American Realty Advisors


Market Commentary, June 25, 2024

In Conversation: Market Segmentation

Real estate has always been synonymous with three things: location, location, and location. In the latest installment of In Conversation, CEO Stanley Iezman and Head of Research Sabrina Unger talk through ARA’s research-driven approach to location strategy and market segmentation. 


Stanley Iezman: Let us begin by talking about something near and dear to our heart as real estate investors: the identification of markets and the segmentation of those markets. Why don't you begin by giving us an outline of how you think of that from a research perseverance? 

Sabrina Unger: At ARA, we have built out what I think is a really robust, data-driven approach to identifying what we believe are the markets that have the best risk-adjusted return profiles. And so how we're doing that is really by combining the key metrics that we think drive that both from a historical and from a projected perspective.

We are thinking about the big picture things like population growth, migration, employment drivers, and also getting down into the much more sort of granular fundamental perspective. What's happening with supply? What is the demand response? How is that feeding into vacancy and rent growth?

And how are all of those things coming together? We are using a lot of technical tools: predictive analytics, algorithms, and modeling. But at the end of the day, it really comes back to basics, which is: what drives demand for real estate? It’s people and businesses. 

SI: We talk about headwinds and tailwinds, and what markets are going to be the appropriate ones to invest in. How do you differentiate between markets where there may be headwinds, which turned out to be just aberrational at that moment in time?

How do you think about that? 

SU: What you're outlining here is a little bit of either a top-down or a bottom-up approach. But I think having a holistic view of markets as we make our investments is really key.

If you're only thinking about the big picture elements, if you’re just focused on the population growth, migration, employment growth – you could miss some of these more nuanced supply-demand issues. But alternatively, if you only focus on supply-demand, then you're going to miss out on some of that growth.

And so I think taking only one piece of that is a picture only half informed. You really want to have a holistic view. I'll use Austin as an example. It is certainly experiencing, from a bottom-up perspective, a softening in fundamentals because we have all-time high levels of supply being delivered into this market.

We had high levels in 2023, and 2024 will be another high year for deliveries. So that might make some investors and some managers a little apprehensive about the market. But for us, when we think about market selection for our funds, it isn't just on a one-year or two-year basis. We're really thinking about things from a five-year perspective, a 10-year perspective.

That way, we're not unduly influenced by these short-term fluctuations, and we’re not missing the forest for the trees. So again, coming back to Austin, do I think that it's going to be the number one performing market for rent growth in 2024? Probably not. It needs to work through the supply.

But when I think about it from a five-year perspective or a 10-year perspective, I still think our view is that Austin is a top 10 market, because all of the things that drove the growth that we've seen over the last few years – companies moving there, people wanting to be there, the lifestyle element – all of those things are still in place – so I still think it's going to make that market one of the top performers. That shows that you need to have both perspectives – that holistic view and an appropriate timeline, I think is really critical. 

SI: So when, when we sit in Investment Committee, and we're talking about research about a particular market, and we have the supply-demand characteristics of the world, it seems that we can somewhat predict a level of demand, but what we don't have the visibility on is supply. How do you factor that in into your thinking?

 SU: If you pull back the curtain a little bit on how we do our forecasting, it does start with supply. We have a fairly solid view of where we think supply is going to land in the first three years of our forecast period, though this varies a little bit by sector. But when you think about an office market we're going to forecast for, it to take years for those projects to get approved, especially now to get financing, and it takes a long time to build them. They're very complicated projects in major markets. And so we have a lot of visibility in a much further timeline to be able to know what buildings are likely to deliver in 2027 in New York, because they will already have started construction.

We have a pretty firm outlook on supply for office and for apartments, because we know the timeline for approximately how long it takes to build a building, and we know when permits have been pulled. So we start to get a little firmer outlook. I think the hardest sector to get supply right is industrial.

And even though the timelines have extended considerably since COVID given the timeline to getting materials and labor and all these other things, in terms of the complexity of construction, they're still generally less complex to build. They can be built quickly, and there may be smaller buildings that maybe you aren't tracking.

And so we do build in a degree of buffer into our supply. The demand function is really a multi-part input, which is thinking about: what is our macro view? Do we think we're going to have a recession? Do we think our economy is going to be booming, and companies are going to start leasing more space that will influence our view of demand?

