The start of a love story with San Antonio Texas. Essex Modern City premiere video launches with great fanfare.
One City Drives to the Top
I haven’t been to every city in the country, but there is one city I have been watching closely over the last couple of years. That I have now moved this City into an extremely bullish category. Disclaimer: I am not suggesting all investments in this City will be successful but if positioned correctly this will be the top city on the country to invest in.
(Spoiler Alert: The Motor City)
Those of you that know me know that I am a data junkie. I don’t make an investment without having a lot of market research. I believe investing without data is attuned to gambling and I don’t like to gamble.
Years ago, I was speaking on declining populations and how population clines (movement) was one of the strongest drivers of the real estate market. “White flight” (not racist) as it is often referred to, is when those capable of moving for better jobs do so, and thus leave a higher percentage of low paying jobs behind. White flight leads to reduced tax basis and struggling finances for municipalities. As I was talking to that, I was bad mouthing Detroit as a city that has been on the decline for five decades and was, more or less, left for dead.
Then about 2-3 years ago I noticed something fascinating. And it has nothing to do with the current racist baiting items the media is currently spinning to sell stories. But I observed the white population begin to increase. The year over year increase of white population happening in Detroit is one of the first times in Detroit in nearly 40-50 years.
Maybe I could call it gentrification or the hipsters’ coolness factor or just healthy growth. Regardless, the Hispanic, White and other Immigrant populations in Detroit have been increasing over the last five years. A larger percentage of those new Detroiters have college degrees, higher income earning jobs and more discretionary income.
In 2010, the city had a white population of 55,298. That population began to climb year after year. There is an estimated 2015 population of 75,758 and close to 80,000-82,000 as of 2016, although the exact number is unknown at this time. This increase is creating a dynamic demographic shift in the city. However, there are two things to consider- the overall population of Detroit has been declining over that same period, and that particular increase and changing demographic has been located primarily in the Downtown area (Downtown, Midtown, Corktown, New Center, and Eastern market).
My speculation is that much of this has to do with Dan Gilbert and that he is locating more businesses downtown. Additionally, Detroit has all four major professional sports franchises (3 of which are downtown), and they have a culture of music and grit. That grit and vibe have been a formula for success in several submarkets across the country. Look at Williamsburg NYC, Wynwood Miami, East Austin, Pearl Portland, RiNo Denver; these are all great examples. Detroit also has that vibe in spades and pride associated with the city that is resurging with renewed vigor. You can start to feel it blossoming amongst the vandalized and falling ruins of the capitalism Mecca from a century ago.
I am not suggesting that Detroit will reemerge as the powerhouse city that it once was, but there is evidence of the start of progress in that direction. As shocking as it might be, there is a lack of quality housing right now which is sending rent prices up, and home prices upward as well. I believe this is something that will sustain because you see award winning chefs and restaurants popping up, you read about cool stories like Shinola manufacturing and Carhartt locating their facilities downtown. Although there is still a tremendous amount of office vacancy, it is mostly owned by Billionaire (Quicken Loans) Dan Gilbert and he has the vision and capacity to slowly reintroduce available space into the market in order to keep a steady growth. They recently released plans for the Hudson department site that would include a new 52 story high-rise which would be the tallest building in the city. (See image above and below)
We are specifically targeting value-add opportunities because I believe that the fringes of the 7.2 sq mile downtown region of Detroit will see the best increase in value and assets can still be purchased below replacement cost. All in all, we feel strongly that Detroit is a rising phoenix and will shine as one of the best markets for investment in 2017.
If you have any questions on Detroit or our other market analysis, please feel free to reach out.
Everyone is talking about self-driving cars and how we should be concerned about Skynet (Artificial Intelligence) as the biggest threat to our future. While I am no Luddite, I think that AI is in nowhere near something I am concerned about in the near term. Let me run you through a scenario that is much more concerning.
