... investing in higher cap rate properties, in less expensive markets nationwide, consistently deliver higher returns on a risk adjusted basis than focusing on quality properties in expensive cities. These results underscore the idea that Value Investing is as valid for real estate as it is for most other asset classes, be they stock, bonds, commodities, etc. and point to alternative real estate investment strategies you may want to consider further.
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The question of whether low cap rate or high cap rate properties are better investments goes back to Warren Buffet’s idea of value investing. The basic tenet of value investing is to invest in assets that are undervalued in some way; those that are not necessarily the most glamorous investments, but that are undervalued for some reason, and to invest in those.
All kinds of academic studies going back to the 1980s that have found that value stocks generally outperform growth stocks. More recently other asset classes – stocks, stock indices, currencies, commodities, bonds – all have been examined to compare how value investments perform relative to growth investments and these too have consistently shown that value investing outperform growth investing. But Geg MacKinnon and his at the Pension Real Estate Association (PREA), and his co-authors, realized that this same effect had not been examined yet in real estate and their study fills this gap.
Typically for most RE investor, when you talk about value you talk about whether the price is high or is it low and the core measure of this is the capitalization (‘cap’) rate. Initial question, then, is ‘do high cap rate properties do better than low cap rate properties’. Though this is a basic starting point, it is one that is very applicable to investors and investment managers as far as how they define their investment strategy – which kind of property, high or low cap properties, to invest in.
The first step in the analysis was to take National Council of Real Estate Investment Fiduciaries (‘NACREIF’) data and categorize the assets in their dbase according to those with high and those with low cap rates. First the researchers controlled for both time – when was a cap rate measured (1970s vs. 1990s for example) – and then for location; where in the U.S. was the property located. Each property in the dbase was then compared to the average at the same time and place for other assets in its class, be it office, apartment, industrial etc. Once that task was completed, the top 30% were defined as having high cap rates, and the bottom 30% were defined as having had low cap rates. Every asset was then analyzed for how it performed over time, and the results were consolidated to see how the assets with different cap rates performed relative to others.
Results show that low cap rate investments are significantly better investments than low cap rate properties. This result holds in absolute terms, in risk adjusted terms, holds across property types, across time.
The (statistically significant) results are, on average:
Of course, the next question is, well, what about risk? Risk was addressed in the study by looking at the frequency by which these results held true over the course of the study period – 1979 - 2010. The upshot was that higher cap rate assets (cheaper properties) consistently outperformed low cap rate (expensive properties) more than 70% of the time across all property types.
Here are the specific results:
Summary: Higher cap rate properties (cheaper ones) consistently yield higher risk adjusted returns.
Is it better to buy a cheap property in an expensive market, or is it better to buy an expensive property in a cheap market? Put another way, are you better off going to Manhattan, which is a high cap rate, expensive market, and buying a cheaper property, or are you better off going to Cleveland or St. Louis or someplace like that, that is a cheap market, and get a relatively expensive property.
What was discovered in the study was that if you look at cheap metropolitan areas, in, say, office for example, i.e. those with the higher cap rates, and you look at properties within those markets with lower relative cap rates, i.e. those that are relatively expensive for the cheap metro areas, what you find is that those types of properties historically enjoy a return of 5.3%. However, if you look at low cap rate markets i.e. expensive market, and you look at the higher i.e. cheaper properties there, the average return there is 4.6%. In short, relatively expensive office properties in cheap markets do better than cheap office properties in expensive markets. For apartments relatively expensive properties in cheap markets do about the same as average properties in
From the value investment standpoint, what applies fairly universally across all property types is that high cap rate investments do better than low cap rate ones. There is a very distinct pattern across the country where cheaper metros do better than more expensive ones on average. If you look within metros, what you find is that the cheaper properties do better than the more expensive ones. So, no matter which way you look at it, high cap rate (cheaper) properties, do better than low cap rate (more expensive) properties.
The typical fund manager will only look at the big major markets, i.e. the higher cost (lower cap rate) markets, and will concentrate on the highest quality properties which, presumably, have the lowest cap rates. But these are not the assets that are going to be delivering the highest risk adjusted returns when applying value investing principles. While some may consider it counter-intuitive for real estate because investing in the ‘highest quality assets’ is the accepted standard, it is, actually, totally intuitive to apply value investing principles to real estate because it works across all other asset classes so why not in real estate also.
The idea of investing in a more expensive property in order to maximize returns is premised on the assumption that these kinds of assets will deliver higher capital appreciation that will compensate for the lower yields. But that is not what this study finds. What the study finds is that not only do expensive properties not experience capital appreciation sufficient to compensate for their lower yields, but, in fact, cheaper properties appreciate at a faster rate than do more expensive ones.
