Matt provides some insight on how to view “The Market”.
People ask me all the time about the “real estate market”. What do I think of “the market”? What do I see happening in “the market”? What happens when “the market” cools off? This last question comes up more and more frequently these days as the general upward trend in real estate has continued unabated for several years running and shows no immediate signs of stopping. The questions are usually broad based, general, and well-intentioned, but they demonstrate an overall lack of awareness by many casual observers and investors who do not appreciate the true nature of what I call the Small Balance Real Estate (SBRE) universe. The true answers are extremely nuanced and not easily communicated in a quick encounter or brief interchange with someone who asks me one of these questions. To provide a real and meaningful answer requires explanation, context, and a deeper understanding of both the SBRE world generally and value investing in particular.
My short answer is that there is no such thing as “the market”. There are in fact many, many markets and sub-markets in SBRE, truly an industry unto itself that encompasses far more than just home prices or other very broad measures of real estate activity and health. These sub-markets are broken up further by multiple categories including asset type, geography, product type (debt or equity), strategy, size ranges, and more. They do not all move in the same direction at the same time or have the same inherent characteristics. To my mind, there are always strong SBRE opportunities, they are just different at different points in time. A big part of the key to long term success for real estate asset based fund managers, syndicators, and other SBRE entrepreneurs (and by extension their investors) is to not get killed by the assets you already own and/or the capital structure you have erected with which to own them when the market or the sub-market in which you are operating moves against you and your strategy. To do this is very difficult for some people. How well an SBRE entrepreneur anticipates and prepares for the inevitable cycle will go a long way towards determining the outcome during a cycle that is less aligned with a given fund, manager or strategy.
First of all, let’s recognize that there are many different strategies to make returns in some way related to real estate that are not what most people think of when asking the aforementioned questions about “the real estate market”. Let me name several strategies with which I am extremely familiar, each of which is being executed on a small, medium or large scale by literally hundreds (if not thousands) of SBRE entrepreneurs around the country right now:
- Buying and fixing houses and selling them (fix-n-flip)
- Buying, fixing and renting houses (buy-n-hold)
- Buying, fixing, renting, operating and/or selling income property including:
- Assisted living facilities
- and more…
- Private lending – making loans to people who are doing 1,2, and/or 3 (either in senior position or in mezzanine position)
- Purchasing existing loans, liens, and/or other interests in real property with the intent to monetize those assets
- Ground up development and construction of one or more of the above property types
- Value-add or opportunistic purchasing of one or more of the above and/or paper secured by such property
- Multiple combinations of all of the above
Within each of these strategies are sub-strategies. Some may do it strictly in a confined geographic area or within a specific size range. Some may stick to one precise property or asset type while other are more opportunistic in their approach. Some will buy paper with the goal to foreclose and acquire the real estate and others will strive to maintain a very low default rate and just collect interest. Some will seek very high quality, A grade property, and others will look for C properties in an A area. The same is done with borrower quality for private lenders. There are hundreds and hundreds of combinations. Sometimes one person’s strategy relies directly on another person’s strategy, sometimes in lockstep and sometimes in complete opposite fashion. I recently ran across a fund whose strategy is to build spec homes averaging around $25,000,000 each in sales price. Yes, $25,000,000 spec homes inside of a fund. (Not one we will invest in for a variety or reasons, but plenty of people have done so.)
The point is that there is no one “real estate market”. Rather, there are many. Some of these strategies rely on natural market cycles and expect to do better when the broader market softens. Some of them rely on values continuing to rise uninterrupted. Different SBRE entrepreneurs have wildly different levels of competency, charisma, experience, risk tolerance, ability to raise capital, and underwriting disciplines. Some of them will weather a significant overall economic downturn that negatively impacts values, rents, cap rates, time on market, occupancy, etc. far better than others depending on their combination of these characteristics. Part of the key to navigating this landscape is understanding these dynamics.
To me, there are some very basic fundamentals that come down to the real estate equivalent of value investing. Paying close attention to market demographics (often quite local), replacement cost, the ability to quickly and consistently generate income or cash if needed, and the amount and type of leverage being used are some of the foundational elements of good underwriting. This is true whether the strategy is to provide equity or debt. The capitalization structure of a given pooled investment fund or individually syndicated deal (property or loan) is also very important, a factor which is widely misunderstood and overlooked. The ability and willingness to underwrite today with an eye towards an inevitable correction and the discipline to adhere to these fundamentals is a very desirable trait in a manager, syndicator or other SBRE entrepreneur. Combine this type of manager with a sound strategy that inherently anticipates cycles and “the market” should always have opportunities.
Clearly a macro level economic downturn will be highly likely to impact the broader real estate markets. Values will likely suffer, rents will cease to increase (and may drop), inventory and time on market will go up, tenants will fail and borrowers will default in greater numbers. This will cause some people great pain. It will not affect others much at all. It will represent significant opportunity to still others. It all depends on what strategy(s) they have been and are pursuing, what position of exposure they have put themselves in when it arrives, what access to capital (or lack thereof) they have, and how well they have adhered to smart fundamental underwriting. “What happens when the music stops?”, as so many people ask me, just depends on who else someone has been dancing with and how hard they’ve been partying while it was blaring.