Lately, an increasing amount of investors have asked us what will happen in the US real estate market.
“Is the real estate market going to hold up?”
“What’s going to happen with the 2020 election?”
“Do you think the Fed will continue hiking rates?”
“Are markets going to adjust?”
All good questions. We usually throw it right back and ask, “What do you think? Let’s walk through the scenarios together.”
The investors usually reference data points they gathered and talk about the long bull cycle, the dynamics in the US government, recent stock market volatiliy, but struggle to come up with one solid conclusion.
We ask them, “Are you more or less sure of the future?”
Most answer: Less
This thread of conversation shows me two things: 1. Most investors are expecting increasing uncertainties in the US economy; and 2. Most investors want to shift asset allocation to have a defensive portfolio, such as in real estate.
Let’s discuss uncertainty first. When we are confident about something, be it a stock, a real estate asset, or any other investment, it means that we believe with a high likelihood that it will meet or exceed a targeted return. When investors are confident about the outcome of an investment, they tend to put more money into that particular investment.
However, with increased uncertainty, the variance of potential outcomes increases. This means that investors tend to have less confidence in the “base-case” projected outcome. Simply, investors become skeptical of the projected returns. As variance increases, we tend to see the markets as more “volatile”, which in turn fuels uncertainty.
Low volatility, high confidence environments tend to have an upward bias. This means that the markets, and its investors tend to assign more optimistic values to future returns. For example, if a market is growing at 5% per annum, and the investor feels confident that the market will remain steady, he may continue to project 5% growth, or even 6% or 7% growth. If nothing else changes except the investor’s certainty, then he should logically assign as much probability to 3% as to 7% growth. However, this is not the case as people tend to project growth “upwards” using the current growth rate as the “base-case”.
Below are two normal distribution bell curves illustrating the above point. The return distribution under normal market conditions (line 1), shows normal variance around the projected return of an investment. Pure uncertainty, with no directional bias, should increase variance on both ends of the Base Case Expected Return (x). The grey curve shows a return distribution under Increased Uncertainty (2a). This illustrates how increased variance increases the potential of outcomes on either side of (x). The areas under far left and the far right sides of (2a) both increase equally.
However, real life does not work that way. Therefore, when the investors feel more uncertainty, it is with a negative bias. Seldom do we hear investors say, “I’m less confident in the markets, but I’m pretty sure they’ll go up higher than I thought.” Rather, I frequently hear people say, “If I’m uncertain about the markets, it’s a good time to be more defensive.
So reality may look more like the chart below, where the outcome set may shift more pessimistically. Taking the growth example above, an investor might think growth at 3% is more likely than growth at 7%, because when people lose confidence in their ability to predict future outcomes, they tend to be more pessimistic.
The chart above illustrates the pessimistic shift. With increased uncertainty, not only does (2b) widen at the “tail ends,” but also the mean expected return shifted lower. In this scenario, if the Base Case Expected Return (x) of an investment is not adjusted, then not only is the probability of hitting that return diminished, but also the probability of underperforming increases dramatically. The area under (2b) to the left of (x) increases substantially. An investment that is using current market conditions for projections while investors are feeling increased uncertainty is setting itself up to underperform.
If, however, investments are underwritten to be conservative, with limited variance in its performance, they increase their chances to outperform their investors’ expectations.
In the chart above, the investment’s Base Case Expected Return (x) is underwritten to be defensive, shifting to a Convervative Base Case Expected Return (y). In addition, the investment is structured to decrease the variance around (y), creating a Defensive Investment Return Distribution (3). This means that if the market conditions turn out to be better than expected, then there’s significant room for outperformance, shown as the area on the right side of (y) under Normal Market Conditions (1). But it shows investors what would happen if the market takes a downturn and uses that as the starting hypothesis.
The chart below puts it altogether now.
Let’s walk through the chart above.
The next logical question is now, “How do I know when underwriting is conservative? Everyone claims to be conservative!”
Indeed, rarely do we hear managers boast about aggressive assumptions. Instead, they focus on the low probability, highly successful outcomes. Managers want to cater to our natural tendency to play “not to lose” and penchance for “capital preservation.” Hence the phrase “… under-promise and over-deliver” has become a cliché in investor presentations. This is not to say there aren’t true conservative underwriters in the marketplace, but investors should take a step back and evaluate whether a manager is objectively being conservative.
This involves rolling up the sleeves and delving into the underwriting assumptions. Let’s take the real estate market in Dallas, Texas as an example. In the previous 5 years 3% annual growth was considered the typical, average growth for many assumptions, including projected revenue and expense.
If a project is in what is perceived as a high growth market, the expectation is that revenue appreciation will be above average. In this case, a company may underwrite revenue at 3% annual growth and refer to it as conservative underwriting only because market participants, including that company, are bullish on that specific real estate market. However, with the benefit of hindsight, we see that a Dallas real estate project underwritten with 3% annual rent growth may have barely hit its revenue projections over the past 5 years. And this was in one of the hottest markets in the country.
As you can see, actual rent growth increased slightly in the first three years, then decreased dramatically to 1.56% from 2014 until 2018, but the “average” growth stayed at 3 percent. Taking it one step further and shifting the projections to now and today, is it prudent to think that 3% rental growth for the next five years is a conservative view of the market going forward? If that is the underlying assumption, how has the investment stress-tested its projections in light of the above chart?
We know that there will always be variance around projected returns. So what kind of stress tests has the sponsors done to show the variance of returns in different circumstances. Using the above example, where does a -1% growth push returns? What about -5%? In contrast, where would 5% growth push returns? These are the types of questions that will start you on the path to truly understand the potential risks and potential rewards of a project.
It is important to determine whether the range of assumptions is fair and in line with your expectations. If so, then it is crucial to determine whether the set of possible outcomes are acceptable. If the above investment stands to lose capital if rent growth ever becomes negative, and you believe that is a strong possibility, then perhaps the investment’s underwriting is not sufficiently conservative.
In closing, it’s important to consider forward-looking market volatility and adjust expectations accordingly. The tendency for market participants is to assume the average in times of uncertainty and adjust expectations only after the broader markets have adjusted. A different approach, and in our opinion a better approach, is to take into account the probability of different outcomes, both good and bad, in a volatile market, truly understand the impact of such outcomes on the investment, and temper expectations accordingly.
Stayed tuned and happy investing!