What "Inning" of the Real Estate Cycle Are We In?Jun 2, 2016
I have now practiced real estate law for almost 35 years, which is a long time to do anything. I am not absolutely “sure” about many things; however, I am confident that no one has a crystal ball about what the markets are going to do.
Some real estate people seem to be so doggone smart. They sell before the market crashes. Then they buy low at the bottom. These people are revered as the smartest names in real estate. They go to conferences and speak at them. They are usually great speakers because they are smart – rich – and self-confident. After all, they pulled it off.
Often they talk about what “inning” of a cycle we are in. If not, the moderator usually asks that question. Those in the audience are busy taking notes like:
“Toby Jones thinks we are in the third inning [of a certain real estate product]”
Perhaps that makes the party taking notes, who has invested in a similar real estate product, “feel” a little better – and after all there are all sorts of articles written about our human emotional need for validation, etc.
However, the truth is that neither Toby Jones nor anyone has a clue what inning we are in. Toby talking about innings and you listening is as useful for investment decisions as going birdwatching.
But, you might ask, what about the fact that Toby Jones has been right for the last three downturns? He always seems to know when to get in and when to get out. However, if you really dig in, I wonder:
Is Toby really right that consistently? Did he really get in and out at the right times to begin with? If you look at a longer time period, was Toby right over a long time period or just the past few times? Did he get in a bit too early and maybe got out way too early? Did he miss a lot of upside and get hit with a decent amount of downside? Did he make almost all of his upside on one dramatically-outperforming transaction?
Did Toby make a lot of predictions and take a lot of actions that were proved completely wrong but no one really remembers that? For example, was Toby sure that interest rates are going up next year for the past seven years? If you are Toby Jones reading this, was that your prediction? Now, almost no one thinks interest rates will go up next year. What does that mean?
And, even if Toby has a great track record over a long time of, say, 30 years, even then it doesn’t necessarily mean Toby is really smarter or has a crystal ball. If there are thousands of real estate players (all dumb as a post) and all making recommendations and decisions over 30 years, it is a statistical certainty that some will be right just about all of the time during that time period.
Let me apply this to New York City (since I am based here). Pricing of most real estate assets here is exceptionally high, say most of the Toby Jones’s, which would lead one to conclude that buying now is a mistake and prices have nowhere to go but down. Indeed, sitting here in NYC, to me it “feels” like a significant correction is starting right now. Maybe prices will be down 50% in the next few years.
However, New York is the financial center of the world – a booming tech center – a cultural center – a diverse melting pot – an exciting and vibrant city – and a place where when you get right down to it, talented people want to go to and stay. It is one of only a few markets in the world in a stable democracy that is large enough to put down an enormous investment that will likely always have liquidity. There is every reason to expect that the flight of worldwide capital will continue and if so what better place than New York City. And with interest rates going to zero, or even negative, around the world, maybe a 3% cap rate in New York City is just fine. Maybe prices will double in the next five years?
The only thing I am sure about is that I don’t know. And I am also sure that no one else – including Toby Jones -- knows either. Indeed, I would guess that there is “smart money” that has been waiting for a correction in New York City pricing of real estate for several years now and the only thing the smart money has achieved is that it has so far missed out on a lot of upside.
But maybe now there will indeed be a “correction” and the “smart money” will “pounce”! To that I say “fiddlesticks!”
For that to be true the smart money would have to know that the correction will be 13.5% rather than 35% and know when the bottom is and I don’t buy that the smart money will know that. How much “smart money” was there at the depths of the financial crisis when prices were down 35% in New York? Precious little – probably because the smart money thought prices were going to drop a lot further. It took quite a while before many would dip their toes in the market. And, yes, those who bought at the bottom look awfully intelligent, but what would have happened if the financial crisis had gotten worse or New York became victimized by more terror attacks or crime had gotten worse or a health panic had occurred or all sorts of things had happened?
I could go on here, but my point is simple; namely, that it is a waste of time making macro predictions about markets that no one can really be sure about. You may get lucky for a while, but sooner or later you will get tagged and I predict you will under-perform over a long-term time period.
Warren Buffet makes this point all of the time. He says he cannot predict the market, and no one can, so it is pointless to try. Instead, he looks for companies that are good value and uses his intellect to buy at good prices.
So, I will stick my neck out and say that if your company’s real estate strategy is based on timing the real estate market – and predicting what “inning” of a cycle we are in – then it is likely a flawed strategy that may work for a while but eventually will be upended with below average long-term returns.
So – enough negativity – what do I advocate? I advocate being market-agnostic and thinking through the best ways to “create value” in real estate (and maybe even looking at my prior – and future -- articles on that subject). Just go about your business looking to create value and finding deals that do so. Sometimes the market will go up, and that will juice your returns to the upside. And sometimes the market will go down and your returns on that deal will be lower than you like. However, in the long run, if you follow this strategy, you will outperform.