Here's an overview of discussions held at this publication's recent family office investment summit. The authors are David Wieland and James Brunger.
Earlier this month, Realized Holdings CEO David Wieland attended the Family Wealth Report Family Office Investment Summit. This recap features a discussion by several panelists, including David Wieland (also a member of the FWR editorial board, see main photograph), as well as Stephen Harris from ClearView Financial Media, James Brunger (see photo below) from Capital Square, and DJ Van Keuren from Evergreen Partners. David Wieland and James Brunger dive into the diverse discussion about the outlook for commercial real estate and the ongoing need to quantify risk in real estate, as discussed at their panel session. Here’s an overview of the ground that was covered. If you have comments and want to respond, email the editorial team at firstname.lastname@example.org
The usual editorial disclaimers apply to views of outside contributors.
An outlook on commercial real estate
Despite the rise in interest rates, many believe that there are still opportunities in the multifamily sector. However, investors have to be careful when using leverage. With interest rates at 7.5 to 8 per cent, the investment can create negative leverage. Negative leverage is created when debt servicing is higher than the return on buying the property with cash (i.e., annual yield is less than financing cost).
Many investors are scrutinizing deals more to see if cap rates
will expand or interest rates decrease. The expectation is that
cap rates will expand. The implication is that property values
will decrease as interest rates remain high.
Overall, there is a structural change in real estate underway. Multifamily is the best it's been in 35 years. There are six million too few housing units because not enough were built in 2016 and 2017. The pandemic only exacerbated this lack of housing.
Advisors should shift to thinking about investing in real estate by property type, looking at segments, and avoiding the media hype. For example, industrial represents an area with incredible opportunities in the industry, whether bulk or last mile.
Examining deal structures
Many dealmakers across real estate are pulling back on debt, which has become fairly restrictive. Financing today is an impediment that is slowing investment down. If cap rates have blown out to a significant margin, the investment won't have a great return. In that case, we are likely to see more folks hold their properties for longer.
David, in particular, recommends that advisors focus more on deals, using moderate leverage and tax benefits on an after-tax basis (i.e. create tax alpha) because leverage is very expensive today.
There is an anticipation that investors will go back to portfolios rather than direct properties. Investors tend to look at slide decks but lack the analytic rigor that includes models and stress tests, which are part of a professional portfolio manager’s process.
Professional real estate investment firms put together these portfolios, often composed of billions of dollars in real estate value. Panelists view portfolios under $1 billion as fairly impractical. Some said 15 properties are about the average number in a well-diversified portfolio.
The quantification of risk
Beta is market return. In the stock market, the S&P 500 is beta because it is the market return.
There's no beta in real estate or standard method for measuring
real estate risk. Although models are used to compare different
properties, risk isn't well-understood in real estate. This lack
of understanding is why RIAs (Registered Investment Advisors) or
family offices don't actively manage real estate the way they
manage stock portfolios.
Historically, money managers and wealth managers haven't asked clients the key question about their investment properties – what will you do with your properties long-term? In part, this is because there is a knowledge gap around real estate as an asset class. When it comes to a standard metric of risk, real estate is in the dark ages.
Risk quantification measures the volatility of income, which is the upside, and the volatility of capital, which is the downside. When these two concepts are combined with Modern Portfolio Theory, it becomes a game changer for risk management.
Specifically, Realized recommends a risk quantification and looks at everything after-tax. An after-tax analysis is a way to evaluate income. On the risk side, these models allow for an after-tax risk-adjusted basis.
With risk better defined in real estate holdings, investors are able to better trade real estate, similar to how they trade stocks. Holding real estate long term as a requirement begins to fade. By owning interest in a trust (i.e. a Delaware Statutory Trust), investors can sell their interest on a secondary market without selling real estate in the trust.
Real estate can be considered an inefficient market. Increasing its efficiency should bring in more capital. Over the next five to 10 years, this shift in industry standards will change how real estate is viewed for advisors and investors alike.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.