Number one, core assets have to exist within
cities that are viewed as institutional and provide a broad group of buyers and sellers
at all times. If you see a brand new building with a long-term credit tenant that’s in a
very, very small city, maybe it’s a city of 200,000 people or less, that is not a core
asset. Now, once you get the city selection, you move on the sub-market selection. I’ll
give you an example of Chicago here because it really is a wonderful example of how a
city can be viewed as institutional and a place for core assets, but you really have
to break it down much further into sub-markets. There are large areas of Chicago that absolutely
are not an area that a core asset can be, even though the city as a whole is a city
that certainly is a place where institutions invest. If you’re talking about Downtown Chicago,
the Loop or the West Loop or River North or Lincoln Park or some of the higher-end suburbs,
the 290 corridor or up into the North Shore, these are areas that would absolutely be institutional
and core assets can exist. However, if you’re talking about the far West Side, the far South
Side, still in Chicago, but absolutely not a place that would provide liquidity on exit,
so it doesn’t check the box in terms of location. Now we’ll talk about vintage in core assets.
What I’m saying when I say vintage is, generally a core buyer wants an asset that isn’t going
to be very difficult to maintain. They’re looking at it much more in terms of a cashflow
stream and less as, “Well, I need to make sure that the roof is not leaking, make sure
that there’s enough capital”, and newer assets tend to mitigate that. The older the asset
gets, the more it’s going to require maintenance and the more you’re going to need to be an
active owner and so the less it becomes in terms of core. Obviously the older an asset gets, the more
maintenance it’s going to require and investment of capital. From there we’re looking at the
cashflow of an asset. In core assets the investor essentially is buying that income stream.
A core building is all about the dividends it produces today and then inflationary growth
or the growth of those earnings over time. An analogy of that would be any dividend paying
stock. For example, a mature company like Coca-Cola. They’ve been around for a hundred
years. They really don’t have amazing growth prospects. You could argue they’ve saturated
a lot of the world in terms of their products, but what they are is a market leader that
produces a dividend and i.e. that’s a dividend stock or I would almost call it a core stock
if it was a private real estate asset. From there the frame moves on to debt to equity.
You can be all those things and still not be core simply because of the debt to equity
ratio. Core assets pair low risk, predictable income stream, high quality liquid markets
with low debt levels. Those low debt levels generally tend to be between 40 to 45% for
core, meaning you’re going to have 50 to 55% equity paired with 40 to 45% debt. And again,
that leaves the asset in a very safe place because if there’s a market correction or
any disruption of cashflow, you have so much equity in the deal that you’re never really
going to be at risk of losing the asset itself. We’ve talked about the characteristics of
an asset to be considered a core asset. Now let’s move to the expected returns the investor
should receive for purchasing that core asset. Generally the market has seen pressure on
all expected returns. This has been something that’s been happening for the last 24 months.
You see it certainly in the debt spreads. We used to have to borrow at three or four
hundred over LIBOR, which is the riskless rate. Those spreads have really gone down
all the way from 200 to 275, so you’re talking about almost a 30 to 40% move in those spreads.
That’s the return banks are willing to accept for a loan at a constant unit of risk. If
you speak to any of the large advisory shops, recently J. P. Morgan and Vanguard both came
out and said, “We believe that the expected value on stocks, U.S. stocks for the next
10 years, is 4 to 6%. Now, historically they’ve been anywhere from 8 to 9% so that’s a massive
move too. You’re talking about 25 to 30% real estate seeing the same. I would say a little
bit less, but we have seen it. That’s something that you need to be aware of because if you’re
speaking to a manager who is offering a core asset at a return level much higher than that,
I would suggest that you really need to do your homework on the manager or the investment
because it could be there are risks that you’re not aware of. There’s generally no free lunch in investing
and if you see a core asset that could get an 8% or a 9% return, maybe that’s possible.
If you see something higher than that, there’s probably a red flag that you need to do a
little bit more work on to figure out why it’s such a high return relative to that asset
class. It could be that it’s in a smaller market and so there’s liquidity risk you’re
taking. It could be that it’s in an up and coming sub-market and so there’s market risk
that it won’t gentrify and there’s liquidity risk. It could be that they’re taking more
debt to equity risk than you think and you have to go down to the asset level to see
that. Are they borrowing 60%, 70% from the bank, because they really shouldn’t be borrowing
more than 40. Who would want to invest in core real estate?
I would simply say anybody who is viewing their public stock portfolio as a dividend
stock portfolio that’s reflective on you and your view of how much wealth do I want to
protect versus place at risk and how much am I willing to take in terms of a return?
Back to the Coca-Cola example. If you buy Coca-Cola stock and you’re buying that dividend
because you want that constant dividend stream, the opportunity cost is you’re not going to
have the upside tail as if you invested in Amazon. Amazon is reinvesting earnings constantly.
They’re not giving you a dividend because they think that they can build a company that’s
bigger and bigger and bigger and you as a stockholder share in that growth. That’s what
a growth stock feels like, but there’s also risks to that growth. When you’re not getting a dividend, I would
say the distribution around your return is much, much larger. But the flip side is, don’t
buy Coca-Cola and expect in five years that you quadrupled your money. That’s not realistic.
If you’re an investor that values dividends or in that part of your portfolio values dividends,
a substitute good would be a core asset. It’ll be low leverage, constant predictable dividends,
and so it’s a substitute good.