In a sense, therefore, it is a contrarian tale of investing in markets and properties that other people – or at least the larger institutional investors – are not. And it is precisely that lack of attention from the bigger investors, institutional, sovereign wealth fund investors, that drives the result.
AMANDA HITE, PRESIDENT, CEO STR
Amanda Hite joined STR in Jan 2006 when the company had one office in Hendersonville with 65 people. She became president and CEO in 2011 and in that role sets company policy and strategy while overseeing daily operations and implementing initiatives for STR's family of companies: Hotel News Now (HNN), based in Cleveland, Ohio and STR’s international headquarters, in London. She is a member of the boards of directors of the U.S. Travel Association (USTA) and the Hendersonville Chamber of Commerce. Today STR has 300 employees worldwide, with 170 situated at the corporate headquarters in Hendersonville, Tennessee, an international office headquartered in London, a regional office in Singapore, and, in total, 16 offices in 15 countries... and a network of 57,000 contributing hotels worldwide. Hardly any wonder they are the most important voice in the industry.
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THE STR REPORT
The STR Report was originally called, and continues to be called, the “Smith Travel and Accommodation Report”. It is the aggregation of data voluntarily supplied by hotels to STR that describes how a set of competing hotels , the ‘compset’, is performing financially relative to a client hotel. In short the STR report provides a competitive set benchmarking tool to a hotel operator by comparing it against those other hotels that it sees as being competitive to itself. Hotels provide their financial results to STR and in return are given market level data at no cost. Or STR will provide compset data to hotel operators who by such data.
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REVPAR – A MEASURE UPON WHICH BONUSES ARE BASED
The key data points that hotel s look at are occupancy and the average daily rate, but the key metric that drives decisions is what is called ‘Revpar’, or, revenue per available room. This is calculate by looking at total revenue divided by the total number of available rooms. The Revpar index is the metric that most hotels use to evaluate their own performance. Having been in the industry for over 30 years, STR knows that all staff meetings for hotels are usually planned around the delivery of their STR report and in many hotels the general manager’s bonus is tied to performance against the Revpar index.
HOTEL INDUSTRY: NEVER BUILT ITSELF INTO A RECESSION
Unique, perhaps, in commercial real estate, the hotel sector has ‘never sent itself into a downturn through overbuilding.’ Any time the sector has had a downturn it has been brought about by external macro-economic factors, and not through the building of excess supply. And each time there has been a downturn for hotels, the impact has been more dramatic than the last time. This is likely due to the continuing improvement in the availability of data in the industry, both on the consumer side and the operator side. When a consumer wants to book a room, there are countless ways that they can find different rates for that same room. Similarly, when an operator sees a competitor reducing rates next door, they can adjust their rates almost simultaneously and this can lead to a more rapid and precipitous drop in rates and bookings and consequently in the all important Revpar measure.
After the last downturn, the transient demand for rooms came back quickly, but room rates did not climb as quickly as had been expected. Hotels are selling more rooms than ever before in the industry, but there are more rooms to sell than ever before, so the hot topic is the new supply and what will be the impact of that supply as it comes on stream.
GROWTH OF 2% FORECAST FOR 2017
In total STR tracks in-construction, final planning, and planning phase pipeline, which are the ‘under contract’ pipeline. As of June 2017, there are 580,000 rooms under contract, meaning planned to be built… though possibly not all of those will actually end up being built. Of those that are actually in construction and coming out of the ground, there are 189,000 rooms in America currently actually being built – which is an 18% increase over where the industry was a year earlier in 2016. In fact, every year for the last five years the industry has seen that growth increase. The prior peak of under construction in 2007 there were 211,000 rooms under construction – so only about 22,000 off that prior peak of new, under construction rooms.
There are 1.8 billion room nights as of April 2017 to sell, of which 1.2 billion were sold. Growth rate for supply is 1.7% for the 12 months to April 2017, although the total growth rate for 2017 is going to end up around 2% i.e. 2% more rooms in 2017 than in 2016, in the US. In the prior cycle, in 2006, there were a lot of rooms being closed to be used for other, non-hotel, purposes, but this time around this trend is not as pronounced – only around 25,000 or so rooms being closed in a year now, compared with 2006 when some 40,000 rooms were being closed and repurposed.
LIMITED SERVICE DOMINATES GROWTH
Of the rooms being built today, and there are lot, are mainly in the upper-mid scale, and upscale rooms ‘chainscale’ with 65% of all rooms in construction in these two segments. And those are the limited/select service segments, i.e. Courtyard by Marriot, Hampton Inn, Holiday Inn Express… not full service, no restaurant, room service and the like. And so because most of the rooms coming on are of the limited service kind, this may be contributing to the slower than expected growth in revpar despite the increase in number of rooms.
