In the world of commercial real estate investing, recognizing mispriced markets and effectively managing through volatility over time, or market cycles, are the two pillars of long-term success. At SMARTCAP, we emphasize the importance of these principles as we navigate fluctuating market conditions. It is not enough to buy assets at a low basis; success comes from identifying when the market has misjudged value and positioning investments to withstand inevitable down cycles.
Why these two specific statements? Mispriced markets or assets allow you to create alpha through a larger strategy. Successfully managing through the volatility of time ensures you have fewer losers. This stability allows the investment managers to take advantage of the market cycle at or near the bottom, rather than focusing all of their efforts on managing a broken portfolio. These are foundational pillars that allow you to build alpha through your larger strategies.
Buying well matters and being able to buy well when the time is right will set a good manager apart from a weak investment manager over the long term.
Buying Well vs. Buying Right
The phrase "buying right" often implies acquiring assets at a low price, but this simplistic approach can lead to poor investments if not backed by a thorough understanding of the market's fundamental drivers. Buying well, on the other hand, goes beyond simply seeking low prices. It means purchasing with a well-supported thesis that explains why a market of asset is undervalued and how it is likely to appreciate.
For example, an investor buying a property at a low basis may initially feel they’ve found a bargain. However, if the asset is in a declining market or lacks potential for recovery, the low basis alone doesn't guarantee success. A good investment requires more than an attractive entry price—it needs a solid foundation, including market recovery drivers, rental rate growth projections, and clear exit timelines.
Another note is that just because an investment was successful, does not mean you 'bought well'. There is a reality where every investment manager makes mistakes; avoiding those mistakes as frequently as possible is what sets the good apart from the weak (or lucky).
Considerations for Buying Well
- Downside Protection: How much room for error do you have in an investment before you lose equity?
- Low Basis: Is the price below replacement cost or historical averages?
- Location: Is the asset in a good location, where market fundamentals will support long-term tailwinds?
- Recovery Thesis: What market forces suggest value growth (e.g., infrastructure development, increasing demand)
- Timelines: How long will it take for value to materialize, and is the investor's timeframe realistic?
- Demographics: Are the demographics supportive of your thesis? Are there long-term net migration patterns, are new jobs likely to be located in these markets?
- Supply / Demand: What is the supply/demand ratio? If you have strong long-term demand in a high-quality market, it creates an environment that provides stability.
What Does It Mean to Recognize a Mispriced Market?
Mispricing occurs when the market price of an asset deviates from its intrinsic value. Recognizing these discrepancies requires keen insight into both market dynamics and investor psychology.
Investment Managers Get Paid for Two Things:
- Seeing and taking advantage of mispriced markets: This involves capitalizing on market inefficiencies, arbitrage opportunities, and pricing errors that the general market has overlooked. Whether due to temporary economic shocks, investor panic, or shifts in sentiment, mispricing can present opportunities for long-term value creation.
- Managing through market cycles: While recognizing mispricing is crucial, enduring through periods of market downturns is equally important. True investment success comes from maintaining discipline and weathering the challenging times in the market cycle.
Investor Psychology: Navigating Market Highs and Lows
Investor behavior is a crucial factor in recognizing mispriced markets. Market highs and lows often align with shifts in investor sentiment, which can create opportunities for strategic buyers. If someone were to ask you 'Would you sell your investment if you were in a market low, or would you buy new investments at the market low', it is easy to answer in a way that appears to make sense. The problem is your natural bias is to imagine the market changes, things are bad, but you are in the same or similar position you sit in today; That is not reality.
The way to frame a question differently: You have lost 50% of your net worth, your spouse just lost their job, the market appears bleak, would you be willing to invest $100K of your savings into real estate at what feels like it might be the bottom of a market cycle. If you put yourself in that position, it is harder to answer yes. Psychology shows that if you did not say yes to this answer in the past when you were in the situation, you are not likely to say yes, the next time it occurs.
Investment Managers are no different. We all have bias and will generally react to that bias in similar ways. A good investment Manager will understand this and develop well-thought-out investment practices and strategies that will allow them to invest when the timing is right! I quoted Howard Marks in my last memo, "You can’t predict the market, but you can prepare for it." Preparation in this context allows you to act when you see value and avoid your bias creating roadblocks you cannot get past.
Market Highs: Euphoria and Overconfidence
During market highs, there's often a prevailing sense of euphoria. Investors may fall prey to the “next biggest fool” theory, assuming prices will continue to rise indefinitely. At these times, properties are often overvalued as investors chase gains without properly assessing the risks. It’s critical to recognize when market prices have deviated too far from fundamental values, as excessive optimism can lead to inflated asset prices.
High prices alone do you signal a market without value, though it should cause you to stop and consider the possibilities. It is also impossible to time a market perfectly, however, this is a time when being a defensive investor makes the most sense. I'll dive into playing defense in a later memo, but in general, the idea here is being more conservative and taking less risk. Yes, you will do fewer deals, and your returns will be smaller, but when the markets turn, you will be more well-positioned to take advantage of the change.
As always, timing matters. Being five years early does not help you, though in real estate when the investment timeline is long, you are forced to think further into the future.
Market Lows: Fear and Retrenchment
Conversely, during market downturns, fear dominates the market, and many investors avoid buying altogether. This can lead to assets being undervalued as investors overestimate risks and underestimate recovery potential. Savvy investors can capitalize on this negative sentiment, recognizing that downturns often create opportunities to acquire assets at significant discounts.
The key is understanding the underlying fundamentals. A market might be at a low, but that doesn’t automatically make it the right time to invest. Timing matters, and investors must consider what will drive recovery, how long it will take, and whether the market has bottomed out for the right reasons.
