation to more speculative investments. Other times (like today), it is nearly impossible for pension funds to achieve this level of return without drastically shifting their allocations and taking more risk. As I mentioned previously, there are many factors influencing the availability of relative returns but the single largest (and quantitative) variable is interest rates. This is why I believe one’s return expectations should always be based on the Fed rate as well as sovereign yields (US treasuries for domestic investments). This enables you to dynamically adjust your expectations and ideally enable you to pursue and capture not only higher relative returns but better absolute, risk-adjusted returns as well.

However, the most important part of this idea is the way this line of thinking discourages an investor to become yield seeking in times of relative low yield. To put it simply, let’s say you normally think 20% IRR on a value-add multifamily deal is a good investment. Yet, today the spread between the 10-year treasury yield and prevailing cap rates is 200 basis points (this means not only are treasury yields historically low, but cap rates have compressed more than the drop in treasury yields which leads to a decreased risk-free rate as well as lower spreads). There is no way that same 20% IRR is achievable today. In order to get that previously achievable 20% IRR, one must take more risk. This change in the prospective return of all assets can push investors to take higher risk unbeknownst to them. A passive investor in a multifamily syndication may have gotten accustomed to seeing 20%+ IRR deals over the last 8 years and expect the next one they invest in (which is still being projected at a respectable 18% IRR) has a similar business plan and takes on similar risks. However, what is really most likely to be the case is that the sponsor has (1) moved further out on the risk spectrum in order to present his investors a deal that underwrites at previously achievable returns at their typical “value-add business plan” risk level or (2) has made their underwriting unacceptably aggressive and does not reflect reality. Truthfully, the latter is less pernicious to investors’ pockets than the former since the same level of risk is being employed, just the true prospective returns are lower than what investors have become accustomed to during this long up-cycle. The former is actually quite scary because investors are assuming they are going to get the same return yet don’t realize it may be at a much higher risk.

You may be wondering why 20% returns are no longer achievable especially since the U.S. economy is now firing on all cylinders as opposed to the sluggish growth characterizing the first half-dozen years of the recovery. Paradoxically, the slow growth and poor outlook on economic growth observed in 2010 to 2013 is exactly what made that time such a brilliant period to invest. The Fed was trying it’s best to stimulate the economy via billions of dollars in quantitative easing as well as rates near zero. Meanwhile, investors were scared and multifamily properties were trading for 8% to 10% cap rates. With 10-year bonds yielding less than 1%, that’s a 900 basis point spread! Fast forward to today, interest rates are moving higher while cap rates are remaining stubbornly low, providing a meager spread (~200-250 for value-add). The reasons for interest rates moving higher are fairly clear and cyclical: The Fed is keeping a close eye on growth and inflation and wants to be prepared for the next recession (have high enough rates so they can be cut to stimulate the economy). However, I believe the story behind cap rates to be a bit more complex.

Cap rates on multifamily (especially class B/C value-add deals) are low today for two main reasons: one is cyclical and the other is secular. First, like any other financial product, multifamily cap rates are correlated to interest rates. As an investor, my decision to invest in something must be based on the relative attractiveness of the investment as well as the risk-free rate. This, in part, explains the dramatic decline in cap rates throughout the last 10 years. Secondly, profound shifts in demographics as well as in the way Americans live (renting has become much more fashionable and due to anemic wage growth and the distrust of owning a home created by the 2008 financial crisis, Americans are heavily skewed towards renting either out of necessity or by choice. This is a massive tailwind for multifamily demand but guess what? Everyone knows this so capital inflow to the asset class is unprecedented, further driving down yields. Additionally, pension funds, endowments, and other major asset allocators used to have a very modest allocation to real estate. However, today, these same institutions are disproportionately allocated to real estate in order to help achieve their actuarial assumptions. In my opinion, these reasons are going to keep cap rates lower than they had been in previous cycles. I don’t think we will ever see 10% caps on solid multifamily in Dallas ever again, marking ~2010 one of the best buying opportunities in history. Lastly, I don’t think the Fed will ever have the luxury of raising its rate anywhere near 5%. I buy Janet Yellen’s prescient hypothesis from years ago that 2% to 2.5% is the new neutral. This permanently lower interest rate environment will also fundamentally change the range in which cap rates move going forward.

The mention above about demographic tailwinds compels me to share an idea I came across on www.realestatecrowdfundingreview.com. The article (LINK) explains that almost all sponsors use the demographic argument to bolster their investment thesis. The pitch goes something like this, “baby boomers are retiring by the millions every year and statistics show that they choose to be renters in retirement. We are excited to take advantage of this trend by purchasing this multifamily property”. However, this article makes the claim and uses evidence to support the idea that these widely known and accepted trends actually do not result in increases in NOI. This is because, since they are widely known, developers take advantage of them and create new supply to help support the burgeoning demand created by these large, secular trends. Lastly, the article does point out that supply constrained markets actually do benefit from increased NOI, however, I’d argue that investor demand compresses going-in yields effectively mitigating the benefits in supply constrained markets as well. In the end, there is no free lunch and the only way to achieve outsized, risk-adjusted returns relative to the market is to make contrarian bets, not by riding the wave of an obvious trend. As Charlie Munger likes to say, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” (LINK)