Introduction: US residential real estate Investments in a portfolio context
We stand nearly a decade from when most US commercial real estate sectors reached the peak of the last cycle in H2 2007. Following the financial crisis, real estate market values have notably recovered. As of today, marking this ten-year anniversary, many real estate markets are again, in our opinion, fully valued. For example, apartments (or ‘multi-family’ residences) in major cities are currently valued at 73% above their December 2007 peak1; similarly, prime offices in major cities are 59% above the March 2008 valuations.
Perhaps this time is different: real estate leverage levels are materially lower compared to a decade ago2 and yield spreads to US government bonds are at long-term averages3. In our opinion, however, we are more concerned about the absolute level of prices and we have proceeded with caution, keeping an emphasis on downside protection rather than (leveraged) return maximization.
At the same time, many of our institutional clients are facing challenging asset allocation decisions as listed equity valuations appear high in our view, and traditional fixed income yields low. Thus, potential income-generating real assets, and real estate assets in particular, continue to attract interest from a range of institutional investors from across global regions. In the real asset space, many of our clients are seeking an equity-like return profile, but they also recognise the cyclical themes described above and are therefore increasingly looking to implement that potential return profile with ‘debt-like’ structural protections and an increasing margin of safety.
This short note outlines the potential investment opportunities consistent with our defensive risk positioning, with a particular focus on relative value opportunities in US residential real estate debt and equity markets, where Man GPM Aalto has been actively investing since the market reached its cyclical trough in 2012.
Why US residential real estate?
Before looking in more detail at the relative risk-return characteristics of US residential real estate debt versus equity instruments, it is important for investors to understand the case for this asset class overall. For many investors, allocations to real estate are largely focused on commercial property, but we believe that the residential part of the market offers attractive potential for long-term growth, and an important element of diversification. Traditionally, this market has been divided into two broad categories:
- 1. Multi-family (eg. apartment buildings), where residential units are rented to tenants and have been owned by various types of investors (with institutional investors and REITs dominating today);
- Single-family houses, where the vast majority of residential units have been owner-occupied and funded with equity from homeowners and mortgages typically guaranteed by Fannie Mae and/or Freddie Mac, the state-sponsored mortgage finance entities.
Why single-family houses?
The financial crisis had a significant impact on the single-family sector, and its lasting effects have created some attractive investment opportunities in our view. The number of single-family rental units increased to 15.9 million houses4 with an estimated capital value of nearly USD 3 trillion. Institutional investors recognized an underserved but huge market, entered the space, aggregated assets and stabilized large rental portfolios into both private and public REITs.
In the introduction, we drew attention to long-term cycles, and the real estate sector valuations that currently stand well in excess of the cyclical peaks of 2007. However, the recovery following the financial crisis has been uneven, with some major sectors notably lagging the broader market recovery: single-family market valuations have barely reached the level of summer of 2006, whereas multi-family valuations are already 73% above the December 2007 levels. Only 34% of single-family properties across the US have recovered to pre-peak prices5.
Figure 1, for example, shows the capital values of US commercial versus residential real estate – where a clear gap in prices suggests a more attractive entry point for residential in our view. We believe Figure 2 helps reinforce this point, illustrating that the value of single-family residential is still below the pre-crisis peak, while other property types have increased in value.
Figure 1: US residential versus commercial capital values
Source: Case Shiller, RCA Moody’s, June 2017.
Figure 2: US real estate capital values relative to peak in last cycle
Source: Morgan Stanley, July 2017. SFR: single-family residential.
In the single-family residential market, we believe asset values are not driven to the same extent by institutional capital flows or ‘search for yield’ as in the other, more traditional commercial real estate sectors, including multi-family property. Rather, single-family market valuations have lagged as US consumers have been slowly recovering from the deepest financial crisis in recorded history, in an environment of reduced mortgage availability.
Figure 3 illustrates the proportion of US household debt relative to GDP. We believe this lower leverage backdrop, combined with reasonable valuations, supports a constructive outlook for US residential real estate, both in absolute terms and relative to other real estate sectors.
Figure 3: US household debt to GDP
Source: IMF, data to Q4 2016.
Ultimately, we believe that the performance drivers in the single-family sector are simply different from those in the commercial sector, offering a different way to play the US recovery. Adding single-family houses as a distinct asset class may help to introduce less correlated growth and stable income potential to a traditional commercial real estate (CRE) allocation.
Seeking attractive risk-adjusted returns: Equity versus debt
At Man GPM Aalto, we access the single-family residential market through both senior debt and equity in investor-owned single-family properties. We believe it is helpful to think about the relative risk-return profiles of real estate debt versus equity strategies as a similar comparison to traditional bonds versus stocks. In other words, real estate equity generally involves greater levels of risk with greater potential (albeit uncertain) return, while debt strategies have offered more stable levels of income return with an element of downside protection. However, they both offer potential ways to play the ongoing recovery in US single-family housing, and may complement each other as part of a broader portfolio.
