By Eric Cress
March 14, 2016
At our heart, UD+P is a value investor. With every investment we make, we must produce income, over time, that is worth more than what it cost us to make the investment. Sticking to this simple notion is how we have been successful at ‘timing’ the market.
I think a great illustration of this is Forest and Garden Apartments, a project we bought near the top of the market during one of the most inflated real estate bubbles in history. Granted, it was the only investment we made during that period, after looking at thousands of opportunities, but we were able to underwrite it. How were we able to underwrite this acquisition at this time? And how did it turn out?
Let’s start by stepping back and looking at the state of the market during that period. I like to use the Green Street National Properties Index to look at national commercial property values over time. The Green Street Index is similar to the Case-Schiller Index, except for commercial property.
As the index shows, the commercial property market has completely recovered from its Q1 2009 low, and now exceeds the peak values of 2006.
I also like to characterize the state of the market based on how far values creep away from longterm nominal averages. At times when property values are within +/- 15% of the longterm nominal average (blue line), I consider that we are in a nominal market. Once property values exceed that +/- 15% window, I label the market exuberant. When prices are below that window, I label the market distressed. In 2006, we were in an exuberant market.
We bought Forest and Garden apartments in the second quarter of 2008, while the market was still in an exuberant state. We sold the property in Q2 2015, earning an annualized return over the holding period of 10.12%, and 156% return on investment. How did we purchase a building during one of the most inflated real estate bubbles in history and still earn a respectable > 10% compounded return over a 7-year holding period? Not by timing the market, but through solid underwriting.
Between second quarter 2008 through second quarter 2015, the overall real estate market appreciated in value by 24% whereas Forest and Garden appreciated in value by 39%. If we place that sales price on the index, and then work backward to the purchase date and identify the point that represents 39% appreciation, we see that the purchase basis was close to the long-term nominal property values. That is a price that will pass our underwriting and trigger a purchase. However, at that time in the market, finding such a deal was a rare thing. After reviewing thousands of investment opportunities, we found only one property during that period that met our investment criteria.
Investment Principles that Apply in Today's Market
1. Don't follow the crowd.
Current buying opportunities are outside the purview of the herd of irrational buyers that are driving prices up. As strategist Michael Porter implied, when you choose your strategy, you choose your competition. In investing, you do not want to choose irrational buyers as your competition, because they drive up the price of assets. We do not want to chase after the same assets that they are chasing after, so we look for different product types. In today’s market, the irrational buyers are 1031 exchange buyers, who pay too much in order to avoid taxes, and institutional buyers who deploy capital in order to earn fees.
2. Good deals tend to be off market.
This is really a derivative of the first principle, to stay away from the herd. Good deals tend to be off market because widely marketed properties draw more irrational buyers, and in this market, there is always some buyer out there willing to pay too much.
3. Leverage your competitive advantages.
UD+P has the competitive advantages of direct construction expertise and private capital. Most developers tend to be architects, brokers, or finance people, not general contractors. We happen to have the advantage that one of our principals, Avi Ben-Zaken, is a general contractor. We leverage that expertise to purchase complex rehab projects and adaptive reuse projects such as Forest & Garden and American Brush, and we exercise ingenuity and experience to deliver them for low prices. These are great projects, but they do not suit 1031 exchange buyers or institutional buyers, and thus avoid that competition.
We leverage our local knowledge through our understanding of local zoning codes and emerging market trends, as well as strong local brokerage relationships. This allows us to build new industrial office property in the right areas. For example, Framework, which is actually built in an industrial zone where land is relatively cheap.
Finally, we leverage our private capital through flexible deal-making and engagements with landowners in joint-venture projects. This is something that institutional investors do not do well, and that 1031 exchange buyers cannot do. We can also do interesting things with programming — like building larger apartments that are condo-ready, sacrificing some dividend yield over the short term while earning a higher return over the long term. This is something that short-term oriented institutional funds, who have to report quarterly, are loath to do. And 1031 exchange buyers generally do not engage in new construction at all.
Was it brilliant insight or a crystal ball that led us to these strategies? Not at all. We simply look at a very large volume of opportunities. Our Portland roots, and relationships, provide us with a lot of deal exposure. We then filter those through our underwriting criteria, and we move forward aggressively on deals that work. Naturally, we find that feasible projects, at any given time in the cycle, have similar characteristics for that time in the cycle. This time is no different.