Recognize cognitive tendencies that will affect decision-making when pursuing a retail tenant.
As much as commercial real estate is a game of numbers, data, and analysis, the human component plays a huge role in what deals are made and how they get done. Examine your decision-making process — can you comfortably say you’re free of unknown cognitive biases? Probably not. In that case, what biases — psychological, emotional, and/or cultural, for instance — influence your choice to go this way instead of that?
To begin this discussion, let’s take a simple hypothetical: You have an opportunity to invest in either a store operated by an Ashley Furniture licensee or a nearby Home Depot. If all significant variables are eliminated, which do you choose? When I ask graduate business students, they generally opt for the Home Depot. Those who don’t are reluctant, still preferring the Home Depot but assuming some subterfuge on my part. After all, Home Depot has exceptional brand awareness, a high investment-grade A credit rating, and is the nation’s largest home improvement chain, with approximately 2,200 locations. In contrast, Ashley Furniture has about 800 locations, most of which are operated by individual licensees. Simply put, Home Depot as a tenant seems to make the real estate more desirable.
Two Cognitive Biases in Favor of Net Leases
Respondents to this question about potential tenants assume that the investment choices are equivalent. They know that they will have to accept a lower rate of return with the Home Depot option, but they think this is like the fixed-income markets, where A-rated bonds command a much lower yield than speculative grade bonds. This approach is consistent with the thought that they are buying a bond-like instrument, and so they raise their hands for the comparatively higher perceived security offered by Home Depot. They have made assumptions potentially based on two cognitive biases:
- The net lease market is as efficient as fixed-income markets
- Net leases, as contractual instruments, are as consistent as corporate bonds.
The net lease market is anything but efficient and consistent — and the choices between Home Depot and Ashley Furniture stores are seldom equivalent. The Home Depot lease may require the landlord to maintain the roof and structure, which entails unknown expense risk. The lease will also likely have a shorter primary term, and the investment can be expected to cost significantly more per square foot. The price for the real estate is important because higher costs elevate the risk of loss in the event Home Depot elects not to extend its lease or becomes insolvent. Home Depot can be expected not to divulge property-level performance data, which means the landlord will have little idea how successful the location is. Such knowledge is important because leases on successful properties are effectively senior corporate contracts that stand in front of most other corporate obligations in the event of insolvency.
As a landlord, you will have fewer concerns in the event of tenant bankruptcy if you know that your location makes money. Home Depot can also be expected to avoid master lease arrangements, wherein multiple locations can be bound into a single lease. Master leases are likewise important and represent the best means for landlords to obtain contract diversity and insulate themselves from poorly performing properties. Leases to highly rated companies tend to be more tenant-friendly, offering the extended ability to close properties or to sublease them. In the end, a landlord has a better chance to have a longer, fully net lease contract — complete with a lower price per square foot, unit-level financial reporting, master lease potential, and added contractual protections — with Ashley Furniture.
Are Net Leases Safe Over the Long Haul?
Even when you know the material contractual differences between a lease to Home Depot and another to an Ashley Furniture licensee, many tend to remain unmoved. After all, they have the credit and support of an A-rated company. Such feelings of security arise from another cognitive bias:
- High credit quality can be expected to be maintained over the long term.
But credit migration statistics tell a different story. The fact is that, over a 10-year period, an A-rated company can expect to lose investment-grade status more than 40 percent of the time. Over a 20-year lease, that credit rating migration will rise to more than 63 percent. As time passes, up to 85 percent of migration can be expected to arise from credit rating abandonment, wherein the company simply elects to be non-rated. In my opinion, credit migration statistics tend to be even worse for companies like Home Depot, which does not depend on credit ratings for its successful business model. For such companies, credit ratings are optional and easy to abandon in favor of capital strategies having the potential to deliver higher rates of shareholder return. Netting out the impact of credit migration: Chasing after investment-grade tenant credit quality typically comes with the expense of lower yields, lower lease escalations, and inferior contract quality in the hope that you will be among the 26 percent to 37 percent of investors who still have an investment-grade tenant at the conclusion of a primary 20-year lease term.
A fourth cognitive bias bears mentioning here:
- Leases are safer than unsecured bonds issued by the same tenants.
