Dr. Strangerisk or: How I Learned to Stop Worrying and Love Uncertainty

The Equity Risk Premium

It has been a tumultuous few years in the investment management industry with the covid pandemic followed by enormous monetary and fiscal stimulus, inflation rates that had not been seen in the US for 40 years, and more recently interest rates that have risen to levels we had not seen since before the Great Financial Crisis. All of this may cause investors to be hesitant to commit capital, deploying phrases like “de-risking portfolios” due to the perceived increase in risk. Yet financial theory tells us that the only way to achieve a return above the risk-free rate is to embrace risk, which I believe can more precisely be described as embracing uncertainty in future returns and the possibility of loss on invested capital.

Risk in Public Markets

AQR published an intriguing paper several years ago titled “Embracing Downside Risk.” In the paper, the authors built a portfolio that was identical to the S&P 500 but broke it down into a portion that would take the worst of market losses and one that would capture market upside. The payoff diagrams for each portion are reproduced below.

What the authors found was that, over longer periods, the portion that exposed them to market losses delivered returns remarkably similar to the S&P 500. The implication for investors is that to capture the equity risk premium, you need to be exposed to the potential of loss. Or, said another way, “de-risking” is “de-returning.”

Risk and Apartments

Green Street Advisors estimates that apartment cap rates increased from 3.8% at the end of 2021 to 5.1% at the end of 2022. This cap rate movement alone implies a 25% loss in the value of apartments. Fortunately, there are additional factors influencing returns on apartments, including income return and, most importantly in 2022, NOI growth, which hit historical highs. While these other factors did mitigate the cap rate increase, Green Street estimates that apartment values are 20% off the peak prices they reached in early 2022.

Development Margins

If we think of the development margin as a spread between the yield on cost and cap rates, the table below shows that, starting with an initial 6% yield on cost, a cap rate expansion from 3.75% to 5% would have reduced margins from 60% to 20%. But this goes the other way also: for example, developers who were targeting a 30% margin at the beginning of 2018 with a 6.5% yield on cost ended up with a 73% margin if they exited at the 3.8% cap rate that was in effect in early 2022.

Yield on Cost

It is important to note that yield on cost does not exist in a vacuum. Land prices have been shown to be about three times as volatile as prices of stabilized properties. With stabilized apartment values some 20% off peak pricing, this suggests that land prices are likely off by around 60%. This puts upward pressure on the yield on cost as the land component of cost decreases significantly.

It should also be noted that there is even more uncertainty in yield on cost. This comes from two major contributors, the first of which is the cost. We have already touched on the cost of land but there is also uncertainty in the hard costs associated with development. For instance, lumber futures spiked from under $500 pre-covid to over $1,500 at its peak and it is now back under $500. Increases in hard costs put strong downward pressure on the yield on cost but the opposite is also true with the recent dramatic decrease in lumber futures putting upward pressure on yield on cost.

The other major contributor to yield on cost is the rents that are going to be achieved. The math on the relationship between rents and net operating income is that because operating margins on apartments are generally in the 65% range and expenses are largely fixed, a 10% increase in rents will increase NOI by over 15%. Yet rent changes are very difficult to forecast accurately (anyone can forecast, forecasting accurately is a completely different story.)

Risk at the beginning of 2022

Somewhat ironically, many real estate investors are becoming much less eager to take development risk today than they were at the beginning of 2022 when apartment cap rates were 3.8%, land prices had run up even more dramatically than stabilized apartments, and hard costs such as lumber were still significantly above their pre-covid pricing. Because of this, capital deployed at the beginning of 2022 is likely to underperform ex-ante expectations due to the dramatic increase in cap rates. Yet there was very little consideration of risk at the time.

Risk Today

Presently land costs are decreasing, and many hard costs are decreasing as demonstrated by lumber costs. This will put upward pressure on yield on cost. Apartment rents, after running up dramatically over the past two years, appear to be on their way to reverting to their longer-term average, which is generally in line with inflation. This is due in large part to the significant increase in supply, especially in the fastest growing markets. The Fed has recently slowed its increases in interest rates to 25 bp and the markets expect that we are likely getting close to the terminal Federal Funds rate. Yet there is uncertainty in each of these parameters, each of which will significantly affect the returns on an apartment development project that will commence today. This exact same uncertainty also existed at the beginning of 2022 but it appears that very little heed was paid. The difference today is that investors seem to be much more aware of this risk which is affecting their decision making.

De-Risking is De-Returning

The aforementioned paper “Embracing Downside Risk,” showed that in traded markets, investors need to expose themselves to the risk of capital loss to capture the equity risk premium such that “de-risking” is in effect “de-returning.” Investors in apartment developments at the beginning of 2022 were eager to take risk, yet due to the increase in cap rates, will likely not hit their return target. But this does not mean that today there is a higher probability of not hitting return targets as land prices have fallen, costs appear to have hit a peak and are flat to decreasing, and rents appear to be mean reverting.

Conclusion

There remains the possibility that the Federal Reserve will have to raise interest rates higher than they currently project to tame inflation, which will put further upward pressure on cap rates. It is also possible that hard cost inflation will return, and the significant number of new apartments being delivered to markets, especially the fastest growing markets, will cause rents to decrease. Both would put downward pressure on yield on cost. Combine the possibility of a continued increase in cap rates and decrease in yield on cost and there is a real possibility that the development margin will not hit its target. Yet exposure to these risks is what is required to achieve the equity return premium. And that.. is How I Learned to Stop Worrying and Love Uncertainty.