What is real estate
Real estate is a physical ‘bricks and mortar’ investment, where income and value are driven by rents that are paid by tenants under contractually-binding leases. Its subsectors include office, retail, multifamily, industrial, self-storage and hospitality. The main sources of real asset cash flows are derived from rents determined by the leases of the underlying real estate assets, which have intrinsic value based on location, quality and lease structure.
Why Real Estate
Stable, reliable income streams
The cash-flow streams of real assets are often supported by regulated or contractual revenues and attractive operating margins. Many of these businesses are subject to long-term lease or concession agreements, which frequently include pricing provisions that seek to ensure a predictable return over time. As a result, these assets tend to generate consistent and stable cash-flow streams with lower volatility than other traditional asset classes.
Real estate has significantly lower correlation to other growth assets and it is not typically impacted by changes in market sentiment as quickly as equities. Its low correlation with other asset classes provides effective diversification benefits and can reduce the overall volatility of an investment portfolio. Since real asset returns have historically had low correlations to traditional equity and fixed-income investments, they can provide an effective way to enhance the diversification of a traditional stock and bond portfolio. Because individual real asset categories have also shown low correlations with one another, investors can further diversify the drivers of risk and return by investing in more than one real asset class.
History shows that inflation can emerge unexpectedly. For this reason, long-term investors can benefit from allocations that generate cash flows with a positive sensitivity to changes in inflation. Real asset revenue streams often respond favourably to higher inflation, as shorter-term contractual revenues (i.e., one-year apartment leases) benefit from frequent resets, while longer-term contractual revenues (i.e., 30-year airport concessions) often include regularly scheduled rent escalations linked to inflation. Some infrastructure asset classes also have volume increases during inflationary periods, particularly when rising prices are spurred by economic growth and improving levels of employment and consumption. As a result of these various drivers, real asset returns tend to exhibit greater sensitivities to inflation than traditional investment alternatives.
Capital appreciation potential
Capital appreciation has represented a meaningful amount of the historical total returns generated by real assets. These long-lived, hard assets tend to increase in value over time, as replacement costs rise, and operational efficiencies are achieved—particularly for well-located assets in high barrier-to-entry markets. This tendency exists across the real asset investing universe, whether it is realized through the improved leasing of vacant space, the growing throughput on toll roads, rising volumes of energy demand, expanded harvesting of timber assets or climbing food prices. In short, real asset-related current income can help protect value on the downside, while operational leverage can enhance value on the upside.
Ways to Invest in Real Estate
Direct real estate
When investing in direct real estate, investors purchase the assets themselves and gain access to the ‘pure’ risk of real estate. This means they can expect predictable secure long-term rental cash-flows and exposure to the real estate market cycle. The downside of owning a physical asset is that money has to be spent on maintaining the asset over time. However, historically direct real estate has produced relatively strong returns for investors. Direct real estate is usually valued once a year to capture a year’s worth of events at one point in time. Actual underlying market fundamentals and asset-specific risks are the principal drivers of direct real estate pricing. Direct real estate investment by most private investors is in residential real estate, as it is beyond the reach of most individual investors to buy an office block or shopping centre, mainly because of the higher dollar amounts required. These days, however, direct real estate is becoming more accessible to retail investors via fund products that offer access to these types of assets.
There are two typical types of pooled funds: syndicates and hybrid funds. For syndicates, retail investors can buy partial shares of physical assets with other investors, where this type of fund typically invests in one or two assets. Hybrid funds, on the other hand, are funds that give investors exposure to partial ownership of direct real estate either via a syndicate or institutional fund, together with some holdings in real estate securities.
Listed real estate
When investing in listed real estate, the investor does not hold the property, but instead owns units in a fund or trust that pools money with the money of other investors to invest in a range of real estate assets. Popular listed real estate investments are Real Estate Investment Trusts (REITs), which make up a significant part of equity markets. One of the advantages of REITs is that they allow investment in commercial and industrial assets, something that is harder to do directly. The pricing of listed securities is driven by market sentiment and prices are considered a reflection of future expectations. Unlike direct real estate, bad news or good news is usually reflected immediately and prices can ‘overshoot’ on the upside and the downside.
