The real estate world is sometimes both familiar and opaque for those looking in from the outside.
Familiar given the tangible and ubiquitous nature of it. Just about everyone has direct experience with various types of offices, retails, and dwellings – whether that’s apartments, single family homes, student housing, senior living, or lodging. GP surgeries and hospitals are equally familiar.
Less familiar, are non-consumer facing and/or niche property types. These may include industrial property, self-storage, and life science buildings. Data centres, cell towers, and specialist facilities will not be familiar, and few will have experienced them up close.
So, while the array of possible investment options is broad, the problem is each property subsector mentioned above has its own unique demand-and-supply factors and therefore rental growth prospects can vary considerably too. Aside from lease structure and covenant strength, growth prospects are the principal driver of value for any given property.
As we all know, property is far less liquid than equities, government bonds, and even corporate bonds. Each property is unique, and the problem of pinning down medium/long-term future growth with any precision is far from easy in stable times. And it is almost impossible when:
- There are structural changes underway for property usage/non-usage.
- There is a massive reversal in the cost of capital, or…
- The economy is on the precipice of a boom/ bust scenario.
Despite the difficulty in assessing future rental growth with any precision, it is still the single most important factor in assessing return prospects and value today.
This is where valuers come in. Their role in estimating value is an important starting point, but is also the root of the fuzzy signal issue as valuers – often instructed by landlords or management – are not fully impartial and they produce point estimates that are subject to a buffer of plus/minus 10%. While valuers are diligent and consider a multitude of factors, they do place heavy reliance on comparable evidence/recent transactions; rear-view mirror stuff that won’t help investors to dodge the potholes that lie ahead.
Furthermore, in choppy market conditions, valuers now insert a material uncertainty clause, as was the case in 2020 due to COVID and after the 2016 surprise Brexit referendum. This can further limit the practical usefulness of their estimates. There also appears to be a lack of symmetry as to their use. To date, we’ve not seen material uncertainty clauses used in sharply rising markets or where the public market is valuing a sub-sector or a company at a significant premium; for example, self-storage, industrial and student accommodation to name a few. Its use appears reserved for markets that are gapping down or imminently at risk of doing so.
In addition, differing levels of leverage can further skew any biases in the appraised values. Take for example two companies – “A” and “B” – trading at 30% Net Asset Value (NAV) discounts, in the same sector with similarly high-quality properties, long lease structures and management competence. Are they both “cheap,” and importantly, by equal measures? Well, that depends on the amount of leverage. Company A with 30% loan-to-value (LTV) is at a 18% discount on a Gross Asset Value (GAV) basis, compared to Company B with 60% LTV which is only at a 9% discount to GAV. Note that if the valuation is off by 10% then company B is arguably not only relatively expensive but perhaps even trading at a premium on an absolute basis.
Now imagine the exact same circumstances and leverage, except now the properties are in an open-ended fund structure – referred to as “C” – which, even in normal times, is expected to have lower liquidity. But every few years the funds will “gate” (i.e. not allow redemptions) – often at exactly the time you want your money back to pay for that important life event, or when you’ve identified a better investment opportunity elsewhere.
Without knowing anything else, A and B should be equivalent, and C should be inferior. Therefore, the pricing should be greater for A and B relative to C.
Incorrect!
Because C is not allowed to find a market clearing price, it must redeem at NAV and to do this it has to sell properties to match redemptions. Now if the fund has: inflated NAVs, NAVs that are likely to fall in the near future, and/or low liquidity for underlying properties at appraised value, then it’ll struggle to meet redemptions and gate.
Of course, there are options other than locking investors in; these funds can sell properties at the market clearing price level to attract buyers, or they can reduce NAV enough to disincentivise redemptions. The big problem, however, is this violates a sacrosanct pretence that direct/unlisted real estate (including funds) is not as volatile as their listed brethren. The other pretence of “daily” liquidity, is not sacrosanct and the interest and convenience of sponsors takes precedence at the expense of capital providers.
So, if daily liquidity is not daily when you need it, is it still daily? If valuations are increasingly less certain in times of flux, should they still be the only/main anchor, and if not, then why artificially restrict liquidity? If you pretend price/value hasn’t gone down, then perhaps in a make-believe world unlisted real estate is less volatile. By all means ignore the listed market because it’s higher volatility; but remember as devasting as a forest fire can be, their aftermath leaves fertile soil for the next phase of growth.
