Value investing as a strategy has been a hallmark of Warren Buffett more recently, and prior to that of his mentor Benjamin Graham – who is incidentally also the founder of the CFA Society NY.
A typical public equities value strategy tends to target stocks that can potentially offer “value” in the medium term. There are a variety of potential iterations – investors could be selecting companies with below-average price-to-earnings (P/E) or price-to-book (P/B) ratios, or even relatively low price to sales multiples. All these approaches aim to search for potentially undervalued stocks, and identify a potential positive catalyst ahead of consensus.
Another approach is to target steady cash flows from companies that have a history of distributing – or are projected to distribute – stable dividends, even as they are not expected to grow fast. Seen through the lenses of the traditional equity valuation model – the “Discounted Cash Flow” (DCF) model – which is the sum future expected cash flows discounted by the prevailing long-term interest rates, value investing seeks to target companies with a steady numerator (the cash flow), which makes them less sensitive to changes in the denominator (the prevailing rates).
Value investing is not inherently less risky than its traditional counterpart – “growth” investing, which targets companies with high growth potential and unsteady or non-existent cash flows. Value investors can end up being “trapped” in a company that fails to increase in value from the alleged discounted levels it is being bought at. In addition, dividends can be discontinued if a company stops performing as expected by the original investment thesis, and value stocks are also sensitive to market risk – if equity markets sell off, the price of any stock decreases.
Just like the stock market, the real estate industry has different schools of thoughts on investment approach. As a reminder, commercial real estate investments can be subdivided into different tiers, depending on the risk-return profile of the investment – in practical terms, the location of the asset, how stable is the income it generates, and the potential for capital appreciation.
On one end of the spectrum and similar to value investing approach, core real estate can typically provide stable cash flow and limited volatility in asset value. A lot of trophy assets in New York City buildings – for instance – would fit this profile as their demand is very stable, which attracts investments.
A good example of the stability of core real estate investment was evident during the COVID downturn, as the shutdown prompted a major fall in rental prices and collection but the recovery was very quick, with asset prices soon rising up to par or even higher than pre-COVID.
“Core” investments are projected to generate income by focusing on established properties that are close to urban centers, have been recently built or completely renovated, have stable tenancy and show slow but steady potential appreciation. Core real estate can also exhibit some of the features of public fixed income investing, namely steady cash flows and some level of downside protection (the value of a “core” real estate investment is unlikely to go to 0) over time.
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As a segment, core real estate tends to attract more risk-averse investors, such as pensions and endowments, that target relatively lower risk-return profiles. The likely IRR of many “core” deals is in the low-double-digit range, and most real estate private equity investors often target 15-20% returns. On the other hand, value stocks do not per se lead to returns lower than growth stocks – some riskier value plays, which border distressed investing, can generate outsized returns.
In terms of duration, core real estate tends to be held for longer compared to other real estate categories. Core deals also tend to use less leverage (60% or less).
While core real estate returns are – intuitively – driven by cash flows, capital appreciation can at times occur if the property is purchased at the bottom of the market, or if there is sustained appreciation and the property is sold in a red-hot market. Again, the situation is not dissimilar to a good value equity play, where the value stock is bought at market bottom and sold in favorable market conditions. However, while timing markets is a famously foolish errand, since real estate is less volatile it may be relatively easier to time the cycle right, especially if an investor is less interested in liquidity and can withstand duration.
The value investing principle can also sometimes be applied to distressed or value-add investment. There are plenty of situations where the owner needs liquidity and is forced to sell at a discount, or the property is mismanaged and the buyer believes they can increase the value of the property by increasing net income.
Accessing a wide choice of real estate investment opportunities has been traditionally harder for retail investors. While public REITs have been an option, high minimums for bespoke deals have been hindering potentially more selective allocations. Yieldstreet’s platform has opened up the opportunity to invest in real estate – among other private market assets – by building a diversified portfolio within the space.
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