Risk associated with Real Estate
Real estate returns may be affected by factors such as investor demand for assets, demand by tenants for commercial space, rental income levels and the supply of new commercial space. The cost of real estate debt, or costs and losses associated with natural disasters or other events which prevent the normal operation of real estate investments also have an impact on the performance of real estate returns. In general, real estate risks refer to three main categories: sector risk, vacancy risk and value risk. As far as sector risk is concerned, there are a number of factors which may affect the real estate sector, including the cyclical nature of real estate values, over-development and increased competition, increases in real estate taxes and operating expenses, demographic trends and variations in rental income. Changes in the appeal of properties to tenants, increases in interest rates, the level of gearing in the real estate market and other real estate capital market influences can also affect the performance of the sector. The vacancy risk refers to the risk of a tenant vacating a property, failing to meet their rental obligations or failing to renew a lease can have a detrimental impact on rental returns. Real estate assets face value risk because asset values are influenced by location, supply and demand, rental agreements, occupancy levels, obsolescence, tenant covenants, environmental issues and government or planning regulations. Changes to these drivers may affect the end value of the asset.
Valuing Real Estate
Real estate assets, in their functions of investment assets, consumption goods, production tools, often need to be valued. In relation to financial assets, real estate assets feature unique characteristics and, for this reason, their valuation gives rise to specific estimation issues and practical problems that still have to be confronted and overcome.
The three main valuation approaches, identified by practitioners as well as by academics, are:
- Income-based approach
- Market approach
- Depreciated cost approach
Each of them better applies in specific situation and are often used in conjunction in the valuation practise.
Income-based approach: financial valuation
The cash-flow valuation models developed for financial assets can be applicable for real assets as well. In particular, the value of real estate property should be interpreted as the present value of the expected cash flows generated by the property. That said, there are serious estimation issues that still have to be confronted, unique to real estate. The inputs of the income-based approach are:
The risk and return models used to evaluate financial assets do not apply to the analysis of real estate. In the estimation of the discount rate, indeed, the following elements need to be considered:
- real estate assets are individual and non-traded thus return and risk parameters are difficult to estimate;
- the market portfolio is generally approximated by a stock index; however, in reality it should include all asset classes in the economy. The shortcoming of this approximation is particularly harmful in REA valuation, considering that the real estate asset class accounts for roughly 30% of the total market, and causes underestimation of beta as well as risk of marginalization
- transaction costs are considerably high and insufficient frequency of deals command higher risk on the market due to lack of liquidity
To overcome the abovementioned problems, common practice in estimation of discount rate is the application of a build-up approach. It allows to obtain an estimate as a function of the risk components influencing the asset: the discount rate should be in fact equal to the risk free plus a specific risk premium. The risk premium aggregates the specific risk components including economic-financial factors, real estate factors and specific asset factors.
First thing to be noticed is that not every real estate asset generates cash flows. In general, cash flows have to be estimated and in particular:
- Inflows, that are mainly rent proceeds, are based on structural vacancy in the market, forecasted rent level and expected demand for space;
- Outflows, that include mainly property taxes, financial cost, management fees, maintenance costs) are easier to forecast a priori since they are generally stable as a percentage of the value of the asset and feature stability across comparable assets.
Key factors in estimating the growth rate are the expected inflation rate and the expected vacancy rate. In normal market conditions, the expected growth rate can be closely approximated by the expected inflation rate. In markets with low vacancy rates, the expected growth rate can be higher than the expected inflation rate and the reverse is likely to be true in markets with high vacancy rates.
