In my last blog post, I discussed the causes and effects of the private real estate (PRE) recession of the late 1980s and early 1990s, and I promised that, in this post, I’d discuss some of the tensions that the downturn created for the relationship between institutional investors and their investment managers. Before I get into that tale of woe, I need to make a quick detour into the dark art of PRE valuation, since one needs to have a basic understanding of that, as it has historically been practiced, before one can appreciate why some of the behaviors of investment managers during the downturn caused consternation among their clients.
Let’s start with the traditional definition of “fair market value,” i.e. the amount of consideration that a willing buyer will pay a willing seller for an asset, assuming both are in possession of all the relevant facts. In public markets, the fair market value of an asset is yours for the asking. Right now, as I write this, according to my iPhone, the fair market value of Apple’s common stock is $332.27. That price will undoubtedly change (probably before I’ve finished writing this paragraph—whoops, there it goes!), based upon the actions of buyers and sellers in the marketplace. And for anyone so inclined, you can follow the action in Apple or any other publicly traded stock on a minute-by-minute basis. The same can be said about many fixed-income instruments, such as the 10-year Treasury note.
As we all know, things are not quite so simple with private assets, including private real estate, alas. For this purpose, I am ignoring publicly traded REITs since we are interested in the value of the real estate that they own, not their stock prices. The stock price of a REIT is most certainly influenced by the value of its underlying portfolio, but other factors affect that price as well. In most instances, a REIT trades at a market cap that reflects either a premium or a discount to the net asset value of its portfolio.
When the discount of a REIT’s market cap relative to net asset value (NAV) becomes sufficiently large, it can prompt a transaction in which the REIT is taken private, like the one that was announced earlier this year with respect to Veris Residential.
The vast majority of PRE assets are valued, either internally by the investment manager or externally through the use of a third-party valuation expert, as of the last day of each calendar quarter. (Our public interval fund, the Accordant ODCE Index Fund (ODCEX) is one of the few exceptions in that we value the NAV of units in ODCEX daily using a set valuation policy that we have carefully and thoughtfully crafted.) Irrespective of whether the valuation is done internally or externally, it typically relies heavily on how comparable assets have traded in determining the value of the asset in question.
This stands to reason, of course. If I own a modern, well-maintained, fully leased and well-located multifamily residential building in Scottsdale, Arizona, and a similar asset in the same submarket has recently changed hands, then the trading value of that “comp” certainly tells me something germane about what my asset would fetch were I to take it to market.
Now, here is where that peculiar but important notion of the “cap rate” comes in. PRE professionals talk about cap rates like baseball buffs talk about batting averages or earned run averages. A cap rate is basically the going-in yield that an investor expects to earn once it invests in a real estate asset. Think of it as the inverse of the price-to-earnings ratio of a stock.
If my neighbor’s multifamily building is yielding, after expenses, $60 per square foot per year, and someone is willing to pay $1,200 per square foot for that asset, then the cap rate is 5% (60/1200). As the owner of a comparable asset, I can look to that trade for guidance as to the value of my property.
There are other factors that influence the valuation analysis, so it’s not solely a function of the cap rate. For example, there may be debt encumbering an asset with terms that differ from what is then available in the market, and that might have some effect on the valuation. Even so, the availability of cap rates from recent trades involving comparable assets heavily influences the analysis.
(You have probably figured out by now that this cap rate business is analogous to fixed-income yield, in that the effective interest rate on a bond varies inversely with its price.)
In any event, real estate being a cyclical business, I like to say that when cap rates are high, we should go long; when cap rates are low, we should go short; and when cap rates are on the move in one direction or another between high and low, we should go to the golf course.
There are, in fact, periods of time when PRE market activity essentially stops—buyers effectively go to the golf course. Since there are no trades, there are no comps. Or maybe trades sporadically take place, but they don’t for whatever reason seem like they provide reliable information about where values are. A market can thus become “high-centered,” so to speak, because values have suddenly been called into question by market conditions (as happened in the late 1980s and early 1990s) or by a sudden credit crisis (as happened during the Global Financial Crisis of 2008-09) or by a rapid upward movement in interest rates (as happened earlier in this decade).
Now, because the managers of open-end funds often earn fees based on the NAV of their funds, and because their investment track records as well as their fee streams can suffer if they mark down the NAVs of their portfolios, they are naturally incentivized to postpone marking their positions to market when values are suddenly collapsing and to cite the lack of cap rates from recent trades as the reason. Investment managers’ unwillingness to mark down their positions in such circumstances has sometimes led some of their investors to believe that they are being both misled and overcharged—and rightly so.
This is, in fact, what happened—or at least what institutional investors suspected was happening—during the PRE recession of the late 1980s. Indeed, an employee of one major investment manager sued his employer under a state whistleblower law, alleging that he had been punished for asserting that the portfolio of a fund sponsored by the manager was carried on its books at a value materially in excess of true NAV.
During the recession, many institutional investors became so concerned about this misalignment of their interests with those of their PRE managers that they tendered their units in open-end funds for redemption, only to be placed in a redemption queue with similarly stuck investors that looked like a line to buy tickets to see Hamilton for half price. Fact of the matter was that, in order to redeem their investors out, the open-end fund managers would have had to sell assets at distressed prices to whatever bottom-feeder they could scrounge up to buy them, which in turn would have put the lie to their current NAVs.
One can, perhaps, understand, if not actually sympathize with, the managers’ plight.
This misery, which went on for years, caused institutional investors to rise up en masse and demand that investment managers reform their ways of doing business so as to improve transparency and governance, create better alignment of interests (through, among other things, requirements that fund staff and sponsors invest their own money alongside the capital raised from institutions, giving them so-called “skin in the game”), and so forth. Fund managers had little choice but to accede to these demands or else find themselves out of business.
From these difficult times emerged a better-managed, more transparent PRE fund management industry, to the benefit of all concerned.
At the same time, as a result of the crash in the late 1980s, Wall Street took a sudden interest in PRE that led to the development or adoption of new vehicles through which PRE could raise capital from both institutions and retail investors. That will be the topic of my next post.
The existence of daily valuation procedures does not eliminate valuation risk, and Fund NAV remains dependent on valuation methodologies and available market information.
Investments in private real estate, including ODCEX and other Accordant-managed funds, involve risks, including loss of principal, limited liquidity, and valuation differences associated with private investments. Past performance is not indicative of future results. View important product risks and disclosures.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Accordant ODCE Index Fund. This and other important information about the Fund is contained in the prospectus, which can be obtained online by visiting www.accordantinvestments.com. The prospectus should be read carefully before investing. For differences between the Class A shares and Class I shares, please see the prospectus of the Fund.