Tuesday, January 26, 2016

Major Property Types and Where They Fall on the Risk Curve

Within real estate there are several major property types each with their own nuances. Generally speaking, the major property categories are:

  1. Multifamily
  2. Office
  3. Retail
  4. Industrial


Multifamily is real estate jargon for apartments. 3 unique features of multifamily are:
  • Short leases. A typical apartment lease is for a year or less.
  • Downturn resistant. Multifamily certainly isn't immune to downturns, but it generally fares better than other property types in a recession. People need a roof over their head and are more likely to reduce spending other ways if necessary.
  • Individual based. Multifamily landlords deal directly with individuals, not corporations, so there's a more human element to the asset class.


Office is where companies provide work space for their employees. 3 unique features of office:
  • Corporate credit. Corporations will put their credit behind the leases, making landlords more likely to get paid.
  • Occupy big chunks of space. Some office tenants will occupy huge chunks of space. Apple is currently building a 2.8M square foot campus in San Jose that will house 13,000 new employees, to give you an idea of how much space can be eaten up by a corporate tenant.
  • Property performance linked to submarket industry. Office properties and their tenants will usually be linked to an industry. It makes sense that San Francisco office properties would be full of mostly tech tenants. Even if the tenant isn't exactly a tech company, if it's a law firm, accounting firm, or any kind of service based tenant it will most likely get a lot of its business from the tech industry. Houston office buildings will probably have a good deal of exposure to oil and gas as another example. Ups and downs in these industries will have a great effect on the office properties.


Retail is where companies / individuals sell their goods. Here are 3 unique features of retail:
  • Mix of corporate credit and non-corporate credit. In one given retail property there might be a Starbucks (investment grade corporate credit) and a hair salon owned by an individual (probably not investment grade credit).
  • Landlord plays a role in overall success of the tenants. The landlord's ability to properly advertise the property, draw foot traffic, and create a good tenant mix are critical to each tenant's success at the property.
  • Location really matters. Location obviously matters for every property type, but retail in particular requires a strong understanding of how the property interacts with surrounding businesses, housing developments, and traffic patterns.


Industrial encompasses several different classes of properties, such as R&D space, manufacturing space, but most often it refers to wearhouse space where distribution companies store goddess along supply chains. Here are 3 unique features about industrial:
  • Requires knowledge of supply chains. Demand for industrial space is very dependent on how goods move through the various supply chains.
  • Building aesthetics don't matter. No one cares what a warehouse looks like. Industrial is cheap to build for the most part. However, there is a need for some specialized storage facilities, such as cool storage facilities used to store goods that need to be kept at a cold temperature. These can be expensive to build.
  • Clear height is very important. The height from the floor to the ceiling is very important and will determine the types of tenants your building will attract.

Although each differs in some areas, the core fundamentals from a finance / acquisitions perspective are largely the same. For example, someone who knows how to build an office pro forma isn't going to have trouble figuring out how to build a retail pro forma. Likewise, submitting an offer on a property, performing due diligence, and closing the deal won't change much between asset classes. The real differences lie in the more intangible aspects of finding a property to buy, such as understanding the demand drivers for that property type in that area, understanding what types of locations are more attractive for that property type, and being able to identify the risks specific to the property type.

An example of understanding the risks specific to property type is the internet. The internet affects each of these different property types differently. For multifamily, it's most likely been a demand driver because it reduces the amount of driving people need to do for shopping, letting people live a more urban and less car-centric lifestyle. It's also helped multifamily landlords advertise their properties better and more efficiently.

For office the internet is a double-edged sword. On one hand, it's created whole new industries that are driving office demand in places like San Francisco, Denver, Seattle, and many other cities. However, for more traditional businesses, it's cut down on their need for space. The most often used example is law firms. Before the internet, law offices used to require entire floors to house their libraries of legal books. Now, all that info is easily accessible online reducing the need for space.

Retail has been decimated by the internet trend. Big box stores are in big trouble because few people shop there anymore--Amazon has eaten their lunch. Another store type killed by Amazon is the bookstore. The Kindle has quite literally put every major bookstore chain out of business or close to it. The smaller retail concepts that relied on the foot traffic from the big box stores are also feeling the negative effects. Overall, the internet has had a hugely negative impact on retail.

Industrial has benefited greatly from the internet. The need for shorter delivery times on online orders has increased the demand for a robust supply chain, which has increased the demand for industrial space. I would expect the need for shorter delivery times will increase. At some point in the near future, Amazon will have free next day shipping. Then it will get free same day shipping. Then it'll be same hour delivery. It won't stop there though, it'll then move to within 10 minutes delivery. Imagine the need for warehouse space to store goods in a close proximity to cities as my predictions become reality.

Where the Property Types Fall on the Risk Spectrum

Determining the relative risk levels of each property type is actually fairly easy. According to the efficient market hypothesis, no asset class should offer a better risk adjusted return over another asset class. Applying this to the different property types, no one type should offer a better risk adjusted return over another property type. This means that a type with a lower average return will have a lower overall risk profile compared to another type. Cap rate is the best measure of return, so all we have to do is look at the relative market cap rates of each type and that will tell us the risk level of each. Luckily, major brokerages often publish cap rate surveys where they report that data. Cushman & Wakefield recently published a cap rate survey, so I'll be going off of that. Here's a list, starting with the lowest cap rate and implied risk:
  1. Multifamily (both in Eastern and Western markets)
  2. Retail (both in Eastern and Western markets)
  3. Office (lower cap rates than industrial in Easter markets, but not in Western markets)
  4. Industrial (lower cap rates than office in Western markets)
It shouldn't be surprising that multifamily is perceived by the market as the least risky given it being somewhat recession proof and a basic necessity for people. Retail being number 2 also makes sense. People need somewhere to buy bread and milk. The real interesting piece of info is office having lower cap rates in Eastern markets, but not Western when compared to industrial. I'm guessing a big reason is so much of our trade is now with China and those imports need to move through Western ports. Since it's very difficult to build in dense cities, as demand for industrial increased dramatically, I'm speculating that supply wasn't able to keep up, driving up the price of industrial space. Certainly an interesting dynamic...

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