Steady Growth in Suburban Vintage Multifamily

Image by Tumisu from Pixabay 

Staff Report from Rastegar Property Company

Key Points

• Multifamily is a historically stable investment class
• Asset class has high occupancy and affordable rents
• Demand is generated by young professionals and families leaving urban centers for affordability and quality living
• Public health concerns drive need for suburban garden-style apartments
• Direct benefit: abundant value-add opportunity

In the current economic climate, stability and performance are paramount in the selection of an asset class. Vintage garden-style multifamily fits the needs of risk-averse, and return-driven institutional investors. Because of an uptick in demand due to the pandemic, along with population shifts away from gateway coastal cities and the urban core, performance is key. Let’s take a look: 

The Economics in Vintage Multifamily

We start with the pragmatic. Vintage multifamily performs well financially in several regards.

Principally, this asset class is more affordable for tenants and provides quality living opportunities in good neighborhoods. Most vintage properties fall within the ‘Class-B/C’ category. In short, these classifications represent existing builds (often pre-2000) in middle-class communities that typically need some renovation and operational optimization to maximize net operating income (NOI) and consequent value (based on the income approach to valuation inherent to income-generating properties).

Historically, multifamily experiences very high occupancy rates – in the mid 90% range since 2000, and remaining over 94% for the better part of the last decade. Despite the recession, Class-B multifamily only dropped to a little over 92% occupancy in 2009 and has steadily recovered since.

In contrast, Class-A has experienced consistent declines in occupancy in the post-Great Recession period, reaching as low as 90%. Additionally, vintage multifamily rents consistently grow at a faster rate than inflation, with an average 30-year return of 12%.

Another bonus for multifamily is the high percentage of on-time payments. Compared to August of last year, the percentage of renters paying on time has only dropped by 1.9% during this year’s COVID-19 impact. This is due both to the resilience of workers and families, and the relief provided by the CARES Act and local government initiatives.

Reduced competition is another advantage of vintage multifamily. Most new development in multifamily is concentrated in Class-A, resulting in significantly less new inventory in Class-B.

Additionally, compared to new builds, Class-B/C assets can be acquired below replacement value, are much less costly to renovate, and encounter fewer zoning approval issues, delays, missed milestones, and cost-overruns.

Incidentally, vintage assets don’t experience funding shortfalls as do chic Class-A developments with higher beta. The low risk, substantial upside, and consistent demand for middle-class rentals put both institutional and private investors at ease.

User Trends Drive Performance

We know that multifamily is a strong performer, but what is it about vintage multifamily that appeals to tenants and keeps occupancy high?

Noted previously, affordability is a primary driver. As rents continuously rise in gateway cities, secondary and tertiary markets are becoming more popular – not only for residential properties and users, but also for tech and other firms looking for better amenities, lower leasing expenses, and availability and quality of labor.

As corporate enterprises move to secondary (more suburban) markets – such as Tesla to South Austin, they’re drawing skilled labor with them that favors affordable long-term living accommodations.

Additionally, the remote working trend is enabling families and professionals to shift away from urban centers in pursuit of superior air quality, affordability, and a better environment to work and thrive.

 The lower density of vintage garden-style apartments, as well as the greater availability of desirable amenities on and nearby the property, create additional appeal to drive the migration. And from a health standpoint, suburban garden-style living presents more opportunities for physical activity, natural views, outdoor green space, and social distancing.

Control Over Value in Vintage Multifamily

Perhaps the most exceptional quality of vintage multifamily is the ability to control value through expense and income optimization.

Compared to securities and other assets, income-generating residential property offers excellent potential to improve conditions and enhance amenities, thereby increasing marketability and rental rates.

Without exception, we find that every multifamily property has opportunities to more effectively manage expenses, and generate ancillary revenue streams, to boost NOI and property value in the near term.

With the multitude of viable acquisition prospects available in this asset class, we’ve found it relatively straightforward to find, vet and build a portfolio of the very best properties with low risk and tremendous income potential.

Visible in the Horizon

We’re in a dynamic economic and social environment. Accordingly, sourcing low-risk, robust investments with projected long-term stability is central to the goal of building portfolios that will weather recession or another national crisis. Vintage multifamily assets have proven to be among the most resilient classes of real estate over the last 20 years and should continue to flourish in the visible economic horizon.

Rastegar Property Company is an Associate Member of TEXPERS. The views expressed in this article are those of the authors and not necessarily RASTEGAR nor TEXPERS. 

