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018 Real Estate Value Investing

Greg MacKinnon, Pension Real Estate Association...

... 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.

Value Investing - Background to the Study

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.

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Proprietary Data - Extraordinary Results

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:

  • High cap rate office properties (cheaper ones) outperform low cap rate office properties (expensive ones) by 75 bps per year – that is a ‘country mile’, and yet not as high as other asset classes.
  • High cap rate apartment investments outperform low cap rate investments by 212 bps per year – over 2% per year.
  • High cap retail outperforms low cap retail by 182 bps.
  • For industrial the difference is 186 bps per year.

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Risk Adjusted

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:

  • Cheaper office properties outperformed more expensive properties 73% of the time.
  • Cheaper apartments outperformed 95% of the time.
  • For retail the less expensive properties outperformed more expensive ones 82% of the time
  • Less expensive industrial outperformed almost 90% of the time.

Summary:  Higher cap rate properties (cheaper ones) consistently yield higher risk adjusted returns.


Looking at the apartment chart by way of example, the solid black line shows annualized returns for high cap rate properties (less expensive) versus the dotted line showing returns for low cap rate (more expensive) buildings.  Consistently, throughout the course of the study, the black line hovers above the dotted line showing that returns are almost always higher for cheaper properties than they are for the more expensive ones.


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 expensive markets.

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.

Fund Manager Bias

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. 


The study finds that an investor is better off going to a higher cap rate market i.e. a relatively cheaper market and acquiring relatively cheap assets in that market.  This is a better strategy to maximize returns than investing in low cap rate, or expensive, properties, and yet, think about this:  The dominant strategy you hear in earnings calls or investment presentations is one that focuses on the highest quality assets.  This points to a concentration of capital all focused on the same types of assets – the lower cap rate, more expensive, quality properties in the ‘best’ markets.  So these assets end up being overpriced whereas it is the ignored assets in the ignored markets that are the ones yielding the highest value returns in part because of that.

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.

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