Volatility's Worst Nightmare...

The first half of 2022 has been a bumpy ride in the equity market – perhaps not unexpected given macroeconomic and geopolitical factors in play.   Volatility is back and sentiment is reacting daily to interest rates, energy, inflation numbers, and more.  The question of whether the sentiment is right or wrong would lead us into an academic debate (rational vs. irrational pricing, short term vs long term, etc.) - let’s not go there... at least not today.

Investors often see volatility as a necessary evil – basically the price that one pays to earn the  solid returns that long term buy & hold investing in stocks has produced over the past 50 years.  Attempts to reduce this volatility through portfolio construction and derivatives has a very mixed track record overall – and for many has done more harm than good.  But no one likes volatility - especially the idea that one’s hard earned money can take big hits by the whim of the market. Accepting volatility as a necessary condition to get great returns though is a flawed assumption.

Why?  Because there are asset classes that have great return profiles that don’t have tons of volatility.   But you have to look outside the public markets to find them.   

Net lease commercial real estate is one such asset class (for a primer on the asset class, see What is Net Lease Real Estate?).   Important clarifying point - to get the returns and get the benefit of low volatility an investor must invest in the private market - either with a manager or directly.  This is opposed to investing in publicly traded REITs.  REITs certainly own net lease commercial real estate - but their valuations get caught up in stock market sentiment - which corrupts the valuations.  

Look at the value of the REIT index in the first half of 2022!!! 

2022 YTD Performance of S&P REIT Index

It’s YTD return is -22.52%., which is absolutely horrendous, especially since many commercial buildings have SOLD AT ALL TIME HIGH PRICES. 

This is a complete dislocation between the share price and the value of the underlying assets.  This subject merits an entire discussion of Public REITs vs. Private REITs, which will be forthcoming, but let’s get back to why the asset class itself has low volatility.

Reasons for low volatility:

1) High value of the asset and time & effort needed to transact

 Buyers and Sellers are much more careful because the building represents a large amount of money, and no one wants to spend time, energy and money on a transaction that isn’t going to produce the desired outcome.  Commercial real estate transactions involve considerable costs (legal, environmental, inspections, etc.).  This plays out over months not minutes and we know that human behavior becomes much less impulsive over longer time frames. If you are wondering about that, please review the studies on Amazon purchasing behavior… if consumers leave items in their cart for at least 24hrs prior to purchase, they don’t end up buying nearly as much.

2) Asset values are based on objective numbers & data that move slowly and don’t reverse direction very often.  Let’s look closer at these factors:

• Capitalization rates (cap rates), which subsume the following :

  Tenant business performance (historical and future)

  Location (perceived benefit to tenant segment)

  Demographics

  Regional Economy

  Physical structure (quality, age, adaptable use, etc.)

  Financing options available to buyers

• NOI is based on rents in relation to expenses

All of the above are pretty slow moving - generally speaking.  This isn’t to say that they never move abruptly or that there aren’t risks because the volatility is low.  There are risks in all of the above factors.  But no where in the list do you see general sentiment. 

3) Duration of lease and the structure of operating expenses in net lease properties

Net leases are long term, usually 5 yrs minimum and can routinely go out 10-20 years.  For tenants to undertake such an obligation they have to be committed to the location and believe that they will be able to achieve the operating performance needed to pay the lease obligation. 

Because expenses are controllable in net lease – tenants are responsible for paying maintenance, property taxes, insurance, etc. – cash flow is predictable which means Net Operating Income is predictable… which means valuation is predictable. 

 There has to be a drawback, i.e. in return for low volatility, net lease real estate must be low return, right?  Not at all.  Total returns in the 15-20% range annualized are very achievable, with cash yield (dividend yield) of 6-8%. 

 We’re not saying abandon stocks because of volatility…  what we are saying is that investing doesn’t have to be a volatile, wild ride.  The right mix of liquid and private investments is different for each person depending on situation & objectives, but one thing is certain - having zero dollars invested in private investments that aren’t sentiment-driven is a mistake. 

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