Risk Mitigation Opportunities: Taking Time to Re-evaluate Portfolio Strategies and Board Governance

Image by Michal Jarmoluk from Pixabay 

By FLOYD SIMPSON III & MALLORY SAMPSON/PFM Asset Management

The traditional 60% S&P 500 - 40% Aggregate Bond index investment portfolio has been the benchmark for portfolio construction for decades due to the inverse return relationship between equities and fixed income and higher historical bond yields. This simplistic mix had provided returns for pensions that allowed them to meet their actuary assumed returns. The S&P 500 index posted an approximate annualized average return of 11.3% for the past 10 years (ending 2019)[1], while the current yield on the Aggregate Bond Index less than 1.5% (coupon rate of hovering around 3%). The correlation between the two indexes has been slightly negative for the past ten years, and bonds have not provided a consistent offset for drawdowns within the S&P 500 index. Over the next five years, earning a 5% annualized return will be tough. Based on recent comments from the Federal Reserve (the Fed), the expectation for higher interest rates in the intermediate term is minimal. While investors cannot control what the Fed is doing, we can recalibrate current positioning and take a serious look at the risk within the portfolio and its governance.

Investment Strategy

The first question that most investors have started to ask themselves is how to replace the missing yield from the fixed income market. When seeking a replacement, many forget to fully vet the additional risks associated with finding an alternative. While there might be other public and private options, each one brings a different type of risk profile to the portfolio, which must be considered. Hence, swapping one investment for another is a naïve approach that could have detrimental effects if the understanding of current and potential strategies is vague. This is an important area to focus on, and what an investment advisor is paid to do. You might have a relationship with an advisory firm in which they present you with options or a fiduciary that does the decision-making and portfolio construction for you. In either case, this is the time for an investment committee to focus on oversight elements that are usually glazed over. From an investment perspective, members should take this time to:

• Re-evaluate their Strategic Allocation
• Update their Investment Policy
• Refresh their Objectives
• Evaluate their tactics around allocation of assets and assessment of those decisions
• Revisiting their Spending Policy

This is also an appropriate time to rethink how the committee gauges success of their portfolio. Instead of looking exclusively at the traditional aspects of asset classes and benchmark performance, committees should start to consider:

• Gauging the overall risk of their exposure
• Homing in on their underlying market exposures to events that could be detrimental to returns
• Measuring the volatility of returns for each fund and portfolio as a whole
• Considering drawdown of the portfolio

Governance Structure

Understanding and addressing the potential holes within the governance of a board is equally important to understanding current market conditions. Unfortunately, this rarely gets the same attention as the latest news from the stock market does.

As investment professionals, we spend far too much time talking about the markets, but clients’ governance structure usually has glaring holes and creates just as much risk for plans. The adoption of good governance starts with:

• Addressing educational needs within the board
• Introduction of term limits
• Staggering board terms
• Independent, third-party reviews of board investment process
• Proactively minimizing conflicts of interest
• Re-evaluate current investment advisor beyond investment performance
• Utilizing board assessments

While most boards would say they follow a couple of these best practices, very few that take time to adopt many of these items because they can be tedious and cumbersome to carry out. The board assessment can help in numerous areas. It can inform a board about members that are not contributing, bring up potential conflicts or educational gaps in knowledge and could even help in determining term-limits based on board needs. Pinpointing weak areas within the governance structure can help prevent surprises during times of distress.

It is crucial for boards to maintain discipline in their governance and review processes; while it may not seem as exciting as stock and fixed income movements, it is equally as important of an exercise for more efficient portfolio management.

PFM is an Associate Member of TEXPERS. The views expressed in this article are those of the authors and not necessarily PFM nor TEXPERS. 

Sources

[1] Bloomberg

About the Authors

Floyd Simpson III, CFA, CFP, is Senior Managing Consultant with PFM Asset Management LLC. As part of PFM’s OCIO business, Simpson works with clients across the country to develop and implement multi-asset class strategies for their portfolios. He also serves on the Multi-Asset Strategies Group and the Multi-Asset Class Investment Committee.

Mallory Sampson, CFP, is Senior Managing Consultant with PFM Asset Management LLC. Sampson manages PFM’s institutional multi-asset class relationships in Texas, with a focus on higher education, endowments, foundations and OPEB trusts.

