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The Transparency of Investing in Brick and Mortar Real Estate

The private commercial real estate investment market will continue to grow.

One of the core truths in value investing is the need to understand the risks involved, and that sometimes the risks are far greater than the rewards. Today, however, investors in the public equity markets are blindly making bets on vast future growth without realizing that the rewards must meet the risks. Are those future profits really going to materialize?

As an example, there is much talk today about Tesla, a company characterized by Seth Klarman—one of the world’s foremost value investors and the founder of hedge fund Baupost Group—as “barely profitable,” yet its shares had soared “seemingly beyond all reason.” As reported by the Financial Times, in a private letter to investors in his fund, Klarman placed considerable blame on current central bank policies and government stimulus that convinced investors that risk “has simply vanished”, and that this has left the public equities market unable to fulfil its role as a price discovery mechanism.

Compare this irrational exuberance with the rigorous, and increasingly data-based, underwriting standards for investing in the hard commercial real estate asset class. One of the greatest attractions of investing in brick and mortar real estate is its transparency.

Simply put, you do not need to have faith; you need to have data. And therefore, the private commercial real estate investment market will continue to grow.

Fact-based underwriting standards and metrics applied to investing in brick and mortar real estate have been in place for decades. Lenders study market vacancy rates and new product coming to market. What are the historical rents, historical operating expenses, NOI? What will the mortgage be? These questions are part of authentic underwriting and how to do a deal.

In contrast, where is the data to show why Tesla should be trading at a 1,200 price-to-earnings ratio? Perhaps this has something to do with space travel? I am no expert in public equities, but no one seems to have an explanation why, in the middle of a pandemic, the S&P 500 is at an all-time high. Furthermore and regarding publicly traded tech companies, how can anyone predict cash flow levels 5 to 10 years in the future? Some of the safest brick and mortar real estate investments can be bought in the 4% cap rate range. This is equivalent to about a 20 price-to-earnings ratio. While the growth potential may not be similar to Tesla, there isn’t nearly as much downside.

With that, when an investor acquires a multifamily property, that said investor will proceed well-equipped with a wealth of data to evaluate downside and risk. I also believe that this is why there is no bubble in commercial real estate. The market has specific guidelines to protect against bubbles. Lenders are no longer offering financing at 100% loan-to-value. Today, it is 65 percent to 70 percent LTV. Banks are looking more closely at the sponsors and how much liquidity they have. They are looking at rent comparables and competing inventories.

With hard assets, the investor has more control. The investor sees real numbers and analyses to make evaluations. Even better, it has gotten easier to purchase and sell real estate over the past 20 to 30 years, because there is more transparency and efficiencies in the real estate markets. When hard assets trade, they generate valuable data. Risk meets reward.

Today, cap rates are depressed, and asset values of commercial real estate are inflated due to the cheap cost of capital. These facts notwithstanding, many real estate asset classes are underwritten with very stringent guidelines. Borrowers are putting a lot of capital into deals and the market is efficiently performing. I believe that hard real estate assets are priced fully, but not overpriced.

Many of my colleagues and I are predicting that approximately $200 billion of investment capital will come off the sidelines this year as investors re-enter the market after waiting out the uncertainty of 2020. Accordingly, we expect commercial real estate investment to rise by 50 percent in 2021’s second half.

To be sure, there are areas of risk. How will people travel, and how will people work in the future? With that said and when you look at the actual deals, the data reveals opportunities that are under-writable. Housing, triple-net retail, industrial and logistics are true to form underwriting situations. These are assets that can be underwritten for investors and offer more predictability. If you are looking for a rational market, look no further than the private commercial real estate market.

There are ways to invest in commercial real estate today that do not require the investor to make major bets on how people will work, travel, and live in the future. This includes hard assets that have undergone stress tests over the past eight months.

For example, an investor does not have to make a major bet on New York City’s economic recovery to buy into local workforce housing in Brooklyn or Queens. A 200-unit multifamily property will generate data to enable the investor to underwrite a cash flow. This investor is not seeking an opportunity to back a luxury resort development in Hawaii. In other words, you will not be required to predict the future to do well. Available data makes the situation transparent.

In short, there is no bubble in the private, hard-asset commercial real estate market. Stringent and rigorous underwriting guidelines, based on data, removes the need to predict the future. Properties are being priced efficiently. You do not need to have faith, but you do need to underwrite according to the wealth of data available to you. Because of the transparency that data provides, money is flowing into brick and mortar.

 

Jason S. Weissman is founder and senior partner with Boston Realty Advisors.

Source: https://www.wealthmanagement.com/investment/transparency-investing-brick-and-mortar-real-estate