You are the quintessential American dream, living in a lovely suburban home with a spouse and 2.5 kids and a pet raccoon/dog/cat. You’re hard working career type person that compromised a short 20+-minute commute to send your kids through an above average school system. As you drive your reasonable well-equipped family vehicle into the city, you hit some light traffic and will barely make your meeting on time. As you get close to arriving at your meeting location, you start scanning the streets for a parking spot. As you eventually drive pass your intended destination, you can feel your blood pressure building as you still don’t see any spots. You think you’ll just take a quick turn around the block and just walk up the street. But, as you round the block, you are again stymied by the lack of parking. Now, you are downright pissed off as you are more than a few minutes late to your meeting. You are cursing in your car questioning why you pay taxes to a city that can’t supply ample amount of parking. After waiting for ten other cars all circling the same few blocks, you find a spot to park, and you storm off to your meeting over 10-15 minutes late. Your tardiness and now general frustration is carried over into the meeting and is perceived as a negative, and you fail to close the sale/deal/account. As you repeat this same scenario over and over year after year, the results begin to compound, and your job and salary are being affected. With your job security and income waning the level of stress in your life increases, and you soon find that you are fighting with your spouse over mundane issues and becoming more distant from your kids. As you sit there depressed and questioning if you can afford the suburban home and wonder why you ever agreed to have a pet raccoon/dog/cat in the first place…
Although this is a hypothetical scenario, I feel this is something most everyone can relate to and presents a real world problem (Sorry Skynet) that we face today. As 53% of people in America live in a suburban area but often have needs to commute into the city for work. Additionally, 30% of all traffic in the city is related to people trying to find parking spots.
Of course, as this article title might suggest I have a solution for this problem and will allow you to have a better marriage, close more sales, be a better parent and pet owner.
Given the same scenario above instead of stressing about a parking spot as you get close to your intended location you simply pull up to the curb and get out of your car right on time. As you leave your vehicle, you press the SELF PARK button and walk away. The autonomous driving system in your vehicle connects to the city parking system and knows exactly where the nearest parking garage spot is located. Like magic, your vehicle drives directly to that spot and parks. As your successful meeting finishes up all you have to do is open your (Knight Rider) app and just like Uber or Lyft drop a pin to where you want your vehicle to pick you up. Your life has just gotten immensely easier, and you have saved time and made more money because the city you live near has an innovative smart parking grid.
Let me talk through a few ways this could be beneficial:
1) More parking spots in existing parking structures (autonomous parking vehicles have no need to open their doors). So traditional parking spot sizes can be reduced from a regular 8-9ft width down to a 6.5-foot width. Although not all spots would be converted maybe the top couple of floors are converted which would allow lower level parking for ordinary parking vehicles.
2) Less traffic in a downtown area, as previously stated 30% of traffic is related to trying to find a parking spot now that number could be reduced as more vehicles have self-parking features.
3) More revenue as most people would prefer street parking given the convenience but the tables would now be turned and increase parking garage usage plus the new spots in existing garages would allow for more revenue producing spots.
4) General awesomeness personally grew up watching Knight Rider and the thought of a car (KITT) driving itself to me or parking itself just would be another level of awesomeness that would be enough of a benefit for me.
Of course, this would be an easy sale who doesn’t want to save time, make more money, have more parking spots, less traffic and have a city of awesomeness??
This can be accomplished by doing two things;
A) allowing autonomous driving vehicles on public streets in the downtown areas
B) building a smart transportation grid.
The self-driving technology is more or less here and readily available. If there was a grid for it to connect to I am confident the software programmers of Tesla, Google, Ford, GM and the sorts could figure it out. Heck, most cars can already parallel park themselves why couldn’t they park into a parking garage at 4 miles an hour.
Let me know what you think, am I off my rocker? Would you use a self-parking feature on your car?
A good deal of properties in this asset class have been chased and hunted down to near extinction. However, given the growth in the millennial working cohort and their propensity to rent over buy, plus the additional amount of baby boomers moving into MF to simplify living expenses, this asset class will see low cost of leveraged capital and relatively good rent growth that will significantly outperform inflationary indexes throughout 2017 and into the foreseeable future.
4) Self Storage
With the self-driving(driverless) car on the horizon, we can see this asset class experiencing some downside risk as more people will free up garage space used for their vehicles, to now store their junk. But, that is a fairly far off reality and suburbia won’t wildly adopt the driverless non-owned vehicle for many years into the future. We also predict that a bounce in consumer confidence will spur some additional spending based on pent up demand. If the public homebuilders are performing well, we expect to see self-storage equaling that matrix.
