Without exception, large asteroids have been found only in craters. There actually is a 100 percent correlation between craters and asteroid sites, a perfect statistical scenario. But does that mean that asteroid risk is highest in craters? And is there no risk of asteroids outside of craters?
You immediately spot the flaw. It would be a typical case of false reasoning as cause and effect are confounded. Correlation is easy to spot, but causation is the actual source for valuable insights into the world.
The example is an analogy to the behavioral economics in today’s real estate market. Along the lines of the asteroid example, real estate investments in prime locations have historically been least impacted by volatility and therefore seem to be a safe choice for investors. The insecurity of investors after the global financial crisis led to a flight of capital into safe assets, so called trophy real estate in top locations. It is an unprecedented herding phenomenon that has pushed real estate prices up dramatically since 2009.
This raises the concern of a bubble. The strongest indicator here is co-movement among investors, unidirectional thinking, which reaches a new all-time high after the financial crisis. This phenomenon is characterized by three elements: one, investors have become less critical. Abundance of capital and low interest rates suspend investor selectiveness and make projects possible that would be not feasible under ‘normal’ market conditions. Two, investors have become less active. They rather invest passively, on the stock market through index-replicating exchange traded funds and in the real estate market through low-effort, fully-leased trophy assets in prime locations. Three, investors behave more uniformly, which means there is a herding mentality. Herding means strong inefficiency for a market and implies stronger market reactions to upcoming external shocks.
How do real estate investors address this dilemma? Uncertainty and risks are best addressed through precaution and prevention. This means actively building up a safety cushion. For example, core assets in prime locations are acquired at below 5 percent cap rates today. Minus asset and property management, there will be approximately
3 percent left for the investor, a pretty low margin which makes investors vulnerable to the slightest volatility. Let us assume markets crash in three years, there will be no more than 9 percent of accumulated return protecting the investor’s downside.
Acquisitions of B- properties at 7 percent to 8 percent cap rates, on the contrary, with a value-add perspective are a totally different game. Even calculating asset and property management plus capital expenditures for renovations there will be a leveraged current distribution of at least 8 percent and an asset appreciation of another yearly
4 percent associated with the renovations. Within three years, there would be an actual 24 percent profit already distributed plus the asset appreciation of another 12 percent. Hence, value-add real estate creates an increasing protection layer against volatility.
Value-add investors are also able to access markets that offer more favorable fundamentals: For example, demographics and affordability are the drivers of sustainable growth in the residential real estate sector. Certain prime locations exhibit perversely low affordability with rent-to-income ratios above 50 percent and stagnating rent growth, while certain secondary locations show high affordability with rent-to-income ratios below 30 percent. A high affordability is the prerequisite for future rent growth. Secondary locations are also supported by exceptional demographics with tremendous population growth in excess of 2 percent per year.
In today’s euphoria for trophy real estate, value-add seems to be the winning exercise for investors. The core real estate strategy indeed turned out profitable in the past. But it is likely we will see an unexpected adjustment in overpriced real estate once an external shock occurs. It would create a new crater, where there has never been one. It could be a military event that destabilizes international safety and the economy, considering tensions between the US and Russia are at a peak. Another issue is China, where an unseen real estate bubble has emerged. Also banks face an uncertain future, beaten down by scandals and low interest rates. Surprisingly investors seem still confident. Apparently markets are no longer a reality show, but a perception game.