We're also going to look at historical patterns. Is there something in the past in that market where the vacancy is comparable to where we think it's going to be today? What has been the corresponding demand response the next year or the rent growth response? So we can look at historical patterns, but then can say, “Something structurally is different in this market today, so we can't look to 2001 and think it's going to behave the same.” So that's also part of our forecasting process. 

And then we build in scenario testing and buffers, because we know we're not going to get 100 percent of every supply to every square foot right. So we need to anticipate what is the band of likely outcomes, and then we can make our market and submarket selection. 

SI: As an investor, one of the things that we're charged with is managing risk, which is fundamental to everything we're talking about.

We can look at real estate and property-level risk by doing due diligence and evaluating the parking lots, evaluating the roof and the elevators, et cetera. But let's deal with some of the other risks that are out there. The exogenous risk. We don't really talk about political risk, economic risk, climate risk.

How do you think about that in the context of evaluating your market segmentation? 

SU: I think we can segment markets into categories based on the type of risk we want to profile. Do we want to talk about climate risk? Well, if you do just a climate lens, markets in the middle of the country, like Kentucky and Tennessee, those are going to screen well, because they're not at risk.

But we also have to balance that against growth risk, right? Neither do we want to go into the Rust Belt that maybe doesn't have as dynamic of growth, and so it's layering the lenses of risk and what is palatable and tolerable for us, and it's effectively in a very simplistic terms is a Venn Diagram of risk. What are the different risk categories? Which markets are exposed to what? What is the bull's eye of markets that seem to satisfy our risk tolerance? And then what other risks are we willing to accept for a trade off in return? And that's effectively how we incorporate that.

SI: When you're talking about your screens that we go through, when you screen certain areas, certain metros and cities as being very positive for long-term growth and certain other ones that are not.

Are there any areas that you, you sort of “X out”, and you want to exit that area or you don't want to invest there? 

SU: If you're thinking about effectively exiting a market, it really comes down to a couple of questions, which is number one: is the environment I'm in today, because it arguably must be bad if you're thinking of leaving, is it sticky? Are the conditions that exist today likely to persist into the foreseeable future, and it’s well throughout my hold period such that it's better for me to cut my losses? So that would be a reason that you would leave a market. I think if you have a certain risk tolerance for climate or for rent control, but again, I don't know that it's necessarily so easy to redline a whole market. I think there are always opportunities, whether it's, “I don't want to be in New York because of the regulatory risk, I'll go to New Jersey.” Or, “I like Miami. South Beach is probably not for me, but maybe I'll go to Wynwood.” I think that there are some submarket lenses, so in reality, I think it would be very difficult to completely exclude an entire market. 

SI: Research is now very different than it was 20 years ago. It's much more sophisticated, and the data that is available today is voluminous. How do you integrate that? What are the things that we should be thinking about as investors, and how can research help drive returns? 

SU: I think, number one, and this is true for researchers, our investors, for everybody: think about the quality of the data that you're looking at, and what does it represent? If you get a report that says this market is X million square feet of industrial, compare it against other sources. There's not one definitive statement of what a certain market or geography should or shouldn't be, so compare and contrast, right? There's truth in the data to the extent that the provider has that perspective, but they only see a certain segment, so it's really about comparing what else is out there, not just accepting everything as truth. There's always a degree of implicit biases that can sometimes appear, so being cognizant of that and asking the question of the data and of ourselves when we analyze it: what aren't I looking at? What data should be a part of this conversation that hasn't been, and does it exist? How do I get it? I think it's asking these really holistic questions. Again, we have all these tools at our disposal and the benefit of the United States as a market versus other global real estate markets is we have so much data, the depth and breadth of it, the amount of history we have.

It's really unsurmounted in the rest of the world. But that can lead to analysis paralysis where we're just trying to find one more data point to make our decision. And real estate is not a homogenous asset class. You can have two office buildings on the same block right next to one another, and the reality is, is they're going to have very different profiles because of vintage, floor plates, tenants, amenities. Data is just one piece of the puzzle. I still think you have to have boots on the ground. Real estate is a real asset. 

SI: Research is fundamental to the selection of markets. And you've really got to be able to understand what those markets are going to do. Asset selection is very important. I agree with you. But the market is going to drive a lot of the factors. You can buy an office building in Death Valley, and it'd be the best office building in the world, but if there's no demand, it doesn't work. 

This transcript of the ARA In Conversation discussion has been edited for clarity.

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