It’s Time to Quit Investing in Private Commercial Real Estate
Have you heard people saying this lately?
We have. It's really no surprise to us, as we’re writing this article in August 2024.
It happens every cycle, to one asset class or another.
I was in my sophomore year of high school on August 13, 1979, when this infamous cover story ran in BusinessWeek:
The Death of Equities: How Inflation is Destroying the Stock Market
This story followed a dismal decade on Wall Street and suggested the stock market may never re-emerge as a profitable asset class.
Not long after this headline, we experienced the bull market of the 80s, a period that significantly boosted the wealth of millions of Americans.
I doubt that many of you have succumbed to "the death of commercial real estate" fallacy. But someone around the water cooler or at the Thanksgiving table may make a comment like this. So, we thought we should do our part to separate fact from fiction in this regard.
Of course, just like the comments from your water cooler pal, our post here is based on our team's opinions and observations. And we can’t predict the future any more than they can.
Don't Let Negative Experiences Drive a Faulty Conclusion
You may not want to hear this. But we don't believe the losses some passive investors are experiencing were caused by commercial real estate (“CRE”) as an asset class. So, we entirely reject the idea that investors should avoid all private CRE.
We believe well-selected and diversified CRE private equity deserves an allocation in every accredited investor’s portfolio.
Depending on the time period selected, real estate outperforms public equities with less volatility—especially when considering the tax benefits enjoyed by real estate investors. Source: The Rate of Return on Everything, 1870–2015
Furthermore, we believe illiquid CRE investments provide meaningful advantages over liquid equity investments that are jerked around by the mood on Wall Street, a CEO scandal, or a war in the Middle East. I've written about the power of illiquidity here.
Sure, you can look back at the last few years to identify the best-performing individual stocks you could have chosen. But that's a fallacy. You couldn't have chosen those in advance, and even if you did once or twice, it is impossible to do this consistently over your career.
Looking back a few more years, CRE broadly produced remarkable returns. Volatility in any asset class is why recency bias, another common fallacy, should be avoided when making investment decisions. (Volatility is another reason to diversify across both private real estate and the stock market, but that’s a topic for another day.)
Wellings Capital reviews many sponsors and deals. Last year, we reviewed 515 deals and invested in only 11. From our vantage point, we’ve observed distinct differences between sponsors who are marketers/capital raisers and sponsors who are true operators.
Most of these "marketers" have never experienced a down market, grew too fast, overpaid for properties with other people's money, or utilized imprudent debt strategies. It has amazed us how many savvy investors flocked to them simply due to their great marketing.
Shiny brochures mailed monthly, a series of webinars or "training" courses, podcast episodes, paid social media ads, conference appearances, a roster with an investor relations team three times the size of the asset management team, etc., are sometimes red flags.
The investible sponsors focus their time and efforts on operations, asset management, and strategy execution. They don't take on disproportionate risk to chase non-commensurate returns via imprudent leverage strategies, over-aggressive acquisition criteria, etc.
These operators are harder to find. They don't always need your money. But they aren't losing investor capital, and their investors continue to earn returns in this market and most any market.
Perhaps most importantly, they utilize conservative downside protection strategies that result in projected a 15% IRR reverting to a 10% IRR when things get really tough. Compare this to projected 25-30% IRRs that become negative 100% when they return the keys to the bank or cram down your position with predatory rescue capital.
From our perspective, the takeaway is not to write off CRE as an asset class but to perform thorough due diligence (no different than the most successful stock market investors do). And don't invest in a deal just because someone you know did…
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The Circle of Codependence
Warren Buffett often speaks of the "Circle of Competence." We have our own theory that sounds similar. We call it the "Circle of Codependence."
It goes something like this: Everyone is standing in a circle, looking at the guy or gal to their left who invested with a sponsor. They think, "He or she is smart, happy with their investment, and must have done a lot of due diligence." That person is looking at the person to their left and thinking exactly the same thing…until it goes full circle back to the first person.
But no one has actually done any real due diligence. Yet the deal caught on like wildfire because a couple of intelligent people in a group invested with that sponsor, sometimes only a few months earlier when there wasn't yet sufficient time for the actual investment results to replace the upfront due diligence that wasn't done.
That's how many of the "marketers" who are now losing investor capital raised a lot of it in the first place.
There's nothing wrong with it if someone you know and trust actually did the due diligence. Or if the operator had round trips through a full market cycle and skin in the game. All too often, however, that just isn't the case.
One example of this “Circle of Codependence” in the venture capital space is the FTX scandal. How could some of the world’s top investment professionals and investment firms miss the glaring issues that could have been discovered with basic due diligence?
Here are a few of the firms and individuals that lost millions or hundreds of millions from the FTX collapse:
Sequoia Capital
Peter Thiel
Ontario Teachers' Pension Plan
Tiger Global
Thoma Bravo
Temasek
An article in the Venture Capital Journal says, “For better or for worse, a very common practice in venture capital is trusting another firm’s due diligence.”
Summary
It's easy to explain undesirable outcomes by blaming an asset class. It's much harder to accept responsibility for investment decisions and recognize that it's not CRE as an asset class but rather sponsor selection that created the undesirable outcome.
We're certainly not judging or trying to rub anything in. I (Paul) hopped on bandwagons early in my investing career, many of which went south and cost me dearly.
The simple fact is that we all make mistakes. But to miss the opportunity to learn from our mistakes would be an unfortunate sin that is far worse than the loss we endured to earn the lesson in the first place.
If you have any questions, please contact us or use this link to schedule a call with us.
DISCLAIMER: This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. Wellings Capital Management, LLC is an Investment Adviser registered with the SEC and currently has Wellings Real Estate Income Fund open to accredited investors. All investments pose risk, including the possible loss of all principal invested. Past performance is no guarantee of future results. There is no guarantee that any projected results will be achieved. Investors should consider the investment objectives, risks, charges, and expenses of any Welling Capital investment vehicle before investing. For a Private Placement Memorandum (“PPM”) with this and other information, please call 800-844-2188 or email invest@wellingscapital.com. Please read the PPM carefully before investing.
The information contained in this article is for information purposes, does not constitute a recommendation, and should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws. All investing involves the risk of loss, including a loss of principal. We do not provide tax, accounting, or legal advice, and all investors are advised to consult with their tax, accounting, or legal advisers before investing. Information and any opinions contained in this article have been obtained from sources that we consider reliable, but we do not represent that such information and opinions are accurate or complete and thus should not be relied upon as such.