While many financial assets are considered to have infinite life, real estate assets have finite life. These differences in asset lives manifest themselves in the value assigned to these assets at the end of the ‘estimation period’. While the terminal value in a standard DCF valuation accounts for 60%-80% of the total value, the terminal value of a building may be lower than the current value because the usage of the building usually depreciates its value. The land component, however, will have an infinite life and, in some cases, may be the main component of the terminal value.
The financial valuation is not the only valuation methodology based on the income approach: there are indeed many variants that all share the DCF structure.
Market approach: comparable valuation
Just like financial assets, real estate assets can be, and indeed are, better valued using a standardised value measure and comparable assets. The advantages of this approach are:
- It allows the valuation of non-cash flow generating asset
- It takes into account market trends not reflected in the cash flow (e.g. rent contractually fixed for a given period or rent control law preventing rent rates from rising)
- It does not require explicit assumption on discount rate and terminal value
The drawbacks of comparable valuation in real estate are even more evident than in financial asset valuation: there is a strong need for standardized measures and adjustments to differentiate according to income production capability, age, location, quality of the construction, maintenance status etc. Each real asset, in fact, features extremely unique characteristics and it is impossible to find a panel of pure comparables for it. Some adjustments are simple, but many of them are instead highly subjective and for this reason they require professional judgement and strong rationale.
With real estate assets, the value is standardised by size – in the form of price/sqm – or by income produced – in the form of multiplier of price-over-gross annual income. This latter standardized indicator, despite being less used, is more complete and explicative since it already accounts for size, quality, location etc.
Moreover, a further application of the market approach is the construction of a regression. The regression approach can in fact be extended also to real estate asset valuation, in order to include the large number of specific characteristics in the model and to “give a price” to each of them, thus reducing the subjectivity in the adjustment. It is common practice to regress price per square meter against the main features of a real asset and market conditions such as vacancy rate, income generating power, size, location, construction quality, design, size of the land, maintenance status etc.
This model however, while reducing considerably the needs for adjustments, retain some subjectivity. Indeed, many important variables such as location are qualitative factors and have to be classified in numerical classes.
Relative valuation works better in real estate than in other businesses’ valuation: while companies differ a lot in terms of growth and risk profile, the main difference across real estate assets, also common to companies, is the cash flow-generating capability. However, it should be noted that such a power is in turn a function of location, quality of the construction etc., thus many factors are actually impacting the valuation. Finally, comparable valuation is particularly appropriate in valuing homogeneous or standard real estate assets and works better for real estate classes for which the market for property, as opposed to the market for space, prevails.
The depreciated cost approach
This approach is uncommon and it is used usually in case income approach nor market valuation can be applied. Examples of applications are the appraisal of special use assets (schools, factories, churches.) or for insurance purpose, as only the value of improvements is insurable and land value is separated from the total value of the property.
The general idea supporting this theory is that value cannot exceed the cost of replication, thus the price of the asset should not exceed the cost of buying the land and building the asset. In most of the cases however, the asset is in use and the development lost value due to economic or functional depreciation. In these circumstances, the value of the asset should be net of depreciation. It is however hardly estimated: the useful life of the building is uncertain and the depreciation, in relation to its maintenance status, is far from objective. One of the solutions commonly used is to estimate the cost of renovating the building and consider it as the sum of the depreciation cost.
Conclusions on valuation methods
Real estate investments generally can and should be valued with the same approaches used to value financial assets. That said, there are still specific estimation issues and practical problems that need to be taken into account:
- Real estate assets are non-listed, thus risk parameters and discount rates are difficult to estimate
- The difficulty to identify comparable assets and to adjust for differences among them remains a significant problem
- The useful life of the development and consequently the depreciation computation retains a subjectivity component
After the introduction of real estate markets and the valuation approaches, it is now worth considering a couple deals which recently took place to gain a deeper understanding of the key drivers shaping real estate investors’ choices. The entirety of deals analysed involves properties located in one of world’s hottest places to be: New York City.
