Would You Like Froth in Your Coffee?

While visiting one of my good friends this past weekend, I witnessed the demonstration of a Bonjour Café Latte Frother. I watched with mild curiosity as scorching hot coffee was poured into a mug and then milk whipped into a froth in the cup until it overflowed, spilling onto the counter. I confess to not being a coffee drinker as I grew up in London and prefer tea, and the unappealing process of creating frothy coffee reinforced my preference.

Watching the steaming mess on the counter led me to thoughts of the current student apartment investment market as best told through a conversation from the quarterly real estate equity event I attended in Chicago last week.

The goal of our quarterly real estate events are professional improvement, networking, and fun. I favor the fun-seeking portion of the crowd, but also enjoy listening to all-comers discuss their strategies and investments. Having somehow drifted into the non-stop-shop-talk crowd, I listened to one bright young fund manager explain how happy they were to finally enter the student housing sector.

My ears perked up, and I asked the student investor newbie, “What strategy does your fund employ?” “We are a value-added allocator fund seeking opportunistic returns by joint venture investing with experienced local real estate operators.” What could be better, I thought, more reward than risk earned through unique relationships and product expertise.

“Great description,” I said. He noted that student housing was in favor, and that their investors would view it as a positive that they were entering the sector. I mentioned, “I hear from a lot of people they want to get in the business lately. Tell me about the student housing deal you closed.”

We ticked through the normal conversation about location, asset quality, university, management, creditworthiness of tenants and cosigners, and the business plan. Turns out the investment is a turnaround and reliant on tenants who attend a low tier university and community college with mid-to-high teens student loan default rates (a proxy of creditworthiness).

Ironically, I had previously reviewed the asset as a reposition play, before the most current business plan failed leading to this reposition² (or, maybe even reposition³). A lot has to go in your favor when turning around an asset, and this one will be especially challenging given that the market currently has a high volume of student properties that defaulted and are being repositioned to undercut competition on rent, compounded by some new development coming in to steal the best tenants.

I remembered the newbie’s previously brilliant tagline of “…joint venture investing with experienced local real estate operators.” “You are going to need every ounce of alignment and expertise your JV strategy employs,” I said. The newbie student investor put his hands in his pockets and began shifting back and forth like a nervous junior high girl waiting for a boy to ask her to slow dance. After a bit of pressing and the onset of flush cheeks, he revealed that the joint venture investment was made through a smaller allocator fund, with no student housing experience, and is based in Chicago over 1,000 miles from the asset.

I did what any thoughtful investor would do when confronted with this fact set, I immediately ordered more drinks.

After taking in additional social lubricant, I attempted to revisit the investment thesis. “Just so I understand, you are an allocator fund new to student housing investing in a turnaround through a joint venture with an out-of-town small allocator fund with no student housing experience, in a market with bad supply/demand dynamics, with low quality tenants.”

“Well, at a good price, I hope, it is student housing,” he responded.

As a mentor of mine likes to say, “hope is not a strategy.”

I fear for the capital placed in this investment. My fear may be unfounded as the property may have been purchased at such a deep discount AND the turnaround plan works AND the market supply/demand suddenly swing into investor favor AND the inexperienced and out of town operator masters the student housing business AND the tenants start paying rent on time in full AND a capable buyer is found to exit the investment. If the asset pricing methodology used proves sound and this investment risks were all clearly priced into the transaction, then it is good for everyone involved and our investment sector.

However, the “hope” for this investment appears to be that the broad and favorable view of student housing will outweigh the giant risks that multiply in this deal as they are stacked to the sky. It made me wonder if the student housing market isn’t getting a little frothy, and in danger of spilling on the counter like my friend’s latte.

— William H. Bennett is principal at Iconic Development and a lecturer of real estate at the J.L. Kellogg School of Management.