Hodes Weill: current pricing ignores downside risk

Hodes Weill & Associates, a real estate advisory boutique with a focus on the investment and fund management industry, believes that the current pricing of many transactions indicates some buyers are paying for future upside today and choosing to ignore the signs of significant downside risk. That was just one of several observations made by the New York-based firm in its latest market commentary.

In the face of global economic uncertainty, Hodes Weill is sceptical about the pace of the recovery for property valuations and believes that assets are being priced for perfection, which only seems supportable if firms are underwriting strong net growth in demand and rents. “We are cautious on operating fundamentals and economic growth in the current environment, which continues to demonstrate a meaningful chance of some shock to the global capital markets over the coming year,” said Doug Weill, managing partner. “To underwrite growth in projections in a market with a lot of uncertainty is risky.” He advocates for a “patient equity” approach to investing, as well as underwriting for potential downside risk and the possibility of a no growth environment.

Hodes Weill also highlighted investors’ assault on fees, the brunt of which, he said, has been borne by smaller, boutique managers. This is having the effect of drastically changing the economic model for boutique managers, while larger managers continue to command full fees and, due to scale, generate high profit margins on fee income. The firm believes investors should recognise that imposing lower fees on highly capable boutique managers may drive them out of the industry, while such demands barely will register with the bigger managers, which keep getting more profitable.

Hodes Weill cites the catch-up as one term that has come under fire. Although it can make an argument as to why a catch-up provides an appropriate incentive for a manager, investors remain convinced that the catch-up was the cause of so many poor results. The decision by Westbrook Partners to eliminate the catch-up provision from its latest fund is a good business decision in Hodes Weill’s view in a world of lower leverage and potentially longer holding periods.

Regarding investment markets, Hodes Weill has offered opinions on the two markets most likely to generate attention in 2012: Europe and China. In Europe, the firm sees many investors afraid to allocate capital in the face of widespread bad news, although it would argue that now is the time to invest or at least allocate capital to experienced managers that will invest in the market over the next several years. With China, the firm sees the risk-return equation for property coming back into balance. Indeed, pricing on retail and office property in first and second tier cities is becoming more rational, while opportunistic returns are becoming achievable without taking on excessive risk.

Other observations include the fact that many long-standing opportunity fund managers are in the market competing for capital at the same time; that IRRs as a measure of performance can be misleading; and that investors are becoming increasingly skeptical about the prospect for distressed investing, absent unique sourcing and in-house value add capabilities. For the complete commentary, click here.