Most people are familiar with the concept of Growth Investing and Value investing regarding stocks. However, not everyone is familiar with those concepts regarding Real Estate.
Most investors have a target rate of return that they are trying to achieve over a certain period. A pension fund might need to make 7% annually over a 10-year period. Or you figure out to hit the level income you need to sustain for retirement you need 10% annually over the next five years. Then from that point, you should approach an investment that will deliver returns greater than your required rate of return.
The most common ways to achieve returns are with growth or value investing.
In real estate terms growth investing is often associated with markets that are projected to see better or GROWTH of appreciation over inflationary indexes. For instance, these are considered CORE markets these key markets are the likes of San Francisco, NYC, Miami, LA, Seattle and on and on. The thought process is that your “going-in” rate of return will be lower than your required rate however over the term of your investment you will see appreciation that will deliver an amount that exceeds your benchmark.
An example of this we will use a pension fund with a 7% required annual return over the next ten years. They buy into a building with a 5% CAP rate in a CORE/GROWTH market. As we know from the Fed, the projected inflation is to be right about 2% annually over the next decade. We would factor the GROWTH appreciation of the property around 4-5% annually or the specifics of that particular city.
Then your CAP rate + Growth over inflation delivers or exceeds your required rate of return.
In value investing an investor is not anticipating appreciation growth rates to exceed inflation. Therefore, to receive their required rate of return they are looking for a better “going-in” rate of return. These value markets are called second tier or B & C markets. Think of cities like Cincinnati, Atlanta, Salt Lake City, and many other middle of America cities.
The example of this will be a high net worth individual investor has a required rate of 10% annually over the next five years. This investor buys into a property with a 10% CAP rate in Nashville TN. As you might expect in the value investing market like Nashville would only expect to appreciate in line with inflationary indexes. So annually you would only expect around 2% appreciation and after backing out inflation, it would be a net zero.
Your return would be directly from the CAP rate, and appreciation would not be part of your expected return.
GROWTH vs. VALUE
The question then is then you a growth or value investor?
One of the ways to approach the question is to create a benchmark for all markets. I sit down and come up with a theoretical “apples to apples” comparison of growth and value markets. So for instance, a property that is $100,000 in a growth market would then be worth less in a value market. The comparison is that similar property would sell for $80,000 in a value market. Which makes sense you need to discount the value market a certain amount.
However, the research is that the vast majority (approx. 85%) of institutional investors and capital (pension funds, REITs, PE firms) are focused on growth/core markets. So even though a property in a value market should trade at $80,000 given the lack of competition, the reality is those properties are trading at a discount of $65,000 or $70,000.
Professional real estate investing has only been studied on an academic level for the last 20-25 years. Given that and a variety of other reasons, there is a tremendous amount of inefficiencies in real estate investing. Even though we can identify the fact that the vast majority of institutional investors are investing in core markets and that value markets are trading at prices below their theoretical value. That doesn’t directly equate to buy anything in value markets and receive the best of both worlds.
However, armed with this information, the advancement of technology, and cheap travel we have found that there are opportunities in value markets that the majority of investors are missing by trying to be SAFE and just investing in growth/core markets. So we are value investors, and in fact, take it to another level and use our opportunistic approach to value investing.