Carpet Guys
Real Estate due diligence has different meanings in different markets
Sometimes you gotta feel the ground under your feet. Sometimes you gotta go barefoot to feel the grass, or the beach sand, or desert dust. The texture of the earth will ground you. It’ll make you feel present.
We’re all living through screens these days. Living in the digital realm. And what we gain in speed and connectivity has a cost. We lose our sensory connection. And often, we lose our spiritual connection.
Real Estate investing is no different. Real Estate is a hard asset, and it is tangible. We can see it, we interact with it. We define cities by their skylines, we define neighborhoods by their homes.
Yet when it comes to investing, investors have lost that sensory connection.
I’m just as guilty of this as anyone. For the first ten years of my career I thought that a REIT is a REIT; that they are all more or less fungible. I just assumed that any REIT would give you something that looked more or less like the Case Shiller housing index. In fact, it was the realization that the correlations between REIT subsectors were lower than style-box correlations that first got me interested in the Real Estate investment sector just a few years ago.
Think about that: there are more diversification benefits within Real Estate than there are in the foundational framework for portfolio allocation. Sure, it’s a small sleeve, but the principles apply all the same. For even a small allocation, optimization is a worthwhile goal.
There isn’t much optimization happening these days. Market cap weighted indexing is dominating in fund flows everywhere, and even more so in Real Estate. Cap weighted REIT ETFs exceed 90% of the category ETF AUM.
I am no fan of passive investing, but as long as flows are driving passive performance, I can abide it. But when it comes to REITs it makes especially little sense.
Index investors often say that the strategy is rational because they just want to track the market. However, when it comes to real estate, listed REITs comprise only 6% of the US CRE market, which leads to all sorts of sub-sector and geographic weighting distortions.
For example, multifamily is under-represented in the public markets by 5%, relative to private markets. Cell towers are over-represented by 12% in the public markets. And so on.
Because the listed REIT sample is so small relative to the CRE market, index investors are not tracking the market as they intend. Passive cap-weighted REIT funds are distorted and not representative of the CRE market.
As valuations of the Real Estate sub-sectors most overweight by cap weight indexes are beginning to normalize, it is time to think about REIT allocations differently than asset classes. We've seen significant alpha in long term strategies this year, and we expect it to continue.
The bottom line is that at the ETF allocator level, investors haven’t a clue what they actually own. There is a complete absence of sensory connection.
The world of active managers for REITs may as well be a different universe. There are real discussions about ratios and financials. REITs are subject to all sorts of reporting and transparency requirements, and it makes for a wonderful valuation puzzle.
Debates over FFO vs AFFO, earnings calls and MSA data replace the pathetic “what are your assets” level of due diligence from the ETF channels. There are some incredible REIT analysts out there doing real valuation work. But the market doesn’t always reward that work - not in an environment where narratives and flows dictate valuations.
It is still so far removed from the actual properties. Any REIT analyst can tell you about how SL Green owns One Vanderbilt or that office buildings are trading at generational buying levels. But the language is one of fundamentals and ratios. It is a valuation game. It’s a view of the financials.
Sometimes you gotta feel the ground under your feet. Sometimes you gotta get inside the properties. You need to touch and feel and see what it is you are buying. If you want to understand, that is. If you want that sensory connection.
I joined my partners at Navarino Capital for a building inspection last week. They were getting ready to place a bid and went onsite to do due diligence. Real due diligence. They went to see and smell and talk to people and to feel the ground under their feet.
“Do you have a carpet guy?”
There aren’t a lot of REIT investors who think about their “carpet guy”. But on an inspection of a large multifamily building, it matters a lot.
“My carpet guy will beat anyone’s prices.”
“Maybe, but my carpet guy is honest and dependable. Been using him for almost twenty years.”
I’m twenty minutes into this carpet guy debate and I’m enthralled. I’ve built and managed institutional Real Estate portfolios and never heard anything like this.
We had people knocking on doors, inspecting individual units. We had guys disappearing into attics and crawl spaces. We checked furnaces and drain pipes. Even contracts for laundry machine revenue-sharing.
An older guy climbs on top of a file cabinet to get another look at the roof. “I’m looking for rusted nails. That tells a story”.
This is due diligence. This is an understanding of Real Estate on a whole other level.
There is only so much we can learn from our computer desk. There is only so much we can understand about the world through screens. Understanding Real Estate requires you to be in it, and to feel it beneath your feet.
There is so much to solve when it comes to CRE and how institutions access it. Valuations swinging wildly based on product wrapper, transaction costs, trading inefficiencies, liquidity… All solvable problems. But not likely solved without a real connection to the asset.
You need a carpet guy. Or you need a guy who has a carpet guy.
Phil, this is a spot-on analysis of how to do proper real estate investing. My father was a home and apartment builder in Philadelphia from the 1960s through the 1990s. He and I taught a course on Fundamentals of Real Estate Development at the Wharton School in Philadelphia in the 1980s, and one of the biggest problems we encountered was that at many of these institutions of higher learning, the real estate departments were largely oriented to "spreadsheet analysis", where most of the learning was just analysis of financial statements. No one at the universities actually ever walked onto a property and looked at the site. No one ever talked to contractors about "carpet guys" as you mentioned. They sort of looked down on that aspect, but as you able point out here, that is the critical part of any kind of real estate investing. Thank you for your analysis!