Risk and return go hand in hand. Typically return expectations of investors increases as risk of the investment increases. Investors seek to reduce the risk by diversifying across industries, asset classes and investment horizons. Whilst diversification is a great way to reduce portfolio risk, often times macro events which cause drastic and severe corrections. The 2008 mortgage crisis was a classic example of that. While the crisis emanated in the housing market, the contagion spread to most public markets in the US and worldwide almost causing a collapse of the US financial system. Nonetheless, the power of diversification cannot be understated regardless of portfolio size and composition.
What makes a portfolio diversified:
Knowing the benefits of portfolio diversification, one may ask what makes a portfolio diversified. The key idea behind portfolio diversification lies in “correlation”. Correlated investment themes tend to perform similarly. By virtue of that, they would tend to do well under similar conditions and on the flip side do poorly under certain other conditions. One can achieve portfolio diversification by investing in assets that have low to a zero correlation among each other.
Swensen’s 20% rule and Real estate’s superior diversification potential:
The 20% rule created by David Swensen, the Chief investment officer at Yale endowment is a popular portfolio risk mitigation strategy and calls for allocation 20% of the portfolio towards alternative investments – one’s that have low correlation with traditional and publicly trades asset classes as as stocks and bonds. We argue that Real estate happens to one of the best choices to achieve near complete portfolio diversification. Some of the top reasons are:
1. Correlation advantage:
Real estate has a low correlation with stocks and bonds. Historically the correlation has been as low as 0 in the early 2000’s to as high as 0.8 during the mortgage crisis. The average correlation across the previous 4 decades has been around 0.3 or so. This is great news from a portfolio diversification standpoint.
2. Inflation advantage:
Real estate acts as a natural inflation hedge. Inflation hedge investments are investments that are expected to increase or at-least maintain their value over a period of time. The most typical example of that fact is the rising rental rates in most major sub-markets in the US. The sheer shortage of housing and the home affordability crisis has further caused an upward pressure on rents.
3. Illiquidity and market inefficiency:
Real estate is an illiquid investment. While that fact could be construed as a negative, there are studies conducted that demonstrate the fact that retail investors don’t make money over the long run in liquid markets. This if often attributed due to “market-timing” tendencies of retail investors and quite to the contrary Real estate’s relative illiquid nature helps more than hurts. Illiquidity often also leads to market inefficiencies which sophisticated market participants can exploit.
To your health and wealth!
It is often said that Real estate is not a “get-rich quick” scheme. Whilst we agree with that, it surely is a “get-rich consistently” scheme. What do we mean by that? Well, consistently investing in Real estate can produce some stellar effects. It takes times to build the momentum but once the flywheel is up and running, it sure as heck runs! And if one is smart about it, one can program the flywheel to keep on running without putting in a lot of effort or even no effort.
It is illustrative to look at some numbers. The attached spreadsheet walks through one hypothetical 10 year investment horizon and showcases the power of real estate investing. First, some assumptions: We assume that every year we initiate a fresh investment amount of 50k, a cash on cash yield of 8% on any investment and a 16% annualized return realized at exit. Please note that these numbers are very typical of the offerings we bring to our investors.
Monthly cash flow is calculated as an 8% yield on the cumulative investment (net worth) in any given year. For instance, in the first year one starts with 50k leading to an annual cash flow of 4k (50k*8%) and a monthly cash flow of $333.33. As time passes and as one’s investment amounts grow, the monthly cash flow and the net worth grows. For instance, in year 6 the monthly cash flows stands at $2333.30 and the net worth at 300k. Here is where the magic happens now!. Come end of year 6, the investment we made in year 0 matures and so does our net-worth. In year 7, we invest 50k as usual but we get a 100k bump from that exit leading to a cash flow of $3000 and a net-worth of 400k. This repeats in the subsequent years as we reap the fruits of our investments. By the time year 10 ends, we stand at a monthly cash flow of $5000 and a net-worth of 800k!