If you are in a market low, have a strong investment thesis, and fundamentals are telling you it is a good time to invest, this is a time to be a more offensive-based investor. These times provide you with the most opportunities to create long-term value and are often short in nature. If an investment manager has a stable portfolio and has shown they can manage the volatility of time, successfully, this is when they can be more aggressive and really provide great value.
Managing the Volatility of Time: What Does It Mean?
Volatility, especially during downturns, presents risks that can wipe out even the best-planned investments. Managing through this volatility requires a deep understanding of how leverage, debt, and market cycles impact performance. Success hinges not just on buying well, but on managing downside risk effectively.
Key Elements of Managing Volatility:
- Leverage: High leverage can be a double-edged sword. While it magnifies returns in good times, it increases risk significantly during downturns. Vacancies increase, rents decline, and costs may remain fixed or rise, creating a precarious situation for over-leveraged assets.
- Short-Term Debt: Short-term financing can be problematic during corrections, especially when refinancing becomes difficult or costly. Higher interest rates or an inability to find lenders can force fire sales or defaults.
- Floating-Rate Debt: Historically, floating-rate debt has often provided advantages, especially in environments where rates trended downward. However, during rate spikes, unhedged floating-rate debt can turn into a "death blow" for portfolios, leading to severe losses.
The key to enduring these challenging periods is through defensive strategies. Being conservative with leverage, using long-term fixed-rate debt, or ensuring interest rate caps are properly matched to liabilities can prevent forced asset sales during a downturn.
Timing Matters: Catalysts for Recovery
Timing market entry and exit points require more than just recognizing mispricing. It requires understanding the catalysts for recovery and how long the recovery cycle will take. Managers need to analyze what will drive pricing increases, rental rate growth, and CAP rate compression before committing to an investment.
Key Considerations (May) Include:
- What will drive rental growth? Are current rents too low to justify new construction? How much supply is on the market, and how long will it take for occupancy rates to recover and drive rents upward?
- CAP Rate Compression: What factors will lead to CAP rate compression—will inflation moderate, or will recessionary pressures drive rates lower?
- Market Fundamental Shift: Was there a major market fundamental shift, like Technology companies expanding into the Seattle / Bellevue markets?
Managers must analyze these trends to determine if the market will return to prior levels, or if the new pricing structure is more permanent.
Offense vs. Defense: Strategy for Different Market Cycles
In any market cycle, balancing offensive and defensive strategies is crucial. The market often dictates when it is appropriate to play offense by taking on more risk for higher returns, and when to switch to defense by focusing on capital preservation.
Offensive Strategy:
- Higher leverage and concentrated risk: In favorable investment markets, managers might increase leverage and take on concentrated risks, especially when assets offer strong potential for capital appreciation or cash flow. You must always be cautious and manage the overall risk in your portfolio. It is more difficult in these times to get high leverage from lenders, so there is natural safeguards, but investment managers must use caution. This can be a time to double down and play higher amounts of equity into the market.
- Being a market buyer: In a difficult environment, if you become known as a 'market buyer' and you can show you will execute, you will have more opportunities. These opportunities will allow you to pick the best deals and create the highest returns, leaving sub-par investments for the others. Being aggressive in closing the deals you choose will allow you to become known in the market and give you the best opportunities.
Defensive Strategy:
- Low leverage and cash flow focus: In more uncertain or late-stage market cycles, the focus shifts to low leverage, fixed-rate debt, and ensuring that assets produce consistent cash flow. This approach mitigates risk and positions the portfolio to take advantage of market opportunities during downturns.
- Howard Marks, the CEO of Oaktree states 'The worst of loans are made in the best of times'. What this really means is that banks are eager to lend, they typically have higher deposits on their books and thus compete for the deals that are not always appropriate from a risk profile standpoint. Being cautious in these environments will provide you stability in the future.
Positive Leverage and Replacement Cost: Buying Below Value
Another strategy for recognizing mispriced assets involves buying assets below replacement cost in core markets. New construction or high-quality assets selling at a discount to their replacement value provide strong potential for cash flow growth. This typically only happens when you are entering a recession or there is a large market correction. These periods are generally short and require a decisive manager to take advantage of them.
Positive leverage can also be a powerful driver of returns. When the going-in CAP rate is higher than the debt cost, it generates immediate positive cash flow and provides a strong basis for value creation from day one.
Another strategy to 'buy low' is called a 'Mark-to-Market' strategy. This entails buying an asset with rents significantly below the current rental rate. Though your acquisition cap rate is often very low, you are buying future value for a slightly higher price today. When a tenant's lease renews or if the tenant vacates, you are able to raise the rents to the current market rents. This gives you a strong appreciation in operating income and thus capitalized asset value.
Value-Add Opportunities: Mark-to-Market Plays
Finally, buying assets where rents are below market but have the potential for growth (a "Mark-to-Market" play) presents an opportunity for value creation. If rents can be increased within a reasonable period, this type of strategy allows managers to purchase at a lower CAP rate and increase returns through the eventual rental rate increase, as well as high-quality management. These opportunities generally allow you to buy at a lower basis and provide you with strong downside protection.
However, time is critical. If the value-added opportunity takes too long to materialize, the investment may not produce the desired returns, exposing the manager to unnecessary risk.
Conclusion: Mispricing, Volatility, and Success in Real Estate
Recognizing mispriced markets and managing through the volatility of time is integral to SMARTCAP’s investment philosophy. These strategies not only help capitalize on market inefficiencies but also safeguard portfolios during inevitable downturns. By balancing offensive and defensive strategies, using thoughtful leverage, and focusing on buying well—not just buying right—investment managers can achieve sustainable, long-term success even in the most unpredictable markets.