Google strikes $2.4bn deal for Chelsea Market building in New York – March 20th, 2018
About the deal
Google recently purchased from Jamestown New York City’s historic Chelsea Market for a price of $2.4b, expanding its footprint in the Big Apple. Lying next to NYC’s revamped High Line elevated park, the 1.2m square feet (sq. ft.) complex has lately been attracting several visitors, both tourists and residents. The deal comes on top of a formerly concluded neighbouring $1.8b purchase dating back to 2010. However, Google will not feel alone in its newly acquired property, which is already home to other prestigious brands such as the Major League Baseball and the Food Network, one of City’s long-lasting traditional markets.
The deal comes in a moment when tech companies have been exponentially increasing their New York-based property holdings. As of December 2017, they owned 29.3m (8%) of the 398m sq. ft. office space available. Moreover, in the last 10 years, new leasing agreements by tech companies covered an aggregate surface of 21m sq. ft.
As of now, none of the parties involved explicitly referred to Google’s future intentions related to the acquired structure, even if agreements included the possibility for Larry Page’s company to add 8 further stories to the existing block and a redevelopment plan does not have to be disregarded. The acquisition therefore entails the potential to generate a new campus the likes of Google’s Californian headquarters, turning a formerly industrial area into a first-class tech-sector hub.
About Google, an Alphabet’s company
Alphabet is a holding company whose portfolio of activities is divided into two main segments: Google and “Other Bets”. The Google segment includes the worldwide known tech giant and the wide variety of internet products it offers, ranging from advertising to digital content and applications, as well as cloud offerings and hardware sales. Google operates with globally-known interactive platforms – its products nowadays boast billions of daily users – such as Search, Ads, Maps, YouTube, Android, Chrome and Google Play. The “Other Bets” portfolio includes instead, among other innovation masterpieces, tools of the likes of Google Fiber, Nest and Verily, active in the internet and TV services’ distribution and R&D licensing. Although its market ticker never changed, it is worth mentioning that Alphabet has officially replaced Google as publicly traded company since October 2015.
Jamestown is an investment and management company focused on income-generating US-based real estate assets. As of FYE2017 – in the early hours of its 35th year of operations – the firm accounted for approximately $11.5b assets under management (“AUM”). Throughout its multiannual experience in the field, Jamestown has established as a reputable asset manager specialized in both M&A transactions and property management, constantly paying special attention to design and sustainability. Headquartered in Atlanta and New York with additional offices in Boston and San Francisco, the vertically integrated operator relies on a thick employee network involving no less than 140 professionals and an EU Investors’ dedicated office in Cologne.
As a stable and thriving company, Jamestown has traced its way to success by approaching all projects with a long-term view, oriented to create value for the local community and consistently being the spokesman of environmentally friendly initiatives.
Savanna is buying 5 Bryant Park from Blackstone – March 5th, 2018
About the deal
Savanna recently reached an agreement with Blackstone for the purchase of another one of its precious Bryant Park’s offices for a price of $640m. The 34-story 665,000 sq. ft. property has its roots in one of the most symbolic districts of the Big Apple. Its history also provides an excellent example of private-public integration. Given its closeness to attractions the likes of Times Square, MOMA and Bank of America’s Tower, the park ends up being among city’s most popular rendezvous points.
Previously acquired by Blackstone in the context of the $7.2b joint venture takeover of Trizec Properties completed side to side with Brookfield Property Partners. With its newly acquired offices, Blackstone will join the company of some of the most important organizations worldwide in City’s most exclusive area. The deal enshrined the end of a two-year odyssey that had since now seen Blackstone trying to come up with a sale. The opportunity was simultaneously seen by the acquiring company as a unique opportunity to acquire one of city’s most iconic properties. Its rationale is centred on creating an attraction for top-tier workforce, providing millennial workers with best-in-class benefits.
Finally, the deal crowned a strong expansionary phase in which Savanna aggressively completed a series of consistent purchases, with Chelsea Market and Berkeley properties being the most popular example. These deals were aimed at using the proceeds raised from the opening of its latest $600m fund and have been facilitated by a still slowed down American real estate market. According to its post-deal plan, Savanna is now expected to hold the property until a redevelopment plan is designed.