3) Logistical Industrial
Logistical industrial is a hard to quantify space because it takes a more technical approach to investing. Amazon has opened the door by introducing same-day and next day delivery. Amazon’s change in delivery methods will require more and more retailers to adapt their business model. As retailers continue to struggle, they will look to mimic the free and fast shipping methods that drive so many customers to Amazon. Logistical industrial sites near growing Metropolitan Statistical Areas(MSAs) will see the best upside and increase in value, particularly in markets that can target several top MSAs within a hub (Think New Braunfels/San Marcus Texas area).
2) Urban Infill (Adaptive Reuse)
Urban infill in post-industrial sites and cities will have significant opportunities for walkable and unique developments. These trends have been exploding across the US. Some examples are Wynwood in Miami, RiNo in Denver, Pearl in Portland, Brewerytown in Philadelphia and East Austin. If you google gentrifying or hipster locations, that will give you a good idea of the areas we are highlighting. This type of investment can be hugely rewarding but is also wrought with challenges. The challenges can range from requiring environmental clean-up, being in high crime rate areas, lack of sources for capital and most significant in my opinion is needing a creative approach to design. As there are no two sites or buildings the same, it is the proverbial can of worms. As most Real Estate Investment Trusts (REITs) tend to work on a proforma spreadsheet model to invest, urban infill projects can be challenging for them to quantify or get approved. The hard to quantify will allow nimble private investors and creative fund managers to find opportunities in this space at a much greater percentage in 2017.
1) Single Family Rental Portfolios
It is our opinion that SFR portfolios will see the most significant investment opportunities in 2017. The reason is that the same drivers that have compressed MF (multifamily) CAP rates into low single digits will also cause investors to chase yield in SFR. It is not uncommon to achieve a high single digit going in rate and levered rate up into the low to mid-teens, all with relatively straightforward debt capital sources since it’s easy to underwrite. We are not saying that it’s easy to acquire well performing SFR portfolios, but that those well-performing portfolios will see unsolicited offers and big institutional players trying to continue to aggregate and build their economies of scale. There is some debate that this space and asset class are dead, and that it only made sense to buy when there was the post-housing bubble collapse (2009-2014). Although we all wish we had held onto more properties from that 2009-2014 window, that doesn’t mean the space is dead. We found a range of numbers, but overall there are estimated 16-20M single family rentals across the country. In the last 6-7 years, we have seen the institutional players begin to enter the SFR space (Invitation Homes (Blackstone), Colony, American Homes 4 Rent, Main Street Renewal, Tricon, and many more). The conversations we have heard are that these giants of the private equity world and REITs have entered the space the game is over- they have already picked up all the good deals and there is nothing left. As we have researched this investment class we have found that the institutionally owned SF rentals are approximately only 200,000 units across the country. That means there are still 15.8 to 19.8M SF rentals out there that are owned by small operators or most significantly “Ma & Pa” investors that only have 1 to 3 properties. As technology improves efficiencies and the big players continue to develop best practices, this space will see some of the best opportunities for investment regarding going in rates, rent growths and best overall risk-adjusted returns in comparison to all other asset classes.
This is a layout and look at our crystal ball predictions for 2017. We would love to hear your feedback or comments. We spend a lot of time researching these trends but didn’t want to go too in depth into an analysis that was too lengthy or verbose.
Let us know if you would like additional information on these asset classes. We are very open to helping by sharing our research and methodology behind the list.
On July 28th 2016, we were a featured panel speaker for the Future of Downtown San Antonio (https://www.bisnow.com/events/san-antonio/Future-of-Downtown-San-Antonio-504). This sold out event had over a couple hundred attendees that were all excited about the future growth of the city.
Some of our partners know this is related to our (Essexmoderncity.com) urban infill project in downtown San Antonio. This project is an 8+ acre high density (100 units/acre) mixed used project.
See an earlier local NBC news story about the rezoning. News4: http://news4sanantonio.com/news/local/portion-of-east-side-could-get-facelift-04-02-2016
As we have more schematic design back from the architectural firms we will be releasing information. If you have any questions about this project or others feel free to reach out at any time.
