Should Real Estate Portfolios Be Valued by Their Dealflow?
Investors in the modern era have generally fallen into two camps developed by two forward thinkers at about the same time: value investing and growth investing.
Benjamin Graham turned down an offer to teach English, mathematics and philosophy after he graduated at the top of his class at Columbia to pursue a career on Wall Street. There he used his financial analysis to find what he considered undervalued investments and authored a number of influential books about investing in companies that have a discount to their intrinsic value, or “margin of safety.” This made him known as the first “value investor.”
Meanwhile, in Baltimore, a young man named Thomas Rowe Price Jr. graduated with a degree in chemistry but decided that he was more interested in money management than scientific research. After a quick rise to head of investments at a major firm he started his own, T. Rowe Price, to focus on identifying future growth rather than fighting with everyone else for the stocks that were the best “value.” His is generally regarded as the father of growth investing.
It was Graham’s student and protege Warren Buffet that first suggested that the distinctions between the two definitions of value should be torn down. In a letter to shareholders of his investment firm Berkshire Hathaway he wrote:
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.
We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Growth is always a component in the calculation of value since value is constantly competing with time. The idea seems obvious when talking about companies that have potential to quickly scale into a much larger version of themselves. But it is often forgotten when it comes to real estate portfolios. We tend to value real estate portfolios only by the value of the properties that are in it, not the direction the fund is headed.
Reporting for an investment is usually done on an arbitrary timeline. The report only represents where that constantly changing entity is for that one moment of time. An active real estate fund can have dozens of properties that they are actively engaging. I have heard some publicly traded real estate firms talk generally about the “strength of their pipeline” but generally not much attention is paid to the actual metrics of deals in progress.
This might be changing, thanks in part to integration of popular real estate investor software. A deal management platform called Dealpath is now integrating with an investor reporting program called iLevel. Joining these two tools is a bit of a no-brainer. Funds will be able to manage their workflow more efficiently by having records go automatically from the deal pipeline into the portfolio once the transactions are complete. But the increased dealflow transparency to investors might help change the way real estate portfolios are managed and reported.
If a good investor should be looking for both value and growth, they need to look forward just as much as they need to look backwards. While I don’t see GAAP advisories coming out telling companies how to value future deals on their books, I believe in giving investors extra transparency and letting them value it as they may. While it might be easy to falsify, I think most investors would place a premium on portfolios with a large amount of deals being negotiated versus an identical one with none.
Companies participate in the growth potential of their future cash flows, so why shouldn’t real estate investment portfolios? One of the reasons that investors don’t consider dealflow is that the future is uncertain. But having a property locked in a negotiation process also has a built in safeguard, an earnest money deposit, that can also be factored into the equation. Another reason is that many transactions are locked into NDAs so many deals would not be able to be verified. Still general knowledge of the amount and type of deals would be worth something to the investor, if not just to get an idea of the team’s thought process and strategy.
I admit that it is a long-shot that any large investor would make decisions based on a proverbial bird in the bush. But if we are able to construct a better view of where portfolios are headed, rather than just looking at where they are, it could benefit not only the people running the portfolio but also the people investing in it.