Factors First: A Risk-based Approach to Harnessing Alternative Sources of Income

Image by Arek Socha from Pixabay 

Staff Report From NUVEEN/Nuveen

The income-generating potential of alternatives seems to be largely underappreciated, despite the trend toward larger allocations to alternative asset classes in institutional portfolios and the quest for yield in a low-rate environment. When we ask institutional investors what roles they look for alternatives to play in a multi-asset portfolio, diversification is the top priority, followed closely by total return. Income generation usually is a distant third.

Institutional investors can enhance their ability to capitalize on the yield and diversification benefits of alternatives by focusing on the risks that drive returns in each specific segment of the alternatives universe. This approach allows investors to stitch together multi-asset portfolios in a more efficient, coherent way.

Executing this, however, is no simple task. If done incorrectly, investors risk negating some of the diversification benefits that make alternatives such valuable contributors to stronger, more resilient portfolios.

Know what risk factors drive return

Alternative asset classes such as private credit, real assets (farmland, timberland and private equity infrastructure investments) as well as non-traditional sectors of fixed income (preferred securities, emerging markets debt, high yield corporate debt and leveraged loans) present attractive income-generating potential.

Idiosyncratic risks play a vital role in driving returns in each of these asset classes — and these risks are what institutional investors should be trying to harness in an income-generating multi-asset portfolio. But it is important to note that each of these asset classes has significant exposure, in varying degrees, to the core, broad-based risk factors: equity, credit spread and rate duration.

As the chart below illustrates, idiosyncratic risks account for less than 60% of the contribution to total risk in all of the alternative asset classes included in the chart, except for real estate. With emerging markets debt, for example, equity risk accounts for 36% of the total risk and credit risk accounts for an additional 33%.

Preferreds are also an interesting case. Some investors consider them to be more like an equity instrument while others consider them to be more like fixed income. This debate is easily settled when viewed through a risk decomposition lens, which shows that equity risk and idiosyncratic risk account for the totality of risk for preferreds.

Click chart to enlarge.

This isn’t to imply that emerging markets debt and infrastructure aren’t valuable diversifiers. Rather, it is to highlight that unless an investor decomposes the risk contributors, a portfolio could end up with significantly more exposure to equity, credit or rate risk than the investor bargained for.

Allocate to risk factors, not asset classes

Investors are compensated for owning risk, not asset classes. We believe that their portfolio construction processes should reflect this and we have developed a five-step approach to do just that:

1. Decompose risk factors driving the performance of asset classes
2. Analyze how the market is compensating those risk factors
3. Determine which risks need to be owned to fulfill investment objectives and constraints
4. Determine which asset classes and vehicles will achieve the desired risk exposures
5. Monitor risk and asset class relationships and how the market is compensating risks

The benefits of a risk-first approach

This framework puts risk at the heart of constructing multi-asset portfolios and delivers multiple benefits to investors. As already noted, it reduces the risk of overconcentration of risk factors in a portfolio, which could undermine the diversification benefits investors seek from alternatives.

It also encourages a more nimble approach to pursuing yield. The relationships among the risk factors and thus the relationships among the asset classes are constantly evolving — and the degree to which the market is compensating various risks is always changing. Predefined asset allocation constraints limit an investor’s ability to exploit these changes and manage risk.

The framework fosters a more nuanced approach to managing liquidity. Liquidity risk is just one of the idiosyncratic risks of an investment. But when using alternatives to generate income and cash flows needed to fund a set liability, liquidity becomes the idiosyncratic risk that institutions need to understand the best. Taking a risk-first approach to multi-asset portfolio construction frees an investor to take a more nuanced and sophisticated approach to managing liquidity risk — not just with alternatives, but across the entire portfolio.

Learn more about harnessing alternative sources of income

The full paper with complete disclosures can be found at Nuveen.com. 

Nuveen is an Associate Member of TEXPERS. The views expressed in this article are those of the authors and not necessarily Nuveen nor TEXPERS. 

Sources
All market and economic data from Bloomberg, FactSet and Morningstar.

Has COVID-19 Made Sustainable Investing More – or Less – Important?

Photo courtesy of Macquarie Group LTD.

By BARRY GLADSTEIN/Macquarie Investment Management

Environmental, social, and governance (ESG) investing has drawn considerable investor attention in recent years. Morningstar[1] reported that 2019 represented a record year of flows into ESG-related funds in both Europe and the United States. Along with this increased interest, Macquarie Investment Management has continued its commitment to sustainability such as through new ESG analytical and performance measurement tools for investment teams to integrate into their process. Yet, as the world continues to seek effective ways to deal with the COVID-19 pandemic, investors have questioned if there has been a shift in the relative importance of ESG issues when assessing investments. In other words, has ESG lost some of its relevance during the pandemic – or does the crisis make it even more important.

