How Attractive is Risk Today?
To fill a pail with rocks of different sizes, it’s better to put big rocks in first, and then finish with small rocks. Investing is similar. If you get the big questions right, you can get other stuff wrong and do well. The biggest question: “How much risk should I take right now?” For individuals, that could mean allocations between stocks and bonds; for institutions, it could mean allocations across various risk buckets. Whatever your seat, this is the key question to get right. The below analysis outlines an approach to quantify the attractiveness of investing in commercial real estate at a given point. The framework could be further altered for other asset classes.
Howard Marks — the co-chairman of Oaktree — released a book in 2011 called The Most Important Thing. In it, he included the below table on various market signals to help investors calibrate their risk appetite.
He suggested that there are clear market signals to offer investors guidance. In general, periods in which capital is scarce, investors are cautious, and returns and asset values are weak offer the best times to take risks. Not coincidentally, these are often the times that people feel more fearful and risk-averse.
Warren Buffett said, “Be greedy when others are fearful, and fearful when others are greedy”. Great advice, but hard to do the “correct” thing when consumed by either of those emotions.
It’s easier when there are objective metrics to help quantify the amount of greed and fear currently in the market. Such hard data can increase investment conviction when either is tempting.
To quantify Howard Marks’ table, I put together the seven metrics for which data was available for at least twenty years. These metrics are a combination of real estate and broad macro variables designed to determine the attractiveness of investing in commercial real estate at a given point. For each, they are calibrated to history and given a score between 0 and 100, rating the strength of the signal.
The seven variables:
- Economy — as measured by recent job growth. The current readings of job growth remain fairly strong, which is a slightly negative signal.
- Sentiment — Measured by the University of Michigan consumer sentiment survey, which despite recent economic health, is currently quite negative. This is a positive signal for investing.
- Capital — Measured by the lender tightening survey from the Federal Reserve. The measure today is extremely tight, offering a very positive signal.
- Terms — The spread of the high-yield bond index, compared to treasuries. Somewhat surprisingly, these terms aren’t overly restrictive today, as the securities markets are healthier than the banking sector.
- Interest Rates– The 10-year Treasury bond today is quite elevated compared to its 20-year history. Higher rates are a positive signal.
- Investors — Transactions activity over the last year, as a percentage of the entire real estate stock. Activity has slowed considerably, which is a positive signal for new investment.
- Recent Performance — Trailing 12-month property value change. According to Green Street, values are down 7% over the past year, offering a strongly positive signal.
Much of this likely sounds counter to conventional wisdom and — more importantly — how we feel. Higher rates are good? Lower values are good? That discomfort is the point.
The graph below shows a history of this Total Score compared to a historical series of three-year forward real estate values.
Taking extra risk in the 2001–02 and 2008–09 time periods paid off. The highest score ever was 97.6 in 2009. Those who invested that year were rewarded with the best three-year returns in the series. There were very (correctly) negative signals in the period heading into the Great Financial Crisis. The last decade has been mixed, but the worst period to invest over the last 20 years was found just last year, when the model offered a score of 9. In the second half of 2022, each of the seven metrics was negative.
Today’s score of 80 is one of the strongest in the series, suggesting that 2024–25 should offer attractive real estate vintages, offering above-average returns and below-average risk at these more attractive entry points.
When the world is murky, models like this can help us get conviction — and it looks like it’s time to move some big rocks!
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