Adversity in Real Estate – More than a Silver Lining?

Iwitnessed the Global Financial Crisis (GFC) from the cockpit of global capitalism of New York, and graduated from Columbia Business School into the post-GFC real estate market. To say that the jobs market (especially for real estate) was bleak would be to understate the savage end-of-the-world assessments of the Americans themselves. Memorably, it was as if the city itself was to be packed up as far as they were concerned.

But … It has been empirically proven that the greatest vintages for real estate (and PE) funds are always in a down market. And indeed, we now know that the years of, and shortly after the GFC turned out to be some of the best ever. I managed to ride that wave, but performance figures can’t hide the challenges faced in operating in this kind of environment.

The knowledge that this current period of adversity should be good years is scant comfort for those that have to scrounge around, jostle and battle for the capital to contemplate and to close deals. Even ‘keeping the lights on’ or the platform alive (those management fees so taken for granted during up years) is no mean feat. It is an emotional roller coaster.

So adversity in real estate - such as has been visited on us over the last few years with Brexit, Covid, increased interest rates and now a recession - in the long term is not a bad thing. It restricts capital, focuses the mind and reminds us of the opportunity cost that should never be far from an investor’s mind when deploying. This necessarily and empirically increases returns for deployments that do manage to happen in this period.

Real estate is one of the longest asset cycles and longest lived assets there are – large allocation decisions, in order to be optimal, should almost be completely counter-cyclical. In other words, you should build large projects in a recession for the recovery. This has the benefit of recession prices for inputs, and boom prices for exits. It also means that you have what is actually required when it is required (without latency).

Obviously all this is easier said than done. No one can predict the length and breadth of a recession, gaining liquidity during a recession can often be impossible and a recession never plays out according to pre-correlations. Because there are so many and inter-dependent variables in an economy, dynamic and stochastic variables cannot be known or mapped out in the status quo ante

Down markets also change how market participants behave. A market is an average term applied to many sectors, and participants don’t always behave in the same way but are a ected by the temper of the times as well as their own predilections. But generally, in a downmarket there is a bigger spread in the relative performance of each of these sectors. Quality typically holds more value, as does income driven assets. This is because in a down market capital is at a premium so that a quality asset can be sold for capital, and an income driven asset can be held for capital. But this same emphasis on quality and income curtails the upside potential, which is why in an up market investors lean towards secondary and development plays.

Down markets test businesses and the covenants that have been ‘bet’ on in more rosy times. Clearly rent is pretty integral to a business and the fact / likelihood of it not being paid there are probably many more serious issues going on in the business itself. This is another reason why real estate is so strongly connected to financial liquidity generally. But beyond the good credit question that banks deal with real estate has to navigate the real life consequences on value of a model tenant, a defective one and a new potential tenant. During down markets the good covenants have a great deal more choice and require a lot more ‘courting’.

So, tenacity in the face of adversity (lack of capital, lack of good tenants and all other support for the real estate industry) necessarily creates a larger alpha. This is because the best possible investment comes down to betting against all the other market participants, securing the liquidity to survive until such a point as a building or investment programme comes to an end or is sold well. Coming to an end, or, being sold well in the built environment means giving people what they want when they want it. This necessarily involves estimating the future – against other market participants – and prevailing.