Marks: “the world where people govern by platitudes”

Howard Marks doesn’t claim to be a real estate expert, but he’s familiar with many of the industry’s most popular sayings. “One of my biggest complaints about real estate is that, from the outsider’s point of view, it’s the world where people govern by platitudes,” said Marks, during a keynote interview at the Pension Real Estate Association’s spring conference in Boston. “I’ve heard them all: ‘They’re not building anymore’; ‘You can always live in it’; ‘I’ll ride it up and get off at the top’; or “It’s great to invest in core because it’s so safe’.”

 

That last cliché was the one with which Marks took the most issue. Core real estate is considered safe because it possesses “the best possible fundamentals” in terms of the quality of the asset, location and tenant base, he explained. What can be “wrong” about core is what investors are willing to pay for it.

 

“When the fundamentals get so good and people believe that all that counts are fundamentals, that’s when they get in trouble on price,” said Marks. “Buying a good asset at the wrong price is a hell of a lot worse than buying a bad asset at the right price. It can’t be what you buy; it has to be what you pay for it.”

 

Marks said the issue has been made more troubling by the start of the Federal Reserve’s tapering of its quantitative easing program, which is widely expected to cause interest rates to rise. “The key question is how much,” he said. “I think rates will go up moderately.  In order to have a yield of more than 3.5 percent to 4.5 percent on the 10-year Treasury note a year or two from now, you need to have either a booming economy, in which the demand for financing is extremely high, or significant inflation.”

 

A high-inflation environment typically arises from too much capital pursuing too few goods or the rapid increase in production costs, either from a booming economy or a limited supply of a good. Marks, however, didn’t see such preconditions for significantly higher interest rates. 

 

The risk for investors in core real estate is the pricing of those assets if the yield on the 10-year Treasury goes up. For example, if the yield increases to 4.5 percent in two years, buying a core building on New York’s Park Avenue at a 3 percent capitalization rate likely would mean the investor signed on for a sub-par return.  “That’s why I would argue that buying on Park Avenue at a three cap does not leave much margin for error,” Marks said.

 

Marks, whose firm has been in the opportunistic real estate business for the last 20 years, said the strategy for offsetting possible increases in interest rates is to find growth opportunities. For Oaktree, that has meant investing in distressed properties in secondary markets, typically in smaller deals between $25 million and $75 million. So-called zombie buildings, which investors often shun because of debt that exceeds market value, offer room for improvement in terms of the business plan, net operating income and possibly the cap rate, he explained. 

 

“People are buying on quality and the belief that there’s no risk,” said Marks. “The riskiest thing in the world is the belief that there’s no risk.”