Beware of Sponsor Promises of a "Demographic Tailwind"
A dry real-estate study contains a hidden bombshell: One of the most popular ways investors pick "the best" investment is usually completely wrong.
(Disclaimer: I'm not a financial advisor or attorney. Consult your own financial and/or legal advisors before making any investment or legal decisions.)
Paul Kaseburg, the author of "Investing in Real Estate Private Equity" has sat on both sides of the table on over $1.7 billion of real estate deals. He says one of the biggest mistakes investors make is falling in love with the "story" of an investment, instead of doing proper due diligence.
A study released by Green Street Advisors confirms exactly how dangerous it can be to rely on some of these stories.
One of the main ways that sponsors pitch the supposed superiority of their offering over others, is demographic demand. And on the surface these pitches sound really convincing. For example:
"Austin, Texas has been ranked in the top 5 places for millennials to live work and play. So while it was a bit expensive to purchase this property, all these young people moving to Austin in the next couple of years will make this a fantastic investment."
"The population is aging dramatically. So we purchased this so-so assisted living home at a great discount. Then once the demographic tailwinds over the next several years kick in, we'll see profitability soar."
"Homeownership is decreasing and renters are increasing. So although the purchase price of this single-family home portfolio was higher than we wanted, it was well worth it because as the demographic tailwinds continue to kick in, we'll all be very happy in the end." (This is a very close paraphrase of an investment that I just recently passed on.)
Unfortunately, all of the above pitches are most likely wrong.
"Tailwind" or "hot air"?
Green Street analyzed the top 50 markets across the country, and also all property sectors. They found that demographic trends that are "easy to see coming," rarely grow net operating income and thus rarely help the bottom line. And sometimes they even work against an investment, and reduce profitability.
In the fairly dry language of the report, they explain why:
"The reason that this trend doesn’t end up having a large influence on NOI growth is because developers generally react quickly to keep pace with demand because supply constraints are limited for the majority of sectors and markets."
Or in other words: these obvious positive demographic trends cause lots of other people to want to do the same thing. Increased supply causes rents and prices to drop, which reduces profitability. So the expected tailwind never happens.
In Austin, the positive demographics actually caused worse performance. Green Street says:
"Terrific demand growth influenced investors, as much of the local apartment acquisitions were underwritten in this decade. However, developers took note of the same trends and flocked to town, shovels in hand. Conversely, with the absence of meaningful supply barriers, Austin’s inventory grew at nearly three times the national rate, resulting in below average RevPAF (revenue per available square foot) growth."
So, too many people, following the same idea, ruin it for everyone. This is a hugely important dynamic, that many investors completely ignore.
"Constrain Your Enthusiasm"
However, the study did find one really important exception.
Demographic tailwinds did increase profitability when supply of new real estate was constrained.
For example, age-restricted manufactured housing has positive demographics, but also nonexistent new supply because no one wants a trailer park in their backyard. So that's a demographic tailwind that will help profitability.
But again, it's important to watch out for hype here, too. For example, many sponsors try to sell investments in New York City as "supply constrained" because of the high price of land and construction. However, Green Street found that when they looked at the numbers, these did not actually constrain supply.
They found that areas like California, where local and state regulations make building truly difficult, are truly supply constrained, and get a boost from demographics. Investing in these areas is not easy though. It requires a sponsor that has both patience and experience. Navigating the local zoning and permitting processes is key.
(We believe we have identified such a sponsor, and will be talking about them in the Private Investor Club. Membership in the Club is free, but requires verification that the investor is not associated with a platform or sponsor. Click here for more info.)
Here is a link to the Green Street Advisors Study.