Construction in top 26 markets is showing some very fast growing cities. Nashville, for example, has 13% of the existing market coming on stream, New York has 14% additional to the existing supply in construction – this compared with only 2% nationwide. New York has been top of the list for the last three years. As an operator in New York it has been challenging because so much supply has come into the market – with almost 16,000 additional rooms currently under construction just in New York, which is an additional 14% coming into the market.
IMPACT OF AIRBNB
So how does this considerable growth in hotel rooms tally with the growth in competitive options like Airbnb and the like? Well, a lot of times those folk coming to stay in an Airbnb room in New York, for example, may simply not have been able to come to the city before and stay in a hotel, so to that extent it is expanding the market for travelers, rather than splitting the market. Millennials and the so called ‘experience economy’ are boosting demand in ways not before seen, and hotel rooms are being sold at volumes more than ever before. People are travelling more than ever before – not the group business – but the single traveler traveling either for business or in pursuit of experiences away from home. And the trend is that people are traveling not just during the traditional summer months, but throughout the year which further broadens demand.
Societal changes are being reflected in the supply coming on of limited service hotels where travelers do not necessarily want a full service restaurant to go sit down in in their hotel, they would rather go out and ‘live like a local’ when they go out. They like having an inviting lobby to sit down in and have drink, with perhaps some light food, but are there to experience the people around them. They want free wifi included in the room rate that is provided to them, and this is also a reflection of the way that work habits are changing also. With more employers allowing staff to work from home or remotely, and people becoming more accustomed to working wherever there is free wifi, this has also had an impact on the demand for travel and the kinds of things that such travelers are demanding when they are on the road. And this trend is being seen in the kinds of hotels that are being built i.e. those that accommodate that kind of traveler.
FORECAST
STR is forecasting slowing growth overall, with a negative occupancy growth rate for the end of 2017 because of all the new supply coming into the market – new supply of 2% but negative occupancy growth as demand catches up with the new room supply. Revpar is forecast at around 2.5% for 2017, and average daily rate (ADR) being at around 2.2% increase over 2016. The trend for 2017 and 2018 is that for any kind of revpar growth, the growth is going to have to come from ADR growth because, although the demand is there, occupancy rates are going to decline because of the new supply. So this presents an area to watch: As occupancy rates decline, it is counterintuitive to increase prices in order to maintain the all important revpar. That said, there were two periods during the 1990’s where this phenomena was seen i.e. where there have been declining occupancy but increasing ADR. STR expects that this will be repeated in the current market.
STR is a focusing on shifting from an email delivery system to an online delivery system for the data that they produce, including improvements in intuitive visualizations and presentation of the data for clients. The company is also expanding even more rapidly around the world. Currently they have 57,000 hotels that participate in the STR program internationally, with the largest country outside of the US being China that overtook the United Kingdom in that position two years ago. The Asia focus will continue to grow, as well as a move into South America in 2017/2018.
STATE OF THE REAL ESTATE CYCLE: PROF. GLENN MUELLER, DENVER.
OFFICE: Demand for office is increasing. The recession is over and all the uses that demand office space are growing. However, technology is changing the way we consume office space. People work from home or use shared office space, and consequently the amount of space required for a new hire has decreased from around 200 square feet, to 120 square feet. Consequently more demand is required to fill space, but with the economy expanding that space is being filled. That said, the office market is highly location dependent because different cities have different industry base profiles that drive the local economies and that is what, in large part, drives office demand.
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INDUSTRIAL: Industrial is in big demand nationwide driven largely by internet sales and the migration from retail to warehouse distribution centers – even though internet sales are just 9% of all retail sales indicating considerable room yet for growth. Occupancy is not at its peak yet but is expected to reach that level by the end of the year this year. Amazon was the biggest consumer of warehouse space last year taking up fully 25% of the entire warehouse supply nationwide. And Amazon are moving from a few huge locations to a more localized format to enable same day delivery schedules, and are being chased by Walmart who are also beginning to expand into a delivery model and consequently beginning to demand warehouse space nationwide. Industrial is ‘hands down the best property type going’. Glenn predicts that: ‘peak occupancy will continue in industrial until 2019’.
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APARTMENTS: Apartments present a ‘good demand story’ with millennials coming on stream not buying as young as prior generations and so fueling demand for apartments. That said, apartments are also among the easiest to finance and so consequently the pipeline of new product is easy to fill and is being overfilled currently leading to hypersupply. And the hypersupply is primarily at the high end of the cost/rent spectrum, the ‘A’ class developments, so it is that end of the market that is going to see reductions in rent levels first but that will cascade down to B and then to C also as renters trade up to higher quality units as rents reduce overall. There is nothing anywhere nationwide – in the cities studied – that indicates occupancies will be rising; every single market is either at peak, or already oversupplied meaning reducing occupancies and rents. In fact, new supply is 10-20% greater than demand can keep up.
