Thursday, February 5, 2009

Vulture Investors

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.

Despite the fact that the volume of commercial real estate transactions fell tremendously in the second half of 2008, there is still a fairly large number of real estate investors in the market looking for opportunities. That’s the good news for sellers. The bad news is that most of these investors fall into the category of “opportunistic” or “vulture” investors. These types of investors have very high return requirements which force them into being extremely conservative in their underwriting and offer what on the surface are very low prices for real estate.

A few weeks back I was having a conversation with a local commercial real estate investor. During our discussion he asked, “How can you make money in commercial real estate these days?” I responded to that inquiry with a question of my own, “How do you define ‘making money’?” My response was not intended to be flippant. Rather it was to suggest that from a long-run historical perspective the expectation for “making money” in real estate has been much more modest than the expectations of today. The return expectations of today are being overly influenced by the excess returns earned a few years ago during the run-up in values, and by the expectation of financial duress, which is not always the reality.

During the period of cap rate compression which ran from 2004 to mid-2007, considerable wealth was created. Many investors realized significant gains in the value of their real estate holdings during that period. The really smart investors (or lucky, depending upon your view) were able to realize those gains by selling their assets prior to 2007. Some investors mistakenly view the returns generated during that period as normal, and are now expecting to replicate and exceed such returns on new investments. The primary problem I have with this viewpoint is in thinking that those gains are “normal” and replicable on a go-forward basis.

I fully admit that the risk of real estate ownership has increased as a result of the current global recession. Finance theory would suggest that this increased risk should result in increased returns (i.e. a “risk premium”). The question becomes, “Should this new ‘risk premium’ be added to the excess returns earned during the run-up in values in the middle part of this decade or should it add to a more normalized average return? Further, what is the average return that investors should expect when investing in real estate.

Rather than state an unsupported opinion, I thought I would try to provide a factual context to the question of what is a “normal” real estate return. The National Council of Real Estate Investment Fiduciaries (NCREIF) produces an index of commercial real estate returns. This index measures both the income and appreciation of commercial real estate values based on reported returns from assets around the country. From 1978 to 2008 the average annual return on the index was 10.2%. If we assume that the income component of this return was 8.0% that would mean that the appreciation component was roughly 2.0%. This time period includes the severe real estate recession of the early 1990’s as well as the sharp run-up in values from 2004 to 2007. During this four year run-up the average returns were 16.7% or 650 basis points above the long-run average. I would suggest that investors should look to the long-run average return as their benchmark, not the excess returns enjoyed during a period of aberration in the commercial real estate market. I would suggest that investors looking for 25%, 35% or even 45% returns need to remind themselves of what is a “normal” real estate return objective.

During another conversation with a group that I would characterize as “vulture” investors, we started discussing some of the various assumptions in the underwriting equation for a project (i.e. Market Rent, Downtime, Absorption Periods, etc). This “vulture investor” took every market assumption that was suggested and then discounted it by 10%. By doing so, this investor effectively eliminated the risk of achieving each of these assumptions. This concept is fine if the investor then solves for the purchase price using a reasonable stabilized real estate return objective (cap rate, discount rate, etc.), but instead this investor solved for the price using an extremely high rate of return. I would characterize this as wanting their cake and eating it too. If all of the risk of a deal is effectively eliminated by applying highly conservative assumptions, why should that investor also earn an inflated return? I would suggest if you are not willing to take on normal real estate risk, maybe you should be putting your money in 5-year Treasuries and earning 1.93%.

The decline in transaction volume in 2008 is an indicator that the Buyer’s pricing model has diverged from that of the Sellers. Based on Washoe County Assessor’s office data, the number of commercial sales (non-residential sales greater than $1,000,000) declined from 255 in 2007 to 132 in 2008. The average price of those sales declined from $11,912,908 in 2007 to $6,211,398 last year. This drop-off is symptomatic of the divergence in valuation between Buyers and Sellers.

So who is right? As with many things, I think the answer is that they both are. There will likely be deals that get done over the next 12 to 18 months at what I would describe as “vulture pricing”. These deals will be driven by the lenders (banks, life companies, etc), not the equity stakeholders. There will also be deals that get done at what I would consider more stabilized pricing. These deals will be driven by real estate investors with a reasonable perspective as to the long-run average returns to be expected in real estate and sellers that can disregard the pricing aberration that existed just a few short years ago. In the meantime, both Buyers and Sellers should not be offended that the other has a different view as to the value of real estate in this market.

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