I have frequently spoken with net lease investors who take pleasure in the good deals to be had when net lease yields exceed bond yields offered by the same tenant. Their palpable excitement is typically compounded by the notion that leases are backed by assets, whereas corporate bonds are generally unsecured obligations. Have they considered that landlords have different risks than corporate noteholders? When tenant credit migration invariably happens, bond holders will generally be fully repaid. And if the migration happens as a result of credit ratings abandonment in association with a change of control or corporate recapitalization (which is often the case), noteholders stand to receive prepayment premiums. Meanwhile, real estate investors will not be so lucky. Their real estate valuations will materially decline with tenant corporate credit ratings. Is it worth taking that risk? Maybe. It depends on the amount of expected cap rate compression that might occur with credit rating degradation, the time it takes to realize that elevated cap rate, and the annual rate of rental increases embodied in the lease. An analysis like this will presume that the tenant remains in the property after the primary lease term. But should the tenant opt to return the property to the landlord upon lease expiration, the analysis of expected performance will take a different turn altogether.
Questioning Common Knowledge in Real Estate
Given the differences in lease contract characteristics between the Home Depot and Ashley stores and in risk undertaken by real estate investors and bondholders, the investment decision no longer seems quite so simple. Nevertheless, prospective investors tend to be drawn to the Home Depot asset. Why is this asset still perceived to have greater desirability and security? Five real estate cognitive biases, pertaining to both private and publicly held real estate, help explain so:
- More highly valued real estate is apt to deliver safer and assured returns.
- Tenants having strong credit quality elevate real estate value, performance, and safety.
- The quality of real estate is evidenced by the yield (cap rate) at which it trades.
- Differences in investment cap rates represent proportional risk differences
- Net asset value is an indicator of asset desirability and expected economic performance.
These biases tend to come from loosely recalled or anecdotal information used to establish our belief system. To my knowledge, no reliable academic studies support any of the nine biases mentioned thus far.
Real estate company investors can be preoccupied with net asset value, or NAV, as a determinant of corporate valuation. Real estate investment trusts were effectively conceived to be mutual funds of real estate, but NAV holds little weight in judging the performance of public REITs. In a study of publicly traded REITs conducted by Goldman Sachs in 2012, growth in funds from operations accounted for 82 percent of stock performance, while the correlation between NAV and share price performance, meanwhile, was virtually nonexistent. The notion that NAV is important remains pervasive and influences each of these five real estate cognitive biases.
Along with NAV, a central theme to these biases is centered around market efficiency. Difficulty in segregating physical assets from their potential to deliver returns can often correlate to irrationality and bias. Public REIT shareholders and securities analysts, therefore, are prone to inconsistencies when considering whether investments are grounded in real estate interests or stock.
The 10th Bias
Nobel prize-winning economist Harry Markowitz describes diversification as “the only free lunch in finance,” because, he argues, an investor can benefit from reduced risk while sacrificing little in long-term gains. Given such benefits, net lease real estate investors should ask, “How many properties does it take to properly diversify?” For net lease market participants, each individual property poses a high level of investment concentration risk, unlike multitenant properties, where each asset can potentially deliver significant tenant diversity. Master leases can help by combining multiple tenant locations into a single lease, but that effort will still fall short of the diversity offered by multi-tenanted properties. Equity portfolio managers should hold 15 to 30 uncorrelated stocks to have an adequately diversified portfolio.
Many, and perhaps most, net lease real estate investors don’t properly diversify, leading us to a 10th bias:
- Portfolio diversity does not apply to single tenant net lease real estate.
Often, the first nine cognitive biases justify ignoring portfolio diversity. Tenant credit ratings and high real estate NAVs can easily divert an investor’s attention from diversification. Federal income tax incentives, such as 1031 exchanges, can also loom large given the well-documented bias of investors to avoid losses, in this case taxes that would otherwise come due.
Warren Buffett, who has guided Berkshire Hathaway to realize annual compound rates of return in excess of 20 percent since 1965, more than double that of the S&P 500 index, famously once said, “Diversification is protection against ignorance; it makes little sense if you know what you are doing.” If I took this advice, while fully aware of the first nine biases, I’d still opt for the Home Depot, because I believe that beating the market through select concentrated investment positions is inapplicable to single tenant net lease properties. For one thing, the risk/reward dynamics are vastly different. Equity investments target higher returns, benefit from high levels of corporate operating leverage, and are supported by the complete operations of a business. Net lease real estate assets tend to target lower levels of return, have virtually no operating leverage, and ultimately rely on the success of a single asset held within a corporation.
The 10th bias encourages investors to look for trees, believing forests to be less important. Focusing on individual assets dismisses the essence of the contributions of diversity. The key is to apply consistent investment and management standards to a highly diverse net lease portfolio to reduce portfolio risk.
In previous decades, behavioral psychologists illustrated our tendency toward cognitive bias, establishing the foundation for behavioral economics. Perhaps more importantly, this work influenced the development of evidence-based disciplines from professional athlete selection to medicine to investing. Once we acknowledge the human tendency toward bias, we can start to use that awareness to create evidence-based best practices in commercial real estate.
Resource: “10 Biases in Retail Investment“