Beta awareness should prevail as cycles turn

Beta is the concept that private real estate managers attempt to ignore repeatedly, such is the heavy focus on generating alpha. The heterogeneity of real estate creates all manner of idiosyncratic opportunities to deploy asymmetrical information along with acquired skills to create outperformance. But at the end of one cycle and the beginning of the next, what gets forgotten is beta trumps alpha.

Otherwise, the return vintages from cycle tops would not be so unacceptably low and the ones at cycle bottoms would not be so consistently attractive. How many managers made great buys in 2007? Were there any bad sells then? Conversely, how many buys in 2011 looked terrible in retrospect? Not many. How many purchases made in 2021 look great today? Few.

Real estate is not an interest rate proxy. Until it is. The bottom line is that knowing how to play the cycle in our interconnected world is as important as knowing how to create alpha in the heterogenous world of real property. Most managers understand this at some level, although the conflict between business considerations and investment considerations cause most to ignore it.

Real estate is not an interest rate proxy. Until it is

Managers sell trailing returns. And investors buy them, implicitly on the notion the internal logic of the current cycle will continue. When they do this, they are not distinguishing the beta within the return series. This is their greatest miscalculation. For, what creates value is not trailing performance but rather, forward opportunities.

Because private markets are so heterogeneous, the valuation and reporting techniques do not provide for an accurate and timely feedback loop. Attribution analysis that can disaggregate alpha from beta in the public markets is difficult to perform for private market data. Therefore, distinguishing alpha from beta is not a self-reflection exercise that private managers can easily engage in. Investors are at a loss to distinguish genius from luck.

There is no doubt the lack of timely transparency in valuations and returns lets managers sell trailing returns, even when the evidence is overwhelming that their corresponding trailing valuations are stale. That only prolongs and exacerbates harmful market tops by keeping investors in the dark for longer than necessary as the next, larger fund is being raised.

Thus, most managers are happy to have the conflation of alpha and beta persist. And thus, we have the achingly perverse result that the largest funds are launched, and the most capital is raised, and the most investments are made at or near the top of the cycle when the investment opportunities are the worst.

In the public markets, there is unequivocal connectivity between positive sentiment and high valuations. Right up until the end of the last cycle, the conventional wisdom held that you could not go wrong plowing ever more money into warehouses and apartments. The ODCE fund index and the largest non-traded REITs wound up being weighted 60-80 percent to these two property types. Paying a 4 percent capitalization rate – mathematically equivalent to paying a 25-time EBITDA multiple – became the reflexive, intra-cycle logic. It had worked, so it would keep on working. The trailing returns were too good to be wrong.

REITs peaked at the end of 2021. The market saw what was coming, in keeping with the historical pattern. Yet as late as August of 2022, private managers were still speaking about how appraised values were still rising, as if gravity could be defied. As if dramatically rising rates, reflecting an inflation spike at the inevitable end of a 40-year bull market in bonds would not affect real estate asset pricing. The reality is real estate does not generate enough growth to outrun the impact of a 400 or 500 basis point increase in interest rates.

Now that we are at the early stages of the great unwind of this intra-cycle logic, can investors break the pattern? If they do not forget the beta, possibly they can.

Corl reflects further on private real estate market prospects in Cohen & Steers’ white paper Private Real Estate Set Up For Attractive Early Cycle Returns. Click here to read it.