In the same phenomenon, If you invest 100k per year instead of 50k, at the end of Year 10, you will get 10k per month of cash flow and Net worth of $1.6 MM.
Now, that is some snowballing! The question is if you are ready to take that first step. We cannot wait!
Take the calculator for a spin and give us feedback.
To your Wealth!
- Zovest Team
We now know why expected returns is only half of the story and its crucial to incorporate risk in the investment a.k.a. Sharpe ratio. Armed with our new knowledge of bench-marking investments on the basis of the their Sharpe ratio, we can find out which investments are truly the outperforming ones. The data is clear, Real estate (esp yield producing Real estate) was the best performing asset class over the past two decades. This may come as a surprise to many and it was clearly to us as well.
Perhaps a picture is worth a thousand words. The plot below shows the annual return on the y axis and annualized standard deviation on the x-axis for a variety of asset classes such as stocks (large cap, small cap), commodities, bonds etc. NPI is an index that tracks “operating” private commercial real estate properties held for investment purposes only. Its an index that is managed by NAREIT (National associated of Real Estate Investment Trusts). Whilst NPI includes most yield producing real estate such as office buildings and retail, multifamily apartments are a significant portion of the constitution of the index.
Its interesting to see that NPI outperforms all the other asset classes. NPI index has a stock like return with a bond like risk characteristic. It is even more interesting that NPI handily beats down listed REIT’s. We will expound on the reasons in a later blog post, so stay tuned. Overall, this is great validation for us as acquirers of yield producing assets.
This is part 1 of a series of blogs on measuring risk adjusted return of a Real Estate portfolio. In this blog, we will focus on a fundamental concept around adjusting for risk to measure the performance of an asset – The Sharpe Ratio.
What is Sharpe Ratio:
As investors, obviously we care about expected return on say a given asset or across a given portfolio. Keeping everything else constant, higher expected return is better than lower, for instance. But just looking at the expected returns masks an important fundamental concept around the risk that we take to sustain that return. One way to measure the risk is to measure the standard deviation of the expected return. Without going into too much detail in this post, one measure of risk is the standard deviation of the return. An asset with a lower standard deviation has a more consistent return than the one with a higher standard deviation. A question arises, whether an investment in an asset with a expected return of 20% and a standard deviation of 10% is better than an investment with 30% expected return and 30% standard deviation. The second investment has a higher expected return but also a much higher standard deviation. This is where the notion of Sharpe comes in.
Developed in 1966 by Nobel prize winner William Forsyth Sharpe, the Sharpe ratio measures the expected return of an asset relative to its risk.
where E(r) = asset expected return, rf is the risk free rate and σf is the standard deviation of the excess return. As we can see expected return increases the Sharpe but standard deviation reduces it. In our contrived example, option one is a better investment despite having a lower expected return. This is due to the lower standard deviation of option one.
Limitations of Sharpe Ratio:
The benefits of Sharpe ratio are obvious. Its a dimensionless way to compare asset returns paying regard to their risk. It establishes a benchmark across different assets and facilitates an objected comparison of return adjusted for risk. As it turns out, there are some limitations as well. One of the biggest limitations of the Sharpe ratio is that it assumes “normality”. Without going into too much detail this means that the return distribution is expected to follow a normal or a “bell-curve” distribution. While this is practically not true (asset returns need not be normal), it still isn’t too much of a limitation. There are other limitations of the Sharpe ratio as well related to the time-structure of the returns. We will not go in too much detail on those for the sake of simplicity.
Suffices to that the Sharpe ratio is a great tool for the modern Real Estate investor to compare the relative performance across different investments properly accounting for the underlying risk and penalizing riskier investments versus lower risk ones and favoring investments with a higher expected return over the ones with a lower value.
1. Taxes will increase after stimulus bills.
During the last two months, Congress has passed more than $4 trillion in stimulus spending, with more probably on the way. Taxpayers will end up paying for this at some point. Medicare, the health insurance program for seniors, could run short of money in 2023 or sooner, as the payroll taxes that finance the program plunge amid record unemployment. Also the future retirement benefits people receive might shrink.