- Thanks from everyone at Harris Bay (Anton, Jake, Chelsea & Brian)
At times we are so consumed in our daily grind of work that we have to remind ourselves to stop take a breath and pop our heads up and look at the macro view of the market. These times allow us to take the micro data we are exposed to in our local markets and activity and see how that translates into the global macro view of the future. As real estate moves at a much more glacial pace than say the equities market, we can help to identify macro trends that may cause minor course corrections to help us be better fiduciaries and deliver the best returns possible.
When we look at a macro view of the US real estate market, we are taking into account several factors. Those factors are GDP, US Treasury interest rates, Job creations, population (births and immigration), wage growth, CAP rates and foreign investments.
When we sit down and shift through this data, we are making analysis and forecast for the near future. Although, our crystal balls are quite fuzzy we have learned that there are some identifiers with economic factors before they become boom and bust cycles (bubble and burst). One of the key takeaways has been the current CAP rate compression in the Big 6 (Boston, Chicago, LA, NYC, SF and DC) and the other core markets. So a quick recap, if CAP rates are compressing that, means the real estate values are going up. So, CAP rate down (compression), asset values up. Currently, we now have real estate values in some of those core markets at new all-time highs. The question across the industry is with new all-time highs are we priming for a new correction and down market.
Given this macro look at the market and the current global environment here is my take on the data and forecast for cap rates and values in 2017. As we are fresh off the rumblings of the “Brexit”, we have to understand this, and other global factors are hamstringing the fed and their ability to make any additional rate increases for the near future.
We then take into account the foreign investment money that is looking for a safe harbor (Sovereign Wealth Funds, Foreign Insurance Companies, international blue chip corporations and PE firms with foreign investment capital). When we make those analyses and the fact that most of the global markets are sitting in a negative interest climate we understand that the spread of negative interest to those compressed CAP rates (high values) of core markets still seem quite attractive to a foreign investor. This, in my opinion, will drive more foreign capital investments into core markets and sustained or further CAP rate compression.
What does this mean for us if core markets continue to see a compressed cap rates (increase in values)? It is my prediction is that when those assets sell in SF, LA, NYC etc that capital will need to be reallocated and reinvested. I believe that most of those domestic fund will choose to reinvest back into the US. However, the fact that the capital is based in the US they will look reinvest into markets that they can make a safe return. This will lead to the spillover effect of more domestic capital into secondary and tertiary markets. Some of those secondary and tertiary markets are Denver, Dallas, Austin, Charlotte, Atlanta, Seattle, San Antonio, Phoenix, etc. That increase of capital will lead to an increase of values and further CAP rate compression for those markets as well. So the macro view of the US real estate market for 2017 is that we will see a very steady eddy status quo moving forward. This is not to say that the US economy or RE markets are doing anything spectacular it is just that we are currently the tallest midget in the global economy.
Have a cool and blessed rest of summer.
With low-interest rates one would think that Real estate markets would be booming and lead to a bubble. However, difficult lending standards have caused the real estate markets to rely much more on traditional fundamentals (Jobs, Affordability, Population increases). Coincidentally the fundamentals of the real estate market have not been this aligned in 20 years. Thus making this one of the most unique and exciting times for real estate.
With the lack of new construction projects over the last 8-10 years, many markets are experiencing huge increases in absorption rates. There is a lack of inventory and has resulted in increases of rents and property values. With the caveat that these values are driven by those fundamentals vs. speculation in previous real estate cycles.
Over the last year and a half, I have been a very big proponent of these fundamentals. So much so we have moved a lot of our investments out of markets that don’t align with fundamentals. One of the biggest challenges we see in California, NYC, Miami and some other core markets is affordability. Of course, there is a lot of foreign capital and institutional money flowing into these core markets to take advantage of the price upswings. But it is hard to predict these types of capital investments, as they tend to follow trends and comes and go very quickly. This
I am sure there are plenty of companies that are taking advantage these upswings in core markets, but we have a healthy respect for down turns in real estate. As such we rely much more on markets with good affordability. As tertiary markets tend to be driven more by local investment dollars i.e. local homeowners and businesses. As a result, the capital investments in those affordable markets are much easier to formulate and predict.
