How Are We Going To Lose Money?
“I just want to know where I’m going to die…so I never go there.”
-Charlie Munger
Risk is something we think a lot about. A mild obsession, actually. The question that is the title to this essay should be a fast 2nd thought to the much more natural one “How are we going to make money?”
If you’re going to invest in commercial real estate, with us or otherwise, where will the main threats come from? Four places:
Interest rates increasing. More correctly it would be cap rates increasing as a result of interest rates increasing- which are not the same thing. There is a spread between the interest rate market and the cap rate for a particular property type. That spread can change in lock step, less than, or more than the interest rate, creating a potentially different experience with cap rates than with interest rates.
If interest rates increase it’s important to note that this is not an operational risk to us. We would already own and operate property when this happens and, unless there is a very good reason, we will almost always secure fixed rate debt. Our income and expenses would be unaffected from rising rates. In fact, there is a historically positive relationship between interest rates and rents, meaning that when rates rise, oftentimes rents follow. Additionally, rising rates may mean higher mortgage costs which erect greater barriers to buying a house which generally benefits apartments.
It might mean, however, that cap rates rise and that buyers demand a lower price to purchase our asset during these times. This can absolutely have a negative effect on our returns. What’s of eminent importance here is that we preserve the ability to continue operating the asset and collecting a strong cash yield. Therefore, we favor structuring our financing such that we have maximum longevity flexibility and minimized potential of being prodded to sell or refinance at an inopportune time. We consider multiple exit timeframes, different prepayment types, and varying loan terms to strike a balance between increased prepayment costs and being built to weather storms. We plan up front so that if we go through a season of increasing cap rates our positioning is such that we’re happy to continue owning a productive asset and reaping the rewards for the hard work done upfront of selecting the property, buying it right, and re-positioning it. As history has clearly shown, particularly in this asset class, time is the friend of the well-chosen asset.
Increased supply. This is an operational risk and would manifest in higher vacancy costs and/or greater concession costs to stem vacancy. Class A properties are most susceptible to oversupply because very little new supply is lower than class A. Cost of land and construction don’t warrant the investment of building property with lower rent potential. In the medium term (through 2030), many markets are anticipated to have an under-supply of apartments, however, the supply in individual markets will get ahead of itself from time to time and expose existing apartment owners to temporary occupancy pressure.
We remain focused on Class B &C workforce housing which, while not immune to the effects of oversupply, is much better insulated.
Reduced demand. A poor location suffering from population shrinkage or household size growth will have much the same negative affect on a property’s operations as oversupply. Class C property is more vulnerable to economic contraction because the tenant base has a higher propensity of “doubling up” (increased household size). Class B properties offer a higher degree of protection as they usually serve a demographic that is somewhat less at risk during economic pull backs. In most locations, demand risk is less a factor than supply risk as demand risk is largely tied to overall economic recession, something that happens about 15% of the time: every 100 years’ passage will typically see 15 of recession.
Operator missteps. Many are the ways a sponsor can muff an investment. Among the most important are:
Inaccurate underwriting of an acquisition's income and expenses leading to paying too much, offering too little. There are penalties for both over aggressiveness and excessive caution- though between these two ditches, the one that contains the most investor wreckage is over aggressiveness.
Over/under improving units relative to market demand.
Inattentiveness to expenses- waste.
Inappropriate financing decisions.
Inappropriate insurance decisions.
There are two basic flavors of commercial real estate deals, and we can look through this lens to further break down operator mistakes.
Value-Add transactions are those that are not currently best positioned to achieve maximum rents and/or have inefficient expenses levels. They offer the ability make investments in the property to substantially improve an underperforming NOI in the first year or two of ownership. This type of transaction requires many more decisions by the operator and operator error mainly takes the form of execution risk while re-positioning the asset.
Momentum transactions are those that have already been re-positioned and very little in the way of improvements are needed upon acquisition. Here the strategy is to ride the assumed natural growth in NOI. Our philosophy with this type of transaction is that if you’re not going to have the control to bump NOI substantially in the first year or two by re-positioning the asset (and, importantly, therefore lack the ability to force your debt service coverage ratio higher), only the best locations, ones that offer low variance in occupancy and strong demographics, should be accepted for momentum plays. Here operator error mainly takes the form of property and submarket underwriting.
You should recognize the above four areas as the primary place where risk likes to hide. We remain alert to lurking risk, in all parts of the market cycle. While knowing where you’re going to die isn’t effective mortality prevention for a human, it certainly is for an investment.
Partnering with you in Excellence.