Apartment investment is one great way to get long term tax free income and also help in offsetting your current income with the depreciation (Check with your CPA before taking tax decisions).
2. People will move from primary to secondary markets due to de-urbanization
In view of future pandemics, due to social distancing requirements, cost of living de-urbanization from the high population density might happen even though its too early to predict. If you see current number of covid infected cities, they all are high population density metros/ cities.
3. Apartments fared better than other asset classes
As per latest article from NMHC (National Multifamily Housing Council) the rent collections for Apartments in April are at 92% by April 26th. So Apartments which come under basic necessities fared better than other asset classes like Retail, Hotel and office which suffered really bad.
4. Stock market will have long period of volatility and low returns
Top wall street forecasters predict that stock markets will deliver lackluster results because of prolonged volatility for a long time due to uncertainties.
5. Less people buying homes
Because of strict criteria by banks like 700 credit score and 20% downpayment recently by Chase and other banks it will be difficult for a lot of people to buy homes. People want to have mobility due to employment shifts. New single family home constructions will slow down and other macro trends will shift people mindset to rent more. The demand for Apartments will increase a lot in future.
6. All time Low Interest rate environment
Interest rates will be low for a foreseeable future which enables to get good cash flow from the apartment investments.
We are carefully observing deal flow and capital markets and we hope there will be many deals that we can present to our investors. Please click on the button to view our investment opportunities so we can reach out to you and know each other and your investment criteria.
Note: I will expand and keep refining this post on a periodic basis so it's up to date
1) Low Income and Bad Demographics Mix
2) High Crime
3) Rent Roll Occupancy and Physical Occupancy don't match
4) Income in T12 and Actual Bank statements don't match
5) Flat Roofs
6) Window ACs or lack of Central HVAC
7) Wood construction issues like wood rot, decks not in good condition, WDO (Wood Destroying Organisms), Termite Damage, Stucco/ Siding issues. Overall be really careful with old wood construction. Prefer concrete block or masonry structures.
8) Water Damage inside units (Use Infrared Cameras to find out during unit walks)
9) Foundation Issues
10) Polybutylene Piping
11) Cast Iron Sewer Lines
12) Water leaks (See Pattern of water bills from past few months/ years)
13) Old Electrical Panels
14) Ignoring age of Water Heaters/ HVAC's/ Roofs while computing CapEx
15) Radon Gas
16) Retaining Walls
17) Water Intrusion
20) Asbestos and Lead Based Paint
21) Gutters, Down sprouts
22) Tree Trimming
23) They just fill in with people by giving concessions before selling. Tenants are not vetted properly and bad quality. See if there are many leases in last 3 months.
24) Always ask for seller story (We passed on several deals just because the story is not right)
25) Get Insurance Loss Runs to see any recent claims
26) Never assume existing LLC - Always do new entity
27) Go to FEMA website and verify if the property is in Flood Zone
28) Self direct IRA investments take time. So work on them first and get funds 2 weeks before closing
CBRE Research did an extensive study on Short Term Rentals and it's impact on traditional Hotels. Also, STR is also getting into MultiFamily space as apartment owners are experimenting by renting 5 to 10% of the units to STR's and getting their NOI maximized ! So lets get into some things in this space and also how Zovest is trying to capture this phenomenon in MF.
1) Why guests chose Short Term Rentals (STRs)
The main reasons guests chose STR vs Hotels is, the home feeling, kitchen, family setting, experience meeting new people and main factor is price.
2) Not just Airbnb
First STR doesn't mean only Airbnb. There are so many other providers like VRBO, Home Away, Flipkey, Trip Advisor and also traditional corporate housing.
3) Know the local laws
Laws are changing every year regarding the STR industry. It will be really difficult for operators of the STR if they only rely on STR income and underwrite the deals. What if the law changes against you and you will be in huge trouble with your money.
