World-class businesses raise prices like clockwork. Every other business suffers from the tyranny of the business cycle.
When demand dips – usually in a recession - most businesses slash prices or are forced to improve the product while keeping prices static. Both options tank profits.
You either have a wonderful business that can stay above the fray, or it's constant war.
Real estate is no different.
It has 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 courageous few that buy, improve and flip. This is especially true if you're buying during extreme distress.
But if you want to reduce execution risk, it’s easier invest in solid assets in great sectors - at reasonable prices - then do nothing.
That isn't to say one shouldn't capitalize on distressed deals in out of favor sectors. Our current recession should present some compelling distressed retail, hotel and conversion opportunities.
However, if you're content to hit consistent doubles; we believe the highest probability path to compounding capital is to buy superior business models and sidestep competition.
So what real estate sectors have structural advantages that enable predictable growth? It's those that have one or more of the following qualities:
- Mission critical facilities - where rent is a rounding error vs. the tenant’s investment in the space
- Assets with network effects - where tenants have to cluster
- 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. Here we're looking for internal (organic) growth, not including acquisitions. While not a bulletproof metric, it's a great starting point.
If an asset can grow profits in good times and bad, it gets our attention.
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 operating consistency.
There are 20+ real estate sectors, but not all report same store operating results.
2021 – 2024 forecasts provided by various sell side analysts.
Of these three we have least conviction in cold storage as it doesn’t have much operating history in the public market (hence the limited data). However, private cold storage operators have confirmed 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:
Lodging is off the chart, in the not so good way.
While most real estate investors view apartments as stable investments, apartment rents can and do go negative. This makes underwriting apartment deals difficult late cycle. Apartments are still great investments and can generate tremendous wealth. They just require more skill (or luck). This is especially true if you're buying a stabilized, fully marketed deal at a 3% - 4% yield in a market with no supply constraints. Not much room for error there.
We don’t have an edge in that endeavor. That feels like trench warfare.
Consequently, most years we'll underweight apartment REITs and overweight sectors with pricing leverage.