Clearer Pricing Picture Sought for Risky Real Estate

Riskier, noncore real estate ventures predominate the private real estate market, said Joseph Pagliari Jr., clinical professor of real estate, at a keynote speech to the first annual Chicago GSB Real Estate Conference, sponsored by the Real Estate Alumni Group, November 5 at Gleacher Center. Yet investors often misunderstand their pricing, he said.

Noncore real estate investments are value-added and opportunistic, and include everything other than core real estate. Pagliari defined core real estate as industrial, office, retail, and stabilized apartment properties. Core real estate, if it is leveraged, functions as noncore does.Of the $36.3 billion of investments in private real estate in 2007, Pagliari said, noncore amounted to $24.7 billion, or about two thirds, and core amounted to $11.6 billion. He also noted that real estate-oriented private equity firms are booming.

Return on real estate investments is affected by capitalization rates, degree of leverage, and transaction costs, Pagliari explained. 

Return on investments changes with cap-rate compression and expansion and with the number of years the investment is held. Pagliari used a chart to show that the sooner cap rates fall, the more total annual returns are achieved.   

Pagliari examined NCREIF history from 1978 to 2006; NCREIF is a basket of 550 institutionally held core properties. He pointed to a graph showing average cap rates steadily declining to a low of about 6 percent in 2006, having peaked at more than 8.5 percent in the mid-1990s.

 “With regard to this sample of institutional properties, I would argue that cap rates look pretty low,” said Pagliari. “I don’t mean to sound gloom and doom, and I’m not, but I do think it should give some pause.”

Earnings from NCREIF real estate investments grew at a rate of about 80 percent of the rate of inflation over that 28-year period, he said.

Financial leverage complicates the real estate investment picture by increasing volatility; the increased returns one would expect with a riskier, leveraged investment are offset by increased volatility, he said.

Because a core property that is leveraged can have the same risk/return characteristics as a noncore property, whether or not the noncore property is an attractive alternative depends on its pricing.

 “I can take core with leverage as an alternative to investing in a noncore deal,” Pagliari said. “Whether that noncore deal is favorable or unfavorable depends on how it compares in a relative fashion to my alternatives.”
 
Transaction costs weigh more heavily on noncore real estate returns than they do on core real estate deals, he said. The greater the leverage and the shorter the holding period, the more transaction costs will act as a drag on total returns.

Pagliari also looked at joint ventures and found typically joint venture deals are structured so that the operating partner starts to see returns after an investor achieves a preordained amount of return, called a preference. The operating partner’s return is alternatively known as a promote, preferred interest, contingent interest, or backend residual. The operating partner’s return functions like an option.

The least understood aspect of joint-venture pricing, Pagliari said, relates to the affect on likely returns because of joint-venture participation. The value of the option for the operating partner together with ongoing fees, including for monitoring the deal, eat into the investor’s likely net returns. 

The investor carries responsibility for the downside. The greater the volatility involved, whether through financing or other factors, the greater the chance that the operating partner will receive a larger return, at the expense of the investor’s return, Pagliari said.

“The value of your promote as a developer actually goes up with the volatility of the asset,” Pagliari said.

In joint ventures, when the promote is earned in-the-money, the operating partner is motivated to “take a conservative approach” and will tend to make “safe bets” in the future because of the volatile nature of the deal, Pagliari said. In that case, for example, the operating partner would tend to execute a lower-rate lease with a strong credit tenant.

But when the promote is out-of-the-money, the operating partner tends to make risky bets because the downside is completely underwritten by the investor, Pagliari said. So, for example, the operating partner may execute a higher-rate lease with a weak credit tenant.

Pagliari analyzed the performance of joint-ventured and non-ventured properties in the NCREIF Property Index from 1983 through 2006. Ventured properties outperformed nonventured properties by about 190 basis points, before the promote was deducted. In recent years, from about 1998 to 2006, that (gross) performance difference has shrunk to about 70 basis points, Pagliari said.“Whether the net performance of joint-ventured properties exceeded non-ventured properties depends upon where the preference and promote were set.”

- Mary Sue Penn