Here is the grading that's given by Airdna and Roomscore on the markets that are best and worst in running STRs. But you need to keep upkeep on how legislature is changing. Like what happened to Newark, NJ Airbnb law that the city is trying to pass. All those people who bought the properties with high prices assuming that they can make a killing in STR are really worried.
“We don’t make enough money to pay double insurance and to pay extra taxes. We don’t make that kind of money,” said Airbnb host Deborah King. “It’s going to hit us hard.”
4) Exponential Growth and eating Hotel Lunch
CBRE Research estimated STR's are eating 12% of Branded hotel lunch. This is huge. STR's grown 500% in last 7 years !
5) Types of properties
There are different types of properties that you can do STR like Entire House, Entire Apartments, Private Room, Shared Room etc. The most popular is entire house or apartments.
6) STR and MultiFamily
Doing STR in some of the units in MultiFamily is highly lucrative proposition that lot of operators are doing these days. For that
See the STR Market penetration.
Zovest is already experimenting Airbnb and STR in our Cleveland Apartment Properties and we will expand to other markets and also we will build new product and carve-out few units for STR to maximize NOI.
Please reach out to me for further questions.
Everyone wants to do value-add deals in Multi-Family. In my opinion these are 3 types of value-add in Multi-Family or Commercial Real Estate in general.
1) Cookie cutter value-add
This is the most common one where there is some deferred maintenance but mostly interior unit renovations that lot of the times proven by the seller. The reason lot of people get into this because of the predictability of the deal. In this climate of low interest rates, so much capital chasing deals and extended economic expansion cycle, lot of people wants to do typical and safe value-add. These deals getting skinnier day by day. The cap rate are compressing, people are overpaying and it usually end up as very thin deal unless its executed perfectly. There is no margin of error in these deals. That's why sponsors are taking 15%, 18% and giving most to investors as deals are not penciling out.
2) Deep value-add
Properties that are not renovated for so long time, high mismanagement, high vacancy, lot of down units, huge deferred maintenance like roofs are bad, sewer lines to be replaced, foundation issues etc where there is a lot of meat on the bone/ reward but at same time it's high risk. In most of the cases, people take bridge loans, refinance cash-out and move to long term loan. In this process they can return lot of their initial capital to investors and still keep them in deal for long term but with lower ownership for investors.
3) New construction
New construction is really big value-add where you are developing from raw land to great product. Its high risk but high reward to investors and sponsorship team alike. There are lot of unknows and risk but with right structuring lot of risks can be mitigated to investors. And when you are there in all the phases of rezoning, horizontal development and vertical development, sell or lease up and manage the property you will be adding most value and pass on the value to investors.
For Zovest #1 is bread and butter, but we are mostly going towards #2 and #3 these days. Please reach out to me at email@example.com for further questions, comments, feedback and ideas on what kind of value-add you typically execute or like to invest.
Have a great year ahead!
A typical syndicated deal for an Apartment is for a specific property. We as sponsors, identify a property (or even multiple properties) and get it under contract, do inspection, get financing and then once all the risks are removed, we raise funds from investors to close the deal and give distributions, add-value and sell at appropriate time and exit the syndication.
It's a lot of work involved and so many moving parts. Instead, we can even create a fund structure which is a blind pool, where sponsors can buy, renovate, sell properties on a periodic basis. This will help sponsors to focus on assets and not to worry too much about how to get the equity money to purchase assets.
Lot of people shy away from the fund structure as investors cannot pick and choose markets/ properties to invest on.
Zovest will be launching real estate fund which will largely focus on Small to Medium MultiFamily (30 to 70 units) which are ignored by large REIT's, Syndicators, Pension Funds and really a lot of work to buy, rehab, either keep for really long term or sell.
If you have suggestions or interest in funds, please reach out to me at firstname.lastname@example.org.
My name is Rama Krishna . We at Zovest Properties, invest in value-add Apartments in growing markets to provide passive cash-flow to our investors.