Commercial Investment Real Estate Spring 2020 | Page 33
Is it worth taking that risk? Maybe. It depends
10 BIASES IN RETAIL
nonexistent. The notion that NAV is important
on the expected change in cap rate that might
INVESTMENT
remains pervasive and influences each of these
occur with credit rating degradation, the time it
five real estate cognitive biases.
takes to realize that elevated cap rate, and the
Along with NAV, a central theme to these
annual rate of rental increases embodied in the
biases is centered around market efficiency.
lease. An analysis like this will presume that
Difficulty in segregating physical assets from
the tenant remains in the property after the primary lease term. But their potential to deliver returns can often correlate to irrationality
should the tenant opt to return the property to the landlord upon
and bias. Public REIT shareholders and securities analysts, there-
lease expiration, the analysis of expected performance will take a dif- fore, are prone to inconsistencies when considering whether invest-
ferent turn altogether.
ments are grounded in real estate interests or stock.
QUESTIONING COMMON KNOWLEDGE IN REAL ESTATE
Given the differences in lease contract characteristics between the
Home Depot and Ashley stores and in risk undertaken by real estate
investors and bondholders, the investment decision no longer seems
quite so simple. Nevertheless, prospective investors tend to be drawn
to the Home Depot asset. Why is this asset still perceived to have
greater desirability and security?
Five real estate cognitive biases, pertaining to both private and
publicly held real estate, help explain:
• More highly valued real estate is always apt to deliver safer
and assured returns.
• Tenants having strong credit quality elevate real estate
value, performance, and safety.
• The quality of real estate is evidenced by the yield (cap rate)
at which it trades.
• Differences in investment cap rates represent proportional
risk differences.
• Net asset value is an indicator of asset desirability and
expected economic performance.
These biases tend to come from loosely recalled or anecdotal
information used to establish our belief system. To my knowledge, no
reliable academic studies support any of the nine biases mentioned
thus far.
Potential investors might be drawn to Home Depot as a brand, but how is it as a tenant?
Real estate company investors can be preoccupied with net
asset value, or NAV, as a determinant of corporate valuation. Real
estate investment trusts were effectively conceived to be mutual
funds of real estate, but NAV holds little weight in judging the per-
formance of public REITs. In a study of publicly traded REITs con-
ducted by Goldman Sachs in 2012, growth in funds from operations
accounted for 82 percent of stock performance, while the correlation
between NAV and share price performance, meanwhile, was virtually
CIREMAGAZINE.COM
THE 10TH BIAS
Nobel prize-winning economist Harry Markowitz describes diver-
sification as “the only free lunch in finance,” because, he argues,
an investor can benefit from reduced risk while sacrificing little in
long-term gains. Given such benefits, net lease real estate investors
should ask, “How many properties does it take to properly diver-
sify?” For net lease market participants, each individual property
poses a high level of investment concentration risk, unlike mul-
titenant properties, where each asset can potentially deliver signifi-
cant tenant diversity. Master leases can help by combining multiple
tenant locations into a single lease, but that effort will still fall short
of the diversity offered by multi-tenanted properties. Equity port-
folio managers should hold 15 to 30 uncorrelated stocks to have an
adequately diversified portfolio.
Many, and perhaps most, net lease real estate investors don’t
properly diversify, leading us to a 10th bias:
• Portfolio diversity does not apply to single tenant
net lease real estate.
Often, the first nine cognitive biases justify ignoring portfolio
diversity. Tenant credit ratings and high real estate NAVs can easily
divert an investor’s attention from diversification. Federal income
tax incentives, such as 1031 exchanges, can also loom large given the
well-documented bias of investors to avoid losses, in this case taxes
that would otherwise come due.
Warren Buffett, who has guided Berkshire Hathaway to real-
ize annual compound rates of return in excess of 20 percent since
1965, more than double that of the S&P 500 index, famously once
said, “Diversification is protection against ignorance; it makes lit-
tle sense if you know what you are doing.” Taking this advice, I’d
opt for the Home Depot, in part because I believe Buffett, but also
because I believe hard asset investing simply entails less risk. But
the risk/reward dynamics are vastly different. Equity investments
target higher returns, benefit from high levels of corporate oper-
ating leverage, and are supported by the complete operations of a
business. Net lease real estate assets tend to target lower levels of
return, have virtually no operating leverage, and ultimately rely on
the success of a single asset.
The 10th bias encourages investors to look for trees, believing
forests to be less important. Focusing on individual assets dismiss-
es the essence of the contributions of diversity. The key is to apply
consistent investment and management standards to a highly diverse
net lease portfolio to reduce portfolio risk.
In previous decades, behavioral psychologists illustrated
our tendency toward cognitive bias, establishing the foundation
for behavioral economics. Perhaps more importantly, this work
influenced the development of evidence-based disciplines from
professional athlete selection to medicine to investing. Once we
acknowledge the human tendency toward bias, we can start to use
that awareness to create evidence-based best practices in commer-
cial real estate.
Christopher H. Volk
CEO and president of STORE Capital
Contact him at [email protected].
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