There are currently two schools of thoughts on this subject. One is that with the considerable toll that the pandemic has taken from both a societal and economic standpoint, seemingly more distant and lower priority issues such as climate change will take a back seat, especially as financial assets needed to make changes appear more scarce.

The other thought is that people have been ignoring warnings about a global pandemic for quite some time and the resulting lack of preparedness is a critical problem the world now faces. The same logic can be applied to longer-tail issues such as climate risk, where a potential crisis may similarly be lessened with nearer-term action.

An eye to the long term 

Macquarie Investment Management’s view on the relative importance of ESG in the investment process has not changed as the result of the pandemic. As Lotte Beck, ESG manager for Macquarie’s Luxembourg-based ValueInvest team, put it, “Our approach to ESG has always been to look at it as a stamp of quality. Stable, quality companies usually also have a higher level of ESG management and vice versa.”

The majority of our investment teams employ a fundamental approach toward identifying and assessing securities. Inherent to their investment process is an in-depth analysis of economic, competitive, and other factors that may influence future revenues and earnings of the issuer of the securities, including factors that have been identified as material from an ESG perspective.

Parsing out “E,” “S,” and “G”

This emphasis on materiality may result in a shift in focus regarding ESG factor consideration when evaluating potential investments. In the past few years, the “E” in ESG – environmental – has taken on ever increasing importance as investors have assessed the risks of climate change and its potential effect on a company’s future revenue and expenses. An example of this is the impact of global warming on the future crop supply for food processors and other industries that rely on these vital raw materials. In a 2019 report, the US Department of Agriculture’s Economic Research Service found that if greenhouse gasses are allowed to continue to increase, US production of corn and soybeans could decline as much as 80% over the next 60 years.

Of a more immediate nature are the dramatic increase in wildfires in recent years that many attribute to climate change. Barry Klein, utilities analyst on Macquarie’s Global Listed Infrastructure team, has regularly traveled to California to gain insights into the impact of utility-caused wildfires, assess the response of utilities, and meet with legislators, regulators, and management teams. “It’s important, from both an investment and an environmental responsibility perspective, that we gain a full understanding of the response of the different parties, and how seriously they are taking this growing issue,” Klein said.

While environmental factors remain important risks to consider, “S”, or social factors, are also taking on increasing importance as investors assess the risks of COVID-19 on individual companies. Workplace health and safety is a social factor that the Sustainability Accounting Standards Board (SASB) has identified as being important to many industries. Adrian David, senior credit analyst on Macquarie’s Fixed Income Global Credit Research team, pointed out that workplace safety has historically been a big focus for riskier industries such as mining or energy, Now, challenged by the rapid spread of the virus, more companies outside these sectors are considering how they can operate while providing a safe environment for their staff.

The “G”, or governance aspect of ESG, has always been an important area of focus for investors and will continue to be in the current environment. Steven Catricks, senior portfolio manager on Macquarie’s US Small Mid Cap Value Equity team, noted “how companies address governance issues such as executive compensation will be an important determinant of management quality. Share buyback and dividend policy will also take on greater relevance as stakeholders assess managements’ ability to be effective stewards of capital.”

ESG only a subset of fundamental analysis

The above-mentioned issues are some of the many on which our investment teams focus and reinforce our ongoing message – that ESG analysis and integration present just a subset of overall thorough fundamental analysis. Investors appear to agree that ESG issues remain paramount even in the face of the global pandemic. Morningstar reported that sustainable funds globally attracted an estimated $45.7 billion in net flows during the first quarter of 2020 even as the overall fund universe suffered $384.7 billion in outflows.[2] Summarizing the impact of the pandemic on ESG, Åsa Annerstedt, a portfolio manager on the International Value Equity team, said, “COVID-19 shone the light on the importance of ESG. It will change industries for good, if humanity is wise enough to learn and adapt.”

Macquarie Investment Management is an Associate Member of TEXPERS.The views expressed in this article are those of the author and not necessarily Macquarie Investment Management nor TEXPERS.

Sources

[1] Morningstar, Jan. 10, 2020, “Sustainable Fund Flows in 2019 Smash Previous Records.”
[2] Morningstar, May 14, 2020, “There’s Ample Room for Sustainable Investing to Grow in the U.S.”

About the Author

Barry Gladstein, CFA, leads Macquarie Investment Management’s Environmental, Social, and Governance (ESG) efforts.