Portfolio Construction
Here are two conversations I have with increasing frequency. In the first, my phone rings and I’m greeted with an “opportunistic buyer, ready to deploy capital for the right opportunity.” This individual, of course, is given the task of calling anyone and everyone to find the needle in the haystack deal. The 10xer that will impress the happy hour crowd and that will be prominently displayed on the fund’s website for years to come.
In the second, I’m the individual calling anyone and everyone – scratch that, my targeted list of likely buyers – and pitching the 5 cap on in place NOI value-add apartment deal. I’m not even halfway through my spiel about how the right buyer can make accreditive renovations and drive rental growth when I hear “Why would I buy that when I can buy 6 month T-Bills for 4.90%?”
My retort to both the opportunistic buyer and the burgeoning Bill Gross is simple: How does this fit into your overall portfolio construction?
To even have this debate we had to ignore the realities of NOI growth, leverage and tax benefits, which we will.
There is a lot of talk of “killing it” on a deal here and keeping “dry powder” in Treasuries there, but no talk about Portfolio Construction. I get it, you can’t drop a few platitudes, sound bites and peacock away. The entire investing game is portfolio construction. That matters far more than any one individual deal. The last decade has faded from memory a core facet of commercial real estate: this is a cyclical business. Creating a diversified strategy for the ebbs and flows is required for long term success.
Portfolio Construction matters and the current environment will reward those who built right. Let’s look at it in the context of the current doom phrase – The Wall of Maturities. If you’ve avoided media publications or are new to CRE, let me simplify it. CRE loans are done on medium length terms – 3, 5, 7 or 10 years depending on a few variables. There are currently loans that are maturing and those owners will have to refinance into a higher rate environment. For some owners, it will be a lower LTV than they would like, maybe even a percentage of the (unexpected) cash flow gains they’ve received over the last few years. Cash will get locked up, distributions shrunk or eliminated.
For other owners the situation will play out differently. There is a flight to quality, but that really is a flight to capitalization. Tenants are seeking properties with owners who can fulfil their obligations. The tenants want a counter party (see previous post on counter party risk) who can pay for the building CAPEX, who can fulfill TI/LC commitments. Some of this happens subconsciously via tenants. When cash flow is tight, buildings can show it. Any asset class. Look at the trim, look at the landscaping, look at the parking lot.
The well capitalized properties will maintain and gain occupancy levels. The well capitalized assets can refinance with a scenario like above and the less capitalized assets are left behind.
When I talk portfolio construction with an owner, I’m looking to see if an owner is only swinging for home run deals, living in the boom or bust cycle, or if they are building a portfolio that balances short term opportunities with long term plays. Are there assets that consistently throw off cash that can support the other deals? Do the safer, more boring assets provide the security blanket to chase the high equity multiplier deals?
The waves in our industry are long and slow. It takes time for them to build. It takes time for them to break.
So what’s the take away? Build your portfolio to ride the waves. Create stability with a mixture of long- and short-term opportunities. High return deals to brag about and steady flows to support the ups and downs.