In conclusion, we at Harris Bay look at massive amounts of data and spend a lot of time and hard work to try and make the most educated decision with a healthy amount of risk calculated into every investment. When we do make decisions to invest, they are typically driven by these fundamentals that we believe will be sustained over a long period.
Happy Friday the 13th!
Jake Harris - Managing Partner
Tarrant County Auction:
Bexar County Auction:
As we have had a few people ask about the process of the foreclosure auctions I figured I would take a few videos of some of the live auctions.
If you have any questions about the process or how we invest using trustee sales feel free to reach out to us anytime.
I would say the number one question asked at trustee sales is: “How does this work?” So I figured I would share how this works.
Let me first say that this is specific information for particular markets I have worked in, all markets and locales have slight variations and different legal requirements. So consult professionals in your local area (attorney’s, title companies, etc.)
Most of the time you will need cash or cash equivalent (cashier’s checks) to bid at trustee sale auctions, some states like Arizona allow you to bid with a deposit amount of $10,000 and pay the balance before 5:00 pm the following day. However, most of the time you pay all of it up front as you finish bidding on the property.
Step 1: Get the List
Get a list of foreclosures for the upcoming day, week or month (several sources for this list exist most of the good ones you have to pay for access). Once you have the list which comes in the form of a spreadsheet, you will then begin to shift through the information. A starting point you may want only to try and bid on houses with an assessed value of $100,000 to $150,000, built in 2000 to 2010.
Step 2: Drive the property
Once you have the list, you can go and physically drive the houses. Many of the houses will be occupied, and you won’t be able to see the insides, but you can now determine the condition of the house from the exterior and the neighborhood feel. Unless you are a weirdo like me, you probably don’t go out for drives and drive random neighborhoods on the weekends. The feel of a neighborhood is important when you comp (come up with a market value) of the house later. Make sure to take notes of the houses and take pictures of the houses. Why you need to drive the houses it the house could have burnt down and is now just a concrete slab, or maybe it’s vacant but they previous owners tore all the windows and doors out of the house and jackhammered up the driveway. (Yes we’ve had those things happen)
*hint takes a picture of the numerical address before taking pics of the house, so you know when one house stops and the next begins in your camera later.
Step 3: Title Search
Depending on your relationship with your county clerk or your title company you may be able to do this before step 2 but to depend on your size of operations you will need to pay for a title search. So that’s why I suggest driving the list of houses first and then whittling down your list further before you start to research chain of title or pay for title searches. This is one of the most important steps in the entire process just as it is important to know that the house physically exists you are only buying a lien position at the trustee sale. So you could be buying a 2nd or 3rd position lien and have hundreds of thousands in a senior position. (I have seen people do this and lose several hundred thousand dollars in a couple of seconds, and it is very cutthroat but most of the fellow bidders will not stop you because they know your lose is their gain) Or you may encounter tax liens, or judgments against the property. The previous owner could have had solar panels or new windows installed, and they recorded a fixture lien on the property till they were paid off, which means you might be stuck paying for it on top of your bid. Do your homework on this part of the process or pay for a title search.
Step 4: Comp
This is the step that separates the pros and amateurs. As this is both an art and science. This is going to ruffle some feathers, but 99% of realtors out there are terrible at this part, and I know realtors are going to flip out, but it’s true. Realtors like to use CMA (comparable market analysis) and give you a price per square foot. They will run the comps like 123 Main St is 3-2 1200 sq. ft. so search for 3-2 1000 – 1400 sq. ft. within a ½ mile radius and then they go through the list and use those as comps. I suggest using programs like Redfin, or Zillow to see active and sold listings. What the CMA does not take into account is your half mile radius might be a completely different subdivision or cross over a highway. Of course, a realtor can refine the CMA, but it is a very cumbersome process. I have found appraisers are much better at comping compared to realtors. Appraisers look at houses with pluses and minuses. That 3-2 1200 sq. ft. house might be a 2 story and the comps on 2 stories are 20% less than 1 stories. Ultimately you can spend years on doing this and never be 100% accurate.