Savanna is a New York-based vertically integrated real estate investment manager, strongly focused on strategic investment opportunities spread across the whole city area. It accounts for a $3.5b stake of capital invested and its assets are distributed alongside a 14m sq. ft. surface. Since inception, investment manager’s operations have been dominated by an active and entrepreneurial culture which allowed the firm to consistently provide its customers with value-added experiences and to embrace market turnarounds as opportunities to adapt to the renewed demand and increase its portfolio value. Savanna’s investments involve both equity and debt instruments. The equity class targets properties characterized by considerable hidden potential, later in the process made subject of intensive redevelopment plans, often accompanied by tangible leasing efforts. Besides this first asset class, Savanna has also been actively involved in managing debt real estate instruments, typically focusing on those which are deemed to have a greater equity-like potential profitability. Firm’s portfolio is also well-diversified in terms of properties’ location – assets are held up and down the capital stack – as well as size and nature.
Blackstone is the largest private equity firm operating in the real estate industry worldwide, with approximately $115bn AUM and concentrated global presence touching upon the whole American continent as well as Europe and Asia. In a fashion similar to its counterparty in the deal, the approach followed by the asset manager in assisting its clients is really hands-on, aimed at targeting high long-term value-added opportunities.
Blackstone’s portfolio is mainly composed of office, retail, hotel, industrial and residential purpose-built properties, with major holdings including masterpieces of architecture such as Hilton and SCGP – the famous Chinese shopping center – together with prime office buildings in most important and economically vital cities around the world.
JPMorgan Chase triples its space at 5 Manhattan West – June 2nd, 2017
About the deal
The deal involved one of the last pieces of Brookfield’s Manhattan West’s project, whose current outlook is gold-plated by two further completely renewed office facilities, a retail building, a garden, a plaza and a 64-storey, 844-unit residential tower, “the Eugene”. This deep restructuring process turned one of Manhattan’s most unsophisticated buildings into a revitalized and sparkling office space. In fact, according to David Arena – Head of J.P. Morgan’s Global Real Estate – this building is different from a traditional office block both “geometrically and experientially” and, again, “you can see the workforce, you can feel the vibe of what’s going on” there.
The bank closed a deal allowing her to more than triple its space at Five Manhattan West, adding further 300,000 sq. ft. to the already deployed 125,000 sq. ft., originally leased four years ago. Since then, the sharp increase in fintech, smart data, client relationships management and other digital services importance led to an extremely fast recruiting process. This generated in turn an exponential increase in this branch’s workforce. In fact, the underlying deal rationale for J.P. Morgan was to create the conditions to move around 2,000 to 2,500 digital teams’ members in the just leased 428,000 sq. ft.
Last but not least, Brookfield’s renovations accounted for over $300m and the firm expected to extract a 30% premium on previously paid rents on top of the considerable investments completed. However, at the time of the deal, the asset manager was able to get rents twice as high, with minimum estimates around $90-per-square-foot.
J.P. Morgan is a global financial services provider as well as the biggest lender worldwide, thanks to its consolidated presence in more than 100 countries. The main clients assisted by the financial giant include large corporations and institutions as well as governments. Besides being globally known for high-end customers and first-class services, one of J.P. Morgan’s backbones is the extreme importance and variety of charity and voluntary activities that all employees offer in the attempt of giving back to the greater local community.
About Brookfield Property Partners
Brookfield Property Partners is a network of around 250 workers that owns and manages one of the largest diversified global real estate portfolios, with assets ranging from hospitality and industrial buildings to multifamily and student accommodation. The firm is active in seeking high-quality assets – located in resilient and dynamic markets – which are believed to lead to a 12-15% long-term ROE and allow for its annual distribution growth rate to lay in the range of 5% to 8%. Diversification and an attentive shift of resources from mature to potentially higher-yielding assets are at the heart of Brookfield’s strategy.