The Problem With Real Estate
Welcome all new subscribers to Alpha Letter. Every week I write about interesting opportunities in the public market. I focus on stocks off the beaten path. Broken businesses. Assets trading under liquidation value. Macroeconomics and where the economy is heading. I don’t like investing in large, popular companies and find a fascination with assets no one else is looking at.
Today’s piece will on the problem with real estate investing.
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The Problem With Real Estate
I have always been a contrarian even before I knew what that word meant. My life has cycled off the beaten path. I like doing things that others are not doing. A rebel by design. Against the grain and the black sheep in the teenage toiling years. This contrarian born nature was a welcomed gift in the world of capital markets. Being able to invest in what others are avoiding generally leads to outsized returns. Avoiding the hype and excitement of new technologies, fads and trends leads to the protection of your hard earned capital. A contrarian born brain is an asset in capital markets.
This mindset of going off the beaten path has lead me into odd investments over the years. I was early into the coal cycle. Coal equities were trading well under replacement value and prices were going higher. Institutions were busy investing in clean energy stocks trading at ridiculous multiples while I was buying coal stocks at 1.0x free cash flow. Mandates with ESG forced many investors to completely avoid coal equities, leaving anyone who could run fundamental analysis on the back of a napkin a layup.
At other times I have invested heavily when there was extreme selling. Anytime an equity crashes 50%, take a close look. Understand the fundamentals of cash flow and what these could look like a few years out and you will do well for yourself. The market is typically over pessimistic when bad stuff happens and too optimistic when good stuff happens. When investors figure out the market psychology and what true free cash flows look like, a reversion to the mean occurs.
All of this contrarian talk leads me to the guts of this newsletter — the overvaluation of commercial real estate. My prediction for 2023 is this:
Commercial real estate valuations will re-rate much lower from a higher cost of capital, higher interest rates eating into NOI, the lack of transactions in the space, banks taking large one-time impairments on their bond portfolio leading to higher scrutiny on underwriting projects and investors pulling their money out of LP deals. TLDR: commercial real estate will get crushed in 2023.
Let’s wind this back a bit and provide some context.
For the past few years I have spent a lot of time on Twitter. I’ve been on the comedy side. The political side. The deep financial side. And from the sidelines I have watched real estate Twitter evolve from a few individuals to a significant amount of Gurus who are raising capital under a GP structure with insane fees.
Here is the problem I saw with real estate early on that generally made me avoid investing as an LP.
GPs were underwriting properties with maybe an eight percent annualized gross return. My cost of capital is at least 15%. When I underwrite an investment I need at least a 20% annualized return to invest. An eight percent gross annualized return is peanuts. Why not just invest in an index fund with liquidity at this point?
Eight percent gross returns are pretty low for an illiquid asset. But these are gross returns and do not take into account any fees incurred. Real estate GPs take a crazy amount of fees it is almost criminal. There are acquisition fees, financing fees, refinancing fees, selling fees, management fee, disposition fee, asset management fee, etc. At the end of the day those 8% gross annualized returns turn to a 4-6% net return real quick.
You are stuck in an illiquid asset earning maybe 4-6% net returns. The opportunity cost is huge here. Invest that money in the S&P 500 and you will get 8-12% annualized returns with liquidity.
These GPs were top ticking the market. Interest rates were at zero. Valuations were sky high. Cap rates were in the 4-5% range. With the Fed moving rates higher valuations will come crashing down and the cost of capital will increase. Any GP that needs to refinance a property will be forced to refinance at a lower valuation and higher interest rate. If you were top ticking the market a 4-5% cap rates, get ready to see your minimal cash flowing property turn into a massive liability where you can’t cover interest expenses. That is, if you can even find a bank to refinance a deal for you.
I’ve seen a lot of small regional and community banks buy bonds at the top of the market. Over the course of 2023 these banks will report a large non-cash loss on their bond portfolio as rates go up. These losses will be in the uncomprehensive income, below net income — where few investors ever look. Coverage ratios will plummet and valuations will come down pretty hard. This will result in banks having less capital to lend in 2023. Anyone needing to refinance a commercial real estate property will have a big issue on their hand. If you are trying to sell your commercial real estate property, good luck. I don’t think there will be many buyers unless you drop your pricing 35%.
Many GPs using variable rate debt when buying properties. I don’t think I need to explain more here.
There will be a big reckoning for commercial real estate in the future. As long as rates stay at this level, or go higher, there is a massive amount of downside in commercial real estate. It is one of the last bubbles pop. Gurus have sold commercial real estate to LPs as the godsend of asset classes. If you are not in commercial real estate you are a nobody. They said everyone should have some of their wealth in commercial real estate.
I disagree with this statement. As an active investor, only invest in markets where the downside is limited and you have double digit upside over a multiyear period. Invest in real estate when everyone is getting crushed. You want to buy properties trading well under the replacement value of the bricks, concrete, windows and wood. When commercial real valuations are trading under the replacement value, that is when you start buying. When there is maximum fear and you are the only bidder. 2023, could be the year.
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