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Value Investing: Not Just for Stocks
By Adam Gower Ph.D.
'It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.'
-Warren Buffet, Value Investor Extraordinaire
When most folk think of value investing, their minds conjure images of Warren Buffett, poring over newspapers and corporate financial reports, or perhaps thoughts of a well-worn copy of Professor Benjamin Graham's seminal work on value investing, "The Intelligent Investor."
While value investing is a common strategy for retirement savers in the equities space, it also has valuable applications for commercial real estate investors.
What is Value Investing?
Value investors seek out companies that are trading at a level lower than their market value, undervalued by the rest of the market for whatever reason. They find underpriced securities by using a form of fundamental analysis, which varies from investor to investor. The one constant is that value investors engage in buying stocks at less than their intrinsic value.
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The same holds true for investments in the commercial real estate – investing in higher-cap (cheaper) real estate, in higher-cap, (cheaper) metros will consistently deliver higher risk-adjusted returns than comparable investments in highly sought-after, so-called low cap-rate, more expensive quality properties and markets.
A Tale of Two Investors
There are two types of commercial real estate investors you may come across in your travels. The first group single-mindedly focuses on high-quality properties in high-quality markets, and they are willing to pay very high prices to acquire those assets. The second group consists of those who are willing to look outside the quality box, to get on a plane and find lower-quality properties in secondary markets.
At the institutional level, the high-quality, high-demand markets dominate the investment landscape. Vast swathes of smaller American cities will be passed over by private equity funds, pension funds, sovereign wealth funds, and other institutional investors. These areas are essentially ignored because they are not of a high enough quality for the big players in the market. However, they neglect these markets at their own peril- recent research shows that value investment properties (cheaper properties in less expensive markets) outperform other properties in both raw and risk-adjusted returns.
Related Article: Real Estate Value Investing Podcast
Value Investment Strategies for Commercial Real Estate
That research, a 2017 paper titled "Value Investment Strategies for Commercial Real Estate," by Professors Greg MacKinnon, Eli Beracha, and David H. Downs set out to determine what, if any ROI advantages come with value-oriented commercial real estate investing. Their work found that investments in undervalued assets in undervalued markets offer consistent risk/return advantages over investing in lower-cap, high-cost assets. Put another way, the study looked at whether high-cap-rate (cheaper) properties or low-cap-rate (expensive) properties were better investments.
The genesis of the study goes back to the world's most famous investor and market-maker- Warren Buffett. He is perhaps the most famous proponent and practitioner of value-investing, but he is far from the only financial whiz that worships at the alter of Good Value.
Researchers have studied whether value-investing works since at least the early 1980s, and almost all the data points to the conclusion that value stocks outperform growth stocks.While initial studies were focused on the equity markets, researchers eventually started to look at other asset classes to see if the same benefits translate over. What they found, from currencies to commodities to bonds, was that value-investing outperforms growth-oriented investing across almost all asset classes.
Making Sense of Cap Rates Across Time and Markets
The MacKinnon study was largely derived from insights provided by a deep-dive into a property-by-property level database supplied by the National Council of Real Estate Investment Fiduciaries, or NCREIF. They mined data relating to cap rates, which they measured by using the income returns on properties across the US and classifying them as high or low.
That begs the question: what's high, and what's low? It all comes down to time. For instance, let's say you have an office property with a 7 percent cap rate. In 2019, in today's market, that would probably be considered a high number. However, back in the early 1980s, that would've been considered a low cap rate. Time was not the only variable to account for, the geographic market also plays a significant role in determining whether a cap rate is high or low- a 7 percent cap rate might be high in Manhattan, but low in a market like St Louis or Indianapolis.
After a careful analysis of the data, the researcher's results showed definitively that high-cap-rate (cheaper) properties are better investments than low-cap-rate (more expensive) properties, by a pretty significant margin in terms of performance. This holds both in absolute returns, a risk-adjusted sense, across property types and time, and throughout the business cycle. While it is not quite a universal truth that value-investing principles hold true in real estate, it is about as close as you can get with actual historical data.
The difference in terms of absolute return is significant, and nothing to be sneezed at.
As we mentioned, the same positive results were seen across property types. Across all the portfolios the researchers looked at from 1979 to 2010, high-cap-rate office properties outperformed low-cap-rate office properties by 75 basis points per year. In the multifamily sector, high-cap-rate apartments beat low-cap-rate properties by 212 basis points per year- over two percent per year in outperformance. High-cap-rate retail outperformed low-cap by 182 basis points per year, and industrial properties exceeded their low-cap cousins by 156 basis points per year.
What About Risk?
Even if you're a greenhorn investor, you know that you can't just look at returns-diligent investors need to look at risk versus return to get a clear picture of an investment or asset class before they deploy capital. To determine risk-adjusted returns, the authors of this study decided that if a value asset outperforms the average by 70 percent of the time or more, that represents a reduction in risk. Since value-focused real estate investments outperformed comparable assets 70-95% of the time, the authors judged these assets to be less risky than your typical property investment. The consistently higher returns over time are what makes value real estate a better risk-adjusted asset.
How Can Investors Benefit From Commercial Real Estate Value-Investing in the Real World?
If you take away one thing from this study, it should be the "value" of focusing on smaller markets that have been passed over by institutional/large-scale investors. Seek good assets in these markets and acquire them for a sensible price based on your traditional due-diligence.
Cheaper properties not only yield greater returns in terms of immediate cash flow, but they also outstrip expensive properties in capital appreciation- and they do this consistently. The conclusions drawn from "Value Investment Strategies for Commercial Real Estate" would suggest that over the long-term, you will receive significantly higher returns overall compared to the same acquisition in a growth asset or high-dollar market.
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