Core and value add opportunities in real estate equity
As is the case with commercial real estate investment, the single-family rental equity segment of the market can potentially offer investors two broad opportunity sets. First, investors may opt for ‘core’ style investments, where existing properties are acquired and then rented, targeting long-term stable rental cash flow generation as the intended primary return driver. Second, investors can pursue ‘value add’ or ‘opportunity’ strategies where, for example, land is acquired, and single-family houses are built for both sale and rent. Within both of these investment styles, additional portfolio leverage could be used by investors seeking to increase both the risk and potential returns.
A range of dimensions in debt
As is often the case in the private credit space, residential real estate debt can be accessed through a wide range of instruments and investment strategies. To simplify the broad universe of potential debt strategies, we believe it is helpful to consider the following three dimensions:
- Underlying real estate asset quality: need for repositioning, required capex, and the question of available liquidity;
- The desired position in the capital structure: first lien senior secured debt, second lien, mezzanine or combination of first/second lien (also known as ‘whole loans’);
- Leverage at the real estate debt portfolio level: levered or unlevered loan portfolios.
The resulting risk-return characteristics of a private real estate debt portfolio can vary significantly depending on how an investment manager combines these three different dimensions to create an investment product. By way of analogy to traditional corporate bonds, the corporate credit world has a similar range of options, from relatively low risk (investment grade exposure to blue chip companies without the use of leverage) to relatively high risk (high-yield mezzanine bonds issued by lower quality corporates with additional leverage at the portfolio level). These trade-offs could have a significant impact on a portfolio, and just as in real estate debt markets, we believe there is no single ‘correct’ answer to the question about how to allocate between available assets. It all depends on the specific risk and return objectives of each investor.
Capturing the characteristics of real estate debt and equity in a portfolio
We believe that both debt and equity assets have a role to play in generating potential returns from real estate, but they require different approaches to management in order to harness their distinct characteristics. At Man GPM Aalto, our positioning in US residential real estate differs slightly between equity and debt strategies. On the equity side, we prefer to invest with limited or zero use of leverage. We also combine the core and value add strategies to help create a risk-return profile driven by ‘operational alpha’, rather than financial leverage. We are primarily focused on properties in what we believe are good quality neighborhoods with good schools, where we can provide entry-level housing product to the rental market. In addition, we seek locations that continue to be affordable relative to average household income and, therefore remain priced for long-term sustainable growth in our view.
On the other hand, when investing in real estate debt, our primary objective is to provide our clients with defensive income-driven investments, and as such, we focus on first lien senior secured debt (with varying degrees of ‘loan-to-value’ risk). All of our debt portfolios are unleveraged at the portfolio level. Given our depth of experience in direct investing and origination, we are happy to lend against ‘value add’ residential projects as we feel that we have the required operating expertise to understand and manage the risks appropriately. We often, but not always, focus on older, more established neighborhoods in geographies where there is need for refurbishment of older housing stock. Typically these affluent areas have recovered from the financial crisis but are not as affordable on an income basis, therefore we invest in debt secured by properties with an additional margin of safety.
Investment structuring considerations
In common with other private markets strategies, we believe it is important to consider the appropriate investment structure when seeking exposure to US residential real estate assets. At Man GPM Aalto, we leverage our significant internal resources to work in strategic partnership with our clients and independent advisors when structuring investment vehicles. We pay particular attention to liquidity management and look to achieve an appropriate match between investment liquidity and vehicle liquidity6. Indeed, this asset class requires investment managers to structure appropriate vehicles which can be tailored to investors’ needs.
Single-family residential real estate is a large market that has only recently started attracting institutional capital. We believe valuations in the space remain reasonable compared to other real estate sectors. Ultimately, we believe that residential real estate debt and equity strategies can be complementary, both to each other and to traditional assets in a wider portfolio, especially when exposure is tailored to each asset class. The two investment approaches offered by Man GPM Aalto can offer an element of diversification in a broader portfolio, as the underlying location and property types have material differences. Common to both is our focus on investment income as a key driver of performance. Naturally, a debt strategy has more clearly defined income (coupon) streams with greater downside protection, whereas an equity strategy may benefit from ‘operational alpha’, meaning that rental growth or active management of the cost base can aim to drive income growth over the medium term.
Past performance is not indicative of future results. Returns may increase or decrease as a result of currency fluctuations.
1. Morgan Stanley Research, March 2017.
2. Source: Morgan Stanley CRE tracker November 2016.
3. Source: Callan Associates US Real Estate Indicators Q1 2017.
4. Green Street Advisors, June 2016.
5. Trulia report, May 2017.
6. Liquidity terms vary by vehicle, and investors should consider any liquidity risks as part of their assessment of the investment.