You Get What You Pay For: Thoughts On Today’s Core Property Markets

By Ethan Penner

(Originally posted on

That was one of my Granny’s favorite teachings. Granny wasn’t a wealthy woman or one who fancied expensive things, but she had a great clarity about the world. Observing today’s institutional investment industry, it seems as though many participants never got Granny’s message. While this may be true broadly in that arena, for the purpose of this column I will focus upon a particularly glaring example in core real estate investing. “Core” is defined as ultra-high-quality real estate that is characterized by its excellent location and its history of stabilized tenancy and cash flow. It also happens to be the largest segment of investors’ real estate allocations, accounting for much more than 50 percent of the total.

The thinking by investors has been that assembling and managing a portfolio of this type of property doesn’t require a high level of hands-on management or too much talent. This has led investors to favor those managers who will work for the lowest fees. For those who doubt that paying less in fees repels those with the most talent, ask yourselves if you could imagine Lone Star Funds’ John Grayken or Starwood Capital’s Barry Sternlicht personally managing a nice, large core fund. Maybe a 25-year-old version of those guys, but not the current version.

Our investment world is mostly backward looking, and many investors might rest easy that this strategy of paying low fees for lesser talent in this massive core section of real estate hasn’t hurt at all. So, many will ask, why change when things have been working just fine? The answer is that past will not be prologue for the coming future. All you need to know is that, for the past 35 years, we’ve witnessed the most favorable investment climate in history. Ten-year U.S. Treasury yields have fallen from near 16 percent highs to the 2 percent to 3 percent range, where they have hovered for the past few years. Population has boomed in that period, as have all debt levels, which has fueled massive spending and investment growth.

In this expansive environment, my nine-year-old son could have made a great return just by staying invested. The one thing we all can agree on is the next 35 years will not see a repeat of the past 35. Most important, yields will not drop by 1,400 basis points, and P/E multiples will not expand concurrently. Just staying invested will likely not be enough to win or to avoid losses. Going forward, it will take far more than a nine-year-old to generate acceptable returns for investors in core real estate.

From now on, it will require great skill and great vision, and a nimble hand, to steer a core real estate portfolio to safety and to achieve consistently acceptable earnings. Not only will we certainly see a less-favorable overall investment environment than the one we just finished but, equally important for the core sector, the world has recently been moving into the early phases of historic changes in tastes. This will lead to unprecedented obsolescence, which will lead to surprising and consequential losses of value.

These taste changes are driven by technological innovation as well as by pure cultural changes that the current and coming young professional generations represent, versus their predecessor generations. A great example of the latter is the rather recent surge in popularity of New York City’s Chelsea district as a desirable office and residential location, which past generations of New Yorkers would never have dreamed possible. A wonderful example of the former is the establishment of the Hudson Yards office and residential market — once again, an area that past generations would have derided as being hopelessly unappealing. Chillingly for core real estate investors is the impact these two success stories will have on the Plaza District, which has historically been the most prime of the core set.

Identifying today’s and tomorrow’s core real estate — the kind that will stand the test of time — will require a level of creative thinking that is very different from the past. In addition, likely few, if any, real estate assets will exist that are so solid a manager can just collect rents and not manage those assets actively. And, finally, in the more turbulent economic world that we now find ourselves in, even a manager of core real estate will need to be attuned to the need to reposition the portfolio much more than in the past.

In sum, yesterday’s approach to core — highlighted by seeking those managers who will charge the lowest fees — will absolutely not produce the results of the past, nor results any investor would find even remotely acceptable. Those few who can embrace this reality will be well ahead of the majority, who will remain backward looking.

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