But I digress your goal in this step is to come up with your ARV (After Repair Value) or market value of course this can fluctuate as well as you could do a full interior and exterior remodel on the house and shoot for a much higher price. This market value price will then help you determine additional fees associated with selling the property. (We budget 6-8% in closing fees, this consist of realtor fees, title fees, home warranties, property taxes, hoa fees, utilities amongst others.)
Step 5: Remodel Budget
This step corresponds to the comp step but is separate as you need to know what market value is and then what your budget is for remodeling. For us we look at it is basic remodels (paint, carpet, flooring, appliances, landscape and maybe a few upgrades like granite or nicer light fixtures) this can fluctuate as we look at the house and the age of the house or the neighborhood. Higher end neighborhoods will require higher end remodels. This part of the equation then will allow you to know what your max that you would pay for a house given your required rate or amount needed.
For instance, I want to make 10% return on $200,000 property ($20k profit). Start with 200k market value deduct my 6% in selling and holding fees (200k-12K = 188k); then I deduct my $15k remodel budget (188K- 15k= $173k) then I deduct the profit I need to make (173k-20k= 153k). That then gives me my max bid price on the property given my required rate of return. Now do that for every house you drove that had a clean title report and get ready for the live auction.
Step 6: Live Auction
You should now have your cashier’s checks made out to yourself and you are armed with your list of properties that you have driven, done title searches on, come up with your comp for market price and have your max bid. Now it is time for the live auction; this will be a little nerve wracking depending on your current area this could range from 6-10 auction cryers auctioning off properties simultaneously with hundreds of other bidders. Alternatively, it could be one auctioneer and a couple of bidders. The bummer is that all those houses you drove and did research on 90% of them will postpone or cancel, and that is why you need to drive so many potential houses just to buy one.
Now let’s say that the trustee/auctioneer does start to cry one on your list then you have to wait to see what the opening bid is and if it is below your max bid. Most of the time you will just yell out the amount over the bid. So if the bid is $50k you can just bid $50,001 if no one else bids you win that auction and turn over your cashier’s checks and sign the receipt. I must caution that most of the time if your max bid was 153k and the bid is 50k you will have competition. They may bid it up 10k a time up to 110k and then drop down to 5k at a time till 135k and then slow down bidding to 1k at a time. However, this is completely dependent on the other people there, and this too can be an art of bidding. Waiting until it gets to going once, going twice and then bid, or you could wait till the bidding has slowed down to the final bit before you jump in, or you can be super aggressive and jump the bid to your max right away. This part is kind of like poker and is about reading the other bidders.
Step 7: Possession
Say you did win the bid at 145k (8K below your max) then you start the possession process. If vacant, then woo-hoo good job change out the locks and the house is yours to start to remodel. Note of caution it may take the trustee a couple of weeks to get you your executed deed which officially transfer ownership to you and there are times in those two weeks that a person could circumvent the sale, and the trustee will simply send you back your cashier’s checks. Which if you spent money on the remodel you may be at a loss for that remodel cost. That is rare on a vacant house but has happened before so proceed with caution. Or in some states like Michigan there is a Six-month redemption period of mortgage foreclosure sales, again proceed with caution on your area.
If the property is occupied, then you need to start the legal proceedings to gain possession. This is very different from state to state so consult an attorney. Tenants (renters) have more rights typically than former homeowners (occupants) since they have been given a lot more legal notice of the process.
Step 8: Remodel
Get your contractor or do the work yourself, that is more up to how many houses you are doing and how skilled you are in doing the remodels. I suggest hiring a contractor and getting multiple bids, as a contractor needs to balance how much can they charge to make a profit but little enough to still get the job. Keep in mind your budget that you established when you bought the house and hopefully, you can get the scope of work done within your budget.
Step 9: Sell Baby, Sell!!
The rubber meets the road here, now that the remodel is done and you are ready to sell the house redo your comps and hopefully there haven't been any crappy comps come on the market since you bought it and then have your realtor list the house. Hopefully, you stuck to your remodel budget of 15k, you comp value stayed true at 200k, and you list it and go into contract at your list price.
