Prices are high, debt is cheap, and construction costs are expensive. It’s really hard to find real value in such a market. Careful investors get frustrated in this kind of buying frenzy, especially if they have capital burning a hole in low-yield bank accounts.
It’s time to take a step back, slow down, and remember the fundamentals, as articulated by Benjamin Graham, David Dodd, and most famously Warren Buffet—value is defined by the relationship between an asset’s price and its intrinsic worth (worth based in indisputable facts like income, location, etc.).
If you can get a price on an asset that is lower than its intrinsic worth, the deal has a lot of value. It has a built-in safety cushion to power it through a downturn. However, buying an asset at a price that equals or even exceeds its intrinsic worth is a deal of limited value, regardless of the quality of the assets.
As investors start to smell recession in the air, they could take one of three courses of action:
Take a breather from real estate deals. Let the buying frenzy play out, the market correct, and then re-enter the market when prices are low. Debt might be more expensive, liquidity might be limited, but that beats buying existing buildings that are more expensive than the cost to build them (i.e. above “replacement cost”). Finding value is easy pickings when there is financial mayhem in the streets.
The downside of this strategy is that capital has to wait. It’s tough to know what asset class is a good value in the runup to a recession, when the entire economy is poised for a fall?
Fly to Safety
For many large-to-midsized family offices and endowments, tasked with investing large sums, the flight to safety means picking cherry assets in core markets—”primary” markets (Dallas, not Abilene) or “gateway” markets (New York, San Francisco). The prices may be high, but the rationale is that these markets will do better in a downturn.
This may be the case, or it may not. Remember the replacement cost concept. If an existing building is being priced at greater than its replacement cost, it is overpriced, even if it’s on Manhattan Island.
Find Value in Secondary or Tertiary Markets
Lower-priced deals in secondary or tertiary markets—offer both challenges and opportunities. This market is large and often overlooked, meaning the same 20 guys are not all chasing the same five deals. Inefficient markets open windows of opportunity for savvy investors. This is especially true considering the fact that secondary and tertiary markets constitute a large volume of the transactions. That’s a lot of opportunities.
The downside for many real estate developers is that fundraising for the equity and debt in secondary markets can be difficult. Big equity groups typically can’t be bothered with secondary markets because they fear exit liquidity (i.e. their fear is that other institutional buyers will not purchase the property when it’s time to sell).
Nevertheless, secondary market real estate may be the best choice for private investors looking to do recession-resistant deals. At Feldman Equities, we like to purchase office buildings in fast growing secondary, which may become primary markets down the road. We can often buy office buildings in up-and-coming markets at significant discounts to replacement cost.
It’s never “if” another recession will happen, but when. Markets have cycled through expansions and recessions for hundreds, even thousands of years. Picking the right strategy in advance of the next recession is critical to the longevity of your investing career, so choose wisely!
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