Not all bricks are the same

Bricks give Spaniards an enormous sense of calm. Our dream is to own the home that shelters us and, if life smiles on us financially, to buy a second home to rent out and generate income that supplements our salary. As a result, 39% of all rental homes are owned by a private individual who rents out only that one property, and if we include individuals who rent out two homes, they account for 72.5% of all rental housing. Bricks are our favourite piggy bank.

The thing is, when a circumstance triggers an emotional reaction, rational analysis takes a back seat, and there is a risk of oversimplifying —especially if someone helps you, or outright encourages you, to make that simplification—. This way, anyone trying to sell you an investment knows it will be much easier if they present it as a real estate deal, because emotionally and unconsciously we attribute to it characteristics of solidity and safety.

But in the world of real estate investment, not all bricks are the same.

Imagine you receive two emails offering you the chance to take part in a real estate investment.

The first proposes contributing money to the company that is going to buy a plot of land to build 40 homes. The plot is not yet zoned as residential, but a planning amendment is expected in the coming months to allow the change of use, given the enormous social pressure in the municipality over housing prices.

The second is about contributing money to acquire the building where a supermarket operates. It is located in a retail park, in operation for over a decade, on a 15-year lease, 8 of them mandatory, with one of the leading national grocery chains.

In both cases you will be told it is a real estate investment, and in both cases it will probably be backed by a mortgage guarantee on the asset, if you have structured it as a loan. But we are obviously not talking about the same investment, nor the same level of risk.

With the supermarket, the risk is that the supermarket chain stops paying its rent on time, with the added advantage that, in the hypothetical case that this tenant went bankrupt, the location in a retail park with foot traffic would make it easier to find a replacement.

But with the plot, the investment carries a multitude of chained risks, all of which must be managed successfully to obtain its return. For example, securing the change of use, the building permit, executing the construction itself, marketing the homes… and doing all of it without deviating from the expected timeline and costs.

That is why, even though it is also called real estate investment, the amount of accumulated risk is far greater, which explains why the expected return is higher too. Remember: return correlates with risk. And it could be that a low-return investment carries a lot of risk, but never that a high-return investment does not carry high risk.

The thing is, in the market it will be infinitely easier for you to find high-risk projects to invest in, because the companies that market them advertise the return —the visible part, because risk is invisible until it materialises—, and it is far easier to compete by putting the highest return figure in their advertising. Especially when the real estate cycle is bullish and rising prices camouflage deviations.

And it is fine that riskier investments exist, as long as investors are aware of the type of risk they are taking on and can therefore assess whether the remuneration offered is worth it.

INREV —the European Association for Investors in Non-Listed Real Estate Vehicles— is a European association that mainly brings together institutional investors and managers of non-listed real estate funds: pension funds, insurers, family offices, asset managers…

Its importance for the institutional real estate market lies in developing common standards, definitions and metrics so that real estate investments are comparable across funds and markets.

And, for our purposes here, it is the author of Europe’s reference classification for ordering real estate funds by risk level. A classification that has seeped into the sector’s culture to the point of becoming standard vocabulary even for individual investments.

What is revealing is how it does it: since its 2012 revision it does not look at the promised return —because doing so presumes the manager has properly assessed its own risk— but at three factors: how much of the portfolio generates no income today, how much development there is, and how much debt is allowed. With those criteria it distinguishes three styles, to which the market has added a fourth, intermediate one:

Opportunistic: The highest-risk rung, and the plot from the first email is a textbook example. Here you buy what generates no income today —land, developments, changes of use— or you buy from someone forced to sell. In that case people speak of distressed: the opportunity is not in the property but in the seller’s urgency, as when funds bought portfolios of properties and loans from banks and Sareb after the crisis. The return depends almost entirely on the final sale, debt can exceed 60% of the value, and many things have to go well, in order and on time, to generate the expected return. It is the real estate equivalent of an accumulator bet.

Value add: Here there is already a building, but with a fixable problem: it is half empty, obsolete or poorly managed. Think of 1990s offices with half the floors vacant, which need refurbishing and re-letting. The return is split between rent and appreciation, debt can reach 60% of the value, and everything depends on the business plan being executed at the expected cost and on time. If it goes wrong, you still have a half-empty building, but now with a half-finished refurbishment and a loan to pay.

Core plus: It does not appear in INREV’s classification, but the market uses it daily for the middle ground: assets that already work and generate income, with something to improve. A retail unit leased to a good chain with a lease expiring in two years, or a building with below-market rents. Or a property in a good location, but not the best. The bulk of the return still comes from rent, with an extra if the lease is renewed upwards or a minor improvement is made. The risk is no longer in construction, but in the lease renewal.

Core: It is the supermarket from the second email: a finished building, let long-term to a solvent tenant, in a consolidated location and with little debt. INREV considers that in this case at least 60% of the return must come from rent, and limits to a small percentage what can be under construction or unlet. There is nothing to transform here: the return depends on the tenant keeping on paying. That does not make it a risk-free investment. A rate hike reduces the property’s value even if the rent does not change, and a single tenant concentrates the risk. The difference is that those risks can be enumerated one by one, and managing them does not mean entrusting yourself to divine providence.

The big difference between the institutional and the retail investor is that the former always knows which category they are buying into and the latter rarely does, because almost no one presents investments to them with that label.

And in that gap lives one of the most profitable businesses in the sector: perceived-risk arbitrage. It consists of financing a high-risk project with the money of someone who believes they are buying bricks, and paying them the return that corresponds to what they think they are buying, not to what they are actually assuming.