Step 10: Collect your money & Repeat
Close the transaction, collect your money, rinse and repeat the process hopefully 20k richer.
All in all that is a much more detailed answer to the question how does this all work, but also still just scratching the surface of the nuances of this process. If you want more information, please feel free to contact our office for our newsletter or detailed information on how to do this at scale.
Cheers and Happy Taco Tuesday,
The collapse and fall of Studebaker Corp in 1963 left 10,000+ employees holding their collective breath as their poorly funded pension fund was divvied up. 4000 workers received 15% of their value, and 2900 workers received no benefit. This significant event of an underfunded pension ultimately led to the Employee Retirement Income Securities Act (ERISA) of 1974. ERISA is a federal law that establishes the minimum standards for a pension plan in the private industry.
“The most powerful force in the universe is compound interest” – Albert Einstein
Before ERISA, very few private pension plans existed and of those that did exist few were properly funded to meet their unfunded liabilities (future payouts to employees). However, since ERISA companies have been forced to comply with certain requirements of funding. In simple terms, a company can achieve those minimum requirements by contributions (cash in) or through returns (interest). As pension funds began to grow slowly in contributions through the 70s and into the 1980s, the effects of compounding interest began to make for more significant amounts of capital. Now 40+ years later the compounded interest on pension funds has grown into a very substantial amount of capital.
To try and give an example of this I will use a simple example to try and give an understanding of this concept if private pension funds as a whole contributed $1M/year and received an average of 5% return over 40 years it would be worth over $120M. That is, of course, a simple breakdown, but the fact of the matter is that Morgan Stanley estimates that pension funds worldwide hold over $20Trillion in assets. Yes, that is a T as in Trillions. Which puts the pension funds as the largest category of investors ahead of mutual funds, insurance companies, currency reserves, sovereign wealth funds (SWF), hedge funds and private equity (PE).
In the example above I used a very simple breakdown and a straight 5% return over 40 years. If I had a crystal ball and could consistently deliver 5% returns risk-free, I would likely manage the vast majority of capital in the world. But alas, I don’t have a crystal ball nor do I manage most of the capital in the world. Since there is a risk in almost every investment in the world. Pension funds have devised a way in which they can help to hedge risk and still deliver their required rate of return. I have covered this before but as a refresher, this is achieved by diversifying their investments into four main categories: Equity, Fixed Income, Cash and Alternatives.
Equity = stocks, Fixed income = bonds, Cash = $$, Alternatives = Private Equity, Real Estate, Venture Capital.
As you can see from this chart from Pensions & Investments the alternatives segment of diversification has been on a steady growth rate over the last 40 years. Pension funds are finding that alternatives are proving to consistently deliver better returns. As pension funds have been growing exponentially in capital size and paired with the substantial increase in allocations towards alternatives we have seen a fundamental shift in the real estate capital markets.
As I talked about in the previous blog, institutional investors favor core/growth markets (SF, LA, NYC, London, Paris, etc.) at nearly an 8 to 1 ratio. The risk to these institutional investors is that they are growing by the day thanks to compounding interest and with higher allocations towards alternatives, they are all chasing the same core markets. The chase of these core markets then leads to institutional investors forced into overpaying for assets. As those assets then fail to perform as expected because of the higher purchase price the subsequent downturn in the cycle ensues, this is especially exaggerated in these core markets. Or this forces the institutional investor into other non-core markets.
The take away from this blog post is that pension funds and institutional funds are slowly beginning to take over the vast majority of real estate holdings and investments in all core markets the world over. As I don’t see the amount of capital slowing down (compounding interest and more allocations) anytime in the future, I am predicting that institutional investors will begin to pivot. As they pivot, they will start engaging in value markets. Today marks a fascinating period in which technology is increasing allowing more access to information; that was limited only to local players. An example is that it is just as easy for me to look at a property down the street as it is for me to research one 1500 miles away. Combine this with the fact that I believe value markets are trading at a discount from their true value. Over the next 10-20 years, I predict the value and second tier cities will see a wave of institutional investors pour money into urban core centers and redefine and reinvent the majority of American cities. Ultimately making the real estate markets more efficient.