In economics and investment 101 classes, students are taught theories underpinned by a sacrosanct assumption that investors are rational. On first hearing, this appears logical and difficult to argue with; it’d be a brave student that stands up to interrupt a professor imbuing foundations that underpin much of what follows. How could people not be rational? Move on, right?
After nearly 25 years in the market, I feel less and less confident that the investing world operates in the way that is often taught and question the validity of some key underlying assumptions. Part of the issue is that market innovations develop far more rapidly than textbooks can be updated – this is a function on how quickly academics keep abreast of such developments, can agree on what they mean, and sometimes admit if they were either wrong or the world has moved on.
To be clear, the point isn’t that investors are irrational altogether but rather that in the real messy world, rationality is not binary. Instead, it should be thought of as a spectrum. Investors and market participants lie at different points, depending on their environment and era. Of course, what is rational in one era may be different to another.
Richard Thaler, winner of the 2017 Nobel Prize in Economics, has “The List” of ways in which even the most sophisticated investors will act irrationally. Some examples are:
- Playing with the house’s money: all money should be treated equally, but investors tend to take larger risks after making a big profit.
- The Endowment Effect: people hugely overvalue the things they own, yet classical theory tells us that owning a stock should have no bearing on the value you place on it.
- Narrow framing: investors are unwilling to make individual bets with good, risk-adjusted outcomes, but high variance, even though over the course of a career they are almost guaranteed to have a positive outcome.
In the stock market if everyone understands and acts rationally on all information, then the volatility and trading volumes would be far lower. Overtrading based on the noise of short-term earnings releases and fluctuating market conditions must be irrational when viewed in a longer-term context and considering trading costs.
Holding in our minds that a thoroughbred rational investor is more mythical than universal, let’s turn to the commercial real estate market in the US – in particular, the US office property market. There is no shortage of dreary headlines about slumping occupational demand, valuations, and regional banks’ outsized exposure. Of course, the larger banks also have exposure, but to better quality assets and a smaller relative weighting. This is in part because they offload some risk to investors by packaging it into Commercial Mortgage-Backed Securities (CMBS), or something similar.
Over the last 12-months, as inflation concerns began to heighten and it became clear the Fed is on a once-in-a-generation hawkish path, the US REIT market has underperformed the broader S&P by over 20%. Since end 2019 the relative underperformance is worse still at nearly 50%. Within the REIT market, office-focused REITs have underperformed other property sectors. To say office real estate is unloved would be an understatement.
Let’s review in a bit more detail; traditional sectors (Figure 1) have reduced from c.80% to 50% weighting in the NAREIT US REIT index. Offices have been the most impacted, having fallen from c.20% and now representing just 7%, or about one Prologis.
Looking at implied office cap rates (Figure 2) shows a recent and sharp divergence relative to all sectors. The chart below underestimates the extent of the swing, as since 23 March office REITs have continued to underperform both the broader equity market and other REITs. The gap today is estimated to have hit a record 200bps.
Finally, on an implied value per sq. ft basis, top US office REITs – including Boston Properties, SL Green, and Vornado Realty Trust – on average are valued at $625 per sq. ft. They trade at a 30–40% discount to estimated private market values and replacement cost.
The London-focused office REITs, such as Derwent London, and Great Portland Estates, have also been hit hard. However, they trade at a higher $900 per sq. ft implied value – a c.5% implied yield, compared to nearly 8% for US Office REITs – and slightly smaller 20–30% discount to their estimated private market value.
If the public office REITs are trading at large discounts to private markets, what are private investors thinking when borrowing at prevailing rates to part-fund higher-priced private market acquisitions? Especially since these invariably also involve higher borrowing costs at prevailing rates compared to what the REITs have locked in. The rationale of such private market investors is not always clear.
On multiple measures, current public market pricing for office REITs is screening well, assuming one still believes large corporations continue to require head office space in gateway cities. Of course, the downsizing of tenant requirements by those moving to a hybrid model is likely to pose a challenge in the intermediate term.
The typical nine to five, Monday to Friday office week has long been fading. However, the acceleration bought on by COVID – to nearly 100% work from home for some people – does not appear sustainable; not for managers on daily Zoom marathons, not for employees missing out on office banter who learn from more experienced colleagues, and certainly not by leaders trying to imprint their corporate vision and culture.
Employees that have gained a taste for freedom and flexibility in the recent war for talent may wish to consider how long-lasting it is given the leaps and bounds in artificial intelligence and automation re-tipping the balance in favour of employers. Also, consider unemployment is at record lows – what happens when it’s not? The idea that employees don’t need to be in the office much and therefore don’t need to be in commuting distance, also has a logical conclusion that employers have a greater geographic span to choose from. The recent shift in power from employer to employee may not last as some may think; successful companies create and maintain an edge, and team presence and cohesion is a vital part of that.
The wisdom of the crowds is powerful and should not easily be dismissed; markets have a reason to be wary of office real estate. Investors in the middle of a conga-line will take comfort. The rational thing is to stick in line – but as the line turns, and you see the blind leader hitting a wall, what, then, is rational?
