Publications

- September 1, 2022: Vol. 9, Number 8

Risk and opportunities: Investors who focus on ground-up real estate stand to capitalize on long-standing trends

by Bernard Wasserman

In periods of uncertainty, wealth managers tend to advise investors to increase their share of hard assets such as real estate, which, because of deep capital sources available to support them, can typically withstand volatility. But all real estate isn’t created equal.

In recent years, the tight labor market and low interest rates widely fueled a surge in real estate valuations. While this exuberance has begun to cool, the fundamental drivers supporting valuations and exacerbating the housing shortage in certain markets remain unchanged. In these cases, ground-up real estate can be attractive, though this is often an underserved portion of an investor’s portfolio. The problem facing most investors is a lack of access to high-quality, ground-up development opportunities. Rather, they invest at the margins. Some invest in single properties, which provide concentrated exposure that isn’t suitable for most investors. Others allocate to broadly diversified REITs that provide exposure to core real estate, which is more bond-like and sensitive to interest-rate swings. Development offers more growth potential and is less volatile, but it doesn’t lend itself easily to REIT investments given the prohibitive cost of frequent valuation.

In general, value-add and distressed assets are not great alternatives to new development in rising interest-rate cycles when margins are tighter and more easily compressed. In frothy markets, the risk of overpaying is high and is often when expectations of further surges in valuation and rent growth can fall short. Though potentially less capital intensive, distressed investing, which involves buying up properties on the brink of foreclosure or already bank-owned, has a similar time frame as new development — three to five years. However, distressed investing often has more obstacles than just a poor business plan or an overly leveraged capital stack. Some aspects such as location can’t be fixed, and often these assets can’t generate the same upside as a brand-new property located in a top neighborhood with the latest features and amenities.

Despite the benefits of investing in ground-up development, most high-net-worth investors are unable to directly access the best developers and opportunities as easily as large institutional investors. Given the predominant focus of most managers on core and value-add strategies, high-net-worth investors are prone to partner with a value-add “generalist” firm that outsources development. This can lead to another layer of costs and the potential for logjams and quality-control issues. There are firms that maintain a level of in-house development expertise, but not many of them have a dedicated, experienced development team capable of undertaking multiple complex projects.

When contemplating ground-up development, it is important to be strategic in your site selection and development partner. The best way to reduce risk is to work with a seasoned development team and concentrate on high-growth markets, which tend to offer the best long-term return potential. When it comes to site selection, development is no different from other real estate strategies; it generally comes down to supply and demand.

Over the past decade, Americans have been flocking to tax-friendly states and territories in the Sun Belt. According to the 2020 census, the South grew the fastest of any region over the previous decade, with a 10.2 percent increase in population, led by states such as Texas, Florida and Georgia.

In a post-COVID-19 environment, these trends have accelerated to an even greater degree, driven in large part by a newly mobile workforce with the freedom and flexibility to migrate to states such as Florida that offer more space and a higher quality of life.

At the same time, the supply of new housing hasn’t kept up with demand. Across the country, population growth has outpaced home construction for the past 20 years, and recent supply-chain issues have further complicated efforts to fill the shortfall. This has led to a nationwide rise in home prices and rents. In New York and Los Angeles, trailing 12-month rent growth at the end of the first quarter reached nearly 6 percent and 7 percent, respectively. This pales in comparison to Florida, where nearly 1,000 new residents arrive each day. Florida home prices and rents are soaring, with trailing 12-month rent growth in the top three markets increasing by more than 20 percent, and occupancy rates rising 2 percent to 3 percent to reach more than 97.5 percent. Tampa, which was named by Zillow as the hottest housing market in the nation, had a 25 percent drop of available homes and apartments during 2021, with a 7.6 percent drop in December alone.

The combination of low housing stock, increasing migration and the rise in remote work make investing in ground-up development in high-growth markets a singular opportunity. Investors who overlook this asset class are ignoring demographic trends with historic implications. Ideally, investors should look to partner with an asset manager that can provide access to a diversified development portfolio with a long history of successful development experience in their chosen markets and property types. The more integrated the development team is with the asset manager, the better the chance of achieving your goals.

 

Bernard Wasserman is the president of Participant Capital, a real estate investment management firm.

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