Finding Your Path

The Darwinian Theory of Real Estate Investing

By Lorne Polger, Senior Managing Director

Lorne PolgerI just spent a week in the Galapagos Islands with my kids. It was a beautiful trip and a photographer’s paradise. The uniqueness of the many species that populate the islands, along with the lack of predators result in an amazing, close up experience with the animals. As you may know, the Galapagos Islands were where, in the early 1800s, Charles Darwin began to develop his theories on evolution.

Darwinism is a theory of biological evolution based on the precept that all species of organism arise and develop through natural selection. The natural selection process then increases the individual members of the species ability to evolve to better compete, survive and ultimately reproduce.

I believe that real estate is also based on evolutionary cycles, albeit ones not based in nature or natural habitat. Instead, real estate cycles are typically created by human nature, economic and monetary policies and worldwide events. Ultimately, just like Darwin’s theories on biological evolution, investors and developers who adapt through a down cycle are better equipped to compete and prosper, and ultimately survive.

I’ve lived through three down cycles now during my professional career, probably more than that during my lifetime. Let’s examine this last one, because in many respects it typifies all cycles. Here are three factors that I observed:

1. Human nature, which typically includes near equal elements of fear and greed/optimism;

2. The basic law of supply and demand; and

3. Monetary policy, which can either accelerate or decelerate the pace of a real estate cycle.

Money BagHuman nature. Let’s start with greed and optimism. In order to either invest in or develop real estate, you need a certain measure of both. Optimism that the project you are investing in will be successful and ultimately pay you a commensurate return for the risk that you are taking (that’s the fear element). Greed as well, in that you strive to make the investment as great a success as possible.

When held in check, they work pretty well. In the beginning of this current cycle, optimism and greed were generally reigned in – there was still a measure of fear as you still looked over your shoulder at the train wreck behind. You remained cautious about what might lie ahead. Some still felt the welts and bruises.

In the middle of the cycle, you looked backwards and forwards. Sure, you got hit before, but boy, look how the train is moving now. Better jump on.

Now, in the latter part of a cycle, for some, optimism and greed begin to exceed rational thought. Fear is a distant memory. Overbuilding occurs. Yields get compressed. Over leveraging occurs as some safeguards on debt are reduced or removed. Financial engineering takes over in order to achieve target yields, in lieu of assessing actual fundamentals. We are now in the latter part of this cycle. Deals are getting done with financial engineering, not because of sound economics; they’re getting done because there is a surplus of capital and not enough places to put it. When left out of balance, things get out of control. Those who remain disciplined survive (and even prosper) but certainly live to see another day. Those that don’t lose their shirts. Some don’t survive.

Shutterstock 130988594Supply and demand. I first learned this concept in Professor Mike Bird’s Economics 101 class at Colorado College 35 years ago and I’ve been using it on a daily basis ever since. Simply put, when demand outpaces supply, prices rise and when supply outpaces demand, prices fall.

For much of this cycle, we’ve had excess demand in rental housing. Demand across office, industrial and retail were somewhere in the range of flat to slightly increasing. That has not been a typical cycle when demand usually rose across the board as the cycle progressed. Given the scope of the last downturn, that’s probably a good thing. And perhaps as a result, it does not appear that we overbuilt (oversupplied) during this cycle. Lots of cranes in the air since 2010, but the vast majority have been tied to hospitality, housing and medical uses. Not a lot of spec office or retail centers this time around. That’s a protective element for the downside of the next cycle.

Percent IncreaseMonetary policy. We’ve been in a zero-interest rate environment now for more than eight years. What happens when that changes? At the beginning of a cycle, the Fed tries to heat up the investing environment by lowering interest rates. When the cycle evolves and overheats, the Fed begins to cool it down by increasing rates. We are nearing the latter stage. What happens to the cost for the U.S. government to service $19 trillion of debt when there is a 50 basis point increase in the prime rate of interest? What if the increase is 150 basis points? The primary questions are when (not if) the increases will occur, how much will they be and what the ripple effects will be?

So where are we in the current cycle? Have we overbuilt across various sectors? So much has changed in such a short period of time; our need for physical office space has fallen off a cliff; Amazon has changed the retail landscape forever (which is why we are installing automated package drop systems in our apartment complexes); industrial uses may change dramatically with the legalization of marijuana across the country. All stuff that would have been difficult, if not impossible, to predict a mere 20 years ago. Yet, we are still well below historical norms in the development of new housing stock (rental and for-sale), office, industrial and retail properties across the country. This is an unprecedented element in a recovery period. Many studies show that our current pipeline of housing stock is not even close to meeting projected future demand.

Have we become sloppier in our underwriting for equity and debt? To the contrary, still feeling bruised and battered from prior mistakes, lenders remain stringent. Less regulated? With Basel III and Dodd-Frank, not in the least. So although we are showing all of the evolutionary signs of being near the top of a cycle, we are not seeing signs that the downturn, this time, will be significant or longstanding.

Are we now nearing the end of a cycle? Well, we are seeing some signs of being near the top. Multifamily vacancies are staying near all-time low levels, but the rapid rise in rents has slowed significantly. Housing starts and homeownership rates remain near all-time lows. Office and retail vacancy rates appear to be stagnating. Does a train wreck lie ahead? I don’t think so this time. Will there be some projects in trouble? Absolutely. Some interesting investment opportunities? Always.

My takeaway? Stick to the fundamentals, take some chips off the table to keep your liquidity in check, don’t use financial engineering or excess leverage to goose yields, and just like Darwin’s finches, live to see another day and prosper. Don’t be the dodo bird.

Lorne Polger is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Lorne was a partner with a leading San Diego law firm, where he headed the Real Estate, Land Use and Environmental Law group. Reach him at lpolger@pathfinderfunds.com.