World class businesses raise prices every year while the rest suffer from the tyranny of the business cycle.
When demand dips – usually in a recession, most businesses slash prices or improve the product while keeping prices static. They must compete like crazy to win and keep customers. For most, it’s war.
Real estate is no different.
There are great sectors, solid sectors and god-awful sectors (looking at you hotels). While there are numerous factors at play here, the first – and arguably most important – is the degree of pricing power.
This isn’t to say you can’t make money in a bad real estate sector. Quite the opposite. Fortunes are minted by the intrepid few that acquire tanking properties, improve and flip.
But if you want to reduce execution risk it’s a lot easier to own solid assets in great sectors, then do nothing. That’s what we prefer. We’re content to compound capital while avoiding blow-up risk. We’ll let the daredevils try to shoot the moon.
So what types of real estate sectors have structural advantages that enable predictable growth?
Its those that have one or more of the following qualities:
- Mission critical facilities - where the rent is a rounding error vs. the tenant’s investment in the space – ex: data centers
- Assets with network effects - where tenants want to cluster - ex: life science (lab space)
- Growing demand + fixed supply - ex: manufactured housing (aka mobile home parks)
How do we verify pricing power? We dig into the data on "same store" net operating income. In other words, internal growth, not including acquisitions. While not a bulletproof metric, it's a great starting point.
Below are three highlighted examples of sectors with above average pricing power. As you can see, each sector - cold storage (industrial subsector), mobile home, and life science - demonstrate unreal operating consistency.
2021 – 2024 forecasts provided by various sell side analysts.
Cold storage doesn’t have much operating history in the public market (hence the limited data). However, we know private cold storage operators that verify this consistency.
Here is an isolated view of manufactured housing (“mobile homes”).
Given the unique structure of the industry, mobile home parks are able to increase rents each year, whether the economy is booming or contracting. This consistency is powerful as even modest 3% rent increases can boost cash yields substantially as many expenses (and debt) are fixed.
While no real estate firms are "recession-proof", this sector is a close as it gets.
Contrast that stability to apartment buildings:
However, apartments are nowhere near as cyclical as hotels, office or retail. Hover on each line below to show the extreme volatility in these asset classes:
While most real estate investors view apartments as stable investments, apartment rents can and do go negative. This makes underwriting (analyzing) apartment deals difficult late in the cycle.
Notwithstanding, apartments are still a strong asset class where most fortunes in private real estate are made. However, the team you invest with better be disciplined and / or an elite operator. That or you must pay attention to what stage you’re at in the cycle and keep a close eye on new supply and net population growth.
We don’t have an edge in that endeavor. Consequently, we are likely to underweight apartments when cap rates are low. That is not necessarily the case for a real estate firm with pricing power run by a stellar team. For those, we’ll happily pay ‘full freight’ if we believe that REIT can predictably grow cash flow over the long term.