Monday, February 23, 2009

Market Timing Doesn't Work - Don't Wait

Posted by: Scott Beggs
Investment Specialist
775 336 4644

Scott joined NAI Alliance in March 2008 to assist the company with investment sales. Previously, Beggs spent over seven years with Dermody Properties as Vice President of Acquisitions and Port Management.

When discussing current investment opportunities with investors, I have heard a lot of them say that they are expecting further deterioration in values and that they are going to wait for those opportunities to emerge. On the surface this seems logical. Why buy something today at a 10% cap rate, if you can buy a similar asset in a year for an 11% cap rate, or at a 12% cap rate in two years? Unfortunately, I think there is a bit of a flaw in this thinking.

Let’s test this strategy with a simple example. Assume that an investor has $1,000,000 and has the opportunity to buy an asset today at a 10% cap rate. Let’s further assume that the NOI grows at an average annual rate of 3.0% per year and that after 5 years the investor can sell the building for a 9.0% cap rate. Under that simple scenario, the investor would earn a 13.7% IRR. As an alternative let’s assume that same investor with $1,000,000 waits 1 year for cap rates to increase to 11.0%. In order to take advantage of that deal when it arises, the investors will have to put his or her money in a low yielding liquid account like a CD which is earning less than 2%. Under that acquisition scenario and assuming the same growth rate and exit cap rate assumptions the investor would earn an IRR of 14.1%. This is not a huge premium over the return that an investor could earn today without taking the risk that these future opportunities emerge. If you extend the waiting period out 2 years and assume that cap rates move to 12% (a 20% decline in values) the investor would earn the very same IRR as in the base case . . . 13.7%.

And what if the expectations for further declines prove false? Let’s say you wait 2 years and cap rates are still 10%. Under that scenario your IRR would be 9.5%.

The point is, you can wait and wait for the exact right deal, but there is no surety that that deal will in fact come along. And as you wait, your holding period return is being weighed down by the fact that in order to take advantage of those future deals, you’ll be earning a near 0% real return as the cost of liquidity. Be confident in your underwriting, capitalize the deal correctly, manage the hell out of the building and be confident that in five years, the world will be getting back to normal. I know that it is tough to have a long-term view in this very difficult climate, but don’t get so mired in the expectation of further value declines that you lose site of the goal of earning the highest total return you can given your current investment time horizon.

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