RETAIL: ‘Retail is dying on the vine’. Good quality retail and shopping centers are doing well, but not much else, and even that is evolving more to being destination entertainment centers. Grocery anchored centers are still a necessity so will continue to do well. Overall though, retail is extremely slow on the recovery, around half that of any other property type, but the good news is that as supply is very low because it is difficult to finance so there are some bright spots on the map for retail as demand has picked up but supply has remained more stable.
HOTEL: The hotel sector is uniquely the most volatile property type because people rent by the day and so when the economy is doing well people consume hotel rooms but when it is not, they simply stop. But the hotel industry is enjoying some generational changes in demographics where millennials are traveling more than their predecessors and as a consequence are unbelievably profitable right now with an ‘all time best ever peak occupancy of 72.5%’ So with this peak occupancy we are seeing additional supply coming on line with more hotel rooms being built.
APPRAISALS CONTRIBUTE TO BOOMS AND BUBBLES? HOW?!
Appraisals contribute to bubbles and exacerbate downturns? How could that be? Well, the Federal Reserve Bank knows and, in today’s podcast, explains just how.
Over the last couple of weeks I have been investigating how to set the listing price for a home when it is put on the market, and the impact that a listing agent might have on that process, and have concluded that setting the asking price at around 3-4% above market is the optimal level at which to maximize sales price while minimizing time on market. Be sure to listen to these at national real estate forum dot org, or NRE Forum dot org.
All that is just fine, but how is market price determined? During the recent downturn banks were expected to ‘mark to market’ their loan portfolios, but the challenge came in determining what market value was. How do you do that when the market is in tremendous flux, or even when it isn’t? Well, there are a few ways. One is to actually market a property thoroughly and whatever is the highest deliverable bid becomes the definitive market value, you could get a broker’s opinion of value, or, you could either write or get an appraisal.
I have always been a skeptical of the third party appraisal process, because I only ever conduct my own due diligence – in other words, conduct my own appraisals – to establish a property’s value. Third party appraisals are only relevant for banks and even they only use them because regulations mandate that they do.
FEDERAL RESERVE BANK GUEST, LEONARD NAKAMURA
It my great pleasure to introduce to you Dr. Leonard Nakamura, who is vice president and economist at the Federal Reserve Bank of Philadelphia, and who very kindly shared with me his unique view of the extent to which the appraisal process can impact the housing market overall. Though I am sure you already know, the Federal Reserve Bank is tasked with implementing monetary policy and, as lender of last resort, is also responsible for monitoring and regulating the entire banking system. Dr. Nakamura’s perspective on appraisals is, therefore, not only extremely interesting, but also provides insights into this ubiquitous component of the housing market that you have doubtless not before considered. This is a rare opportunity to hear from one of the foremost experts in our banking system so please tell your friends and colleagues to go to NREForum dot org and just hit play to hear him and my other guests.
Oh, and be sure to listen to the end of my conversation with Dr. Nakamura for some personal insights into his fascinating background.
[That’s Walt Wriston, W.R.I.S.T.O.N. As CEO in the late 1970s, Wriston was famous for having changed the name of the bank from First National Bank to Citibank and for having launched the Citicard pioneering, as it did, the development of the now ubiquitous 24 hour ATM machine.]
Fascinating. In the period before the market tanked in 2009, 2010, and while property values continued to rise relentlessly, an overestimated appraisal was insulated from repercussions because, well, prices kept rising so they were never wrong. As a consequence, in the refinance market, which accounted for much of the lending in the pre-downturn period, appraisers became accustomed to over estimating house prices. This contributed, in part, to the run up in house prices. Once well intentioned regulations were implemented that put stricter guidelines on the appraisal process, the pendulum swung the other way and a higher proportion of appraisals started coming in below market price, causing both purchasers and refinancers to fail to conclude their transactions. This may have further exacerbated the downturn by making it harder than it already was to finance home purchases and so inadvertently propelled an already steep decline in property values.
I never thought of the appraisal process as having the potential for anything but an impact on individual loan transactions. It never occurred to me that, when viewed as a systemic cog in the entire industry, that they actually contribute to the swings both up and down in the market, so I am most grateful to Dr. Nakamura and the Federal Reserve Bank of Philadelphia for taking the time out to share this aspect of their work with us today.
If you also found this an interesting perspective please do share this on linked-in book, or facechat, or twittering about it if you have the inclination. And please tell your friends and colleagues to check out the website www.nationalrealestateforum.org or www.NREForum.org where all you need to is hit the play button to hear the latest episode.