Guest Feature

Trading Places

By Scot Eisendrath, Managing Director

Scot EisendrathWikipedia defines “Core” real estate as a “low-risk/low-potential return strategy with predictable cash flows” and “Value-Add” real estate as a “medium to high-risk/medium-to-high return strategy that involves buying a property and improving it in some way.”

In the 1983 comedy, “Trading Places,” a blue-blood commodities broker (played by Dan Aykroyd) and a homeless street hustler (played by Eddie Murphy) switch roles when they are unknowingly made the subjects of an elaborate bet between the commodity firm’s upper-crust owners. I reminisce about the film as I watch the goings-on in the real estate market – it almost feels like “core” real estate has been trading places with “value-add” real estate, where certain characteristics of each strategy have flip-flopped. Core real estate investing has become higher-risk, while still delivering the same low potential returns, and value-add real estate investing has become slightly less risky with potentially more predictable cash flows, while still delivering medium-to-high returns.

It has been well documented that in the rebound of real estate values over the past few years, core properties in A+ locations have out-performed the overall real estate market. I get it – a flight to safety in an uncertain economic environment characterized by investors paying up for the very best assets in the very best locations. The strategy made a lot more sense when the consensus view was that the world was coming to an end, and prior to the recent run-up in real estate values (Moody’s/RCA CPPI Major Markets Property Index has increased 101.7% from its low in January 2010 to March 2015).

Over the past 12-24 months, we’ve seen prices for core assets reach astronomical levels. While it may seem counter-intuitive, buying core assets today may be riskier than buying value-add or bread-and-butter real estate assets that can still be purchased at reasonable prices. This is especially true because core properties are in essence being priced “for perfection” going forward, while because of the improving overall economy, value-add assets may ultimately end up outperforming the original projections made at the time of their acquisition.

Price IncreaseI think that what has occurred in the multifamily space is a good example of how core and value-add real estate investing have traded places. I remember in the early 2000s when we first broke through the $200,000 per unit price barrier for apartments in San Diego County. It felt like such a milestone at the time. As a foreshadowing of things to come, I attended a multifamily real estate conference in 2013 sponsored by a national real estate brokerage house. One of the panelists predicted that there would soon be property trades in major markets at previously unheard of price levels. I really took the prediction with a grain of salt – I just didn’t see it happening.

Flash forward to 2015 – in downtown San Diego’s hot Little Italy district, a pension fund advisor broke a new price record, paying above $500,000 per unit for a newly constructed multifamily project with all the bells and whistles. And that price is cheap compared with recent sales in other West Coast markets such as Seattle, Los Angeles and San Francisco, some of which have had recent trades approaching $1,000,000 per unit! See the chart below for a few examples of apartment sales from September 2014 through May 2015 which are approaching nosebleed levels.

Selected Recent High Price/Unit Multifamily Sales

Property Location # of Units Sale Date Price Price/Unit
Belnord New York, NY 218 March 2015 $575,000,000 $2,638,000
Etta San Francisco, CA 107 May 2015 $100,000,000 $935,000
Blu Beverly Hills, CA 37 March 2015 $30,000,000 $811,000
Eighth & Hope Los Angeles, CA 290 February 2015 $200,000,000 $690,000
Mode by Alta San Mateo, CA 111 March 2015 $73,600,000 $663,000
The Lane on the Blvd. Redwood City, CA 141 April 2015 $84,000,000 $596,000
Broadstone Little Italy San Diego, CA 203 September 2014 $102,5000,000 $505,000

How does an investor make money buying an apartment project for north of $1 million per unit? By my back-of-the-napkin calculations, if you buy an apartment building for $1 million per unit, you need to achieve rents well above $5,000 per month to even earn a 4% initial yield after property-level expenses. With rents at that level, how much rent growth do you realistically think you will see in the near future? How many prospective tenants can even afford $5,000 monthly rents? Based on housing costs of 40% of income – a level at the upper end of the range for most people – a household would need gross earnings of more than $12,000 per month to write rent checks like that – this is in the top 12% of U.S. household incomes. The vast majority of people with these incomes are homeowners, not apartment renters.

I get that the demographic and other trends are currently in favor of the landlords – millennials favor renting over owning, empty nesters are moving back to urban settings, the home ownership rate is at an all-time low, etc. But what happens when the trends revert to the mean?

Money BagWhen an investor buys a high-end rental property at “Main and Main” at a 3.5% capitalization rate – he must be banking on some appreciation, or a pot of gold at the end of the rainbow. Earlier in the cycle, I thought that buying luxury rental properties made a lot of sense (and I still do if they can be bought at the right price). The investment thesis being buy condominium-quality product at a low initial yield, and as the for-sale market improves, make the majority of your return on the back-end by selling individual condominiums to homeowners or exiting to a condo-converter that would employ a similar strategy. In many markets today, capitalization rates are now so low that core multifamily buyers are paying prices in bulk for rental projects that are higher than what individual homeowners would pay for each home, making the above strategy difficult to pencil. I can’t figure out how these core multifamily buyers will make money, or find that gold at the end of the rainbow acquiring properties at these prices.

I compare some of Pathfinder’s value-add acquisitions to the core multifamily purchases that I have witnessed recently. Pathfinder has found success looking under rocks for assets that have provided attractive yields going in and the added benefit of being under-managed with operational upside and the immediate potential to push rents and/or reduce expenses. Other Pathfinder properties have been acquired through less competitive avenues, either off-market or through a distressed seller that favored a quick response and certainty of close over price. Pathfinder has also acquired assets that for one reason or another don’t check all of the boxes for the most aggressive institutional investors – maybe they are in secondary locations, or smaller in size. My favorite Pathfinder acquisition is the one that we buy with an issue that needs to be corrected, such as significant vacancy or a property in dire need of cosmetic upgrades and once the issue is corrected, the property can then be sold to an aggressive core buyer at a 3.5% capitalization rate.

It should be pretty interesting to see how this part of the real estate cycle plays out, and if the core real estate investors will get the predictable cash flow streams they bargained for at the end of the day. My prediction is that core real estate investors will have gotten part of the equation correct – their strategy may prove to be low-potential return (or no potential return), but unfortunately it may not prove to be low-risk.

Scot Eisendrath is Managing Director of Pathfinder Partners, LLC. He is actively involved with the firm’s financial analysis and underwriting and has spent 20 years in the commercial real estate industry with leading firms. He can be reached at