Tuesday, April 26, 2011

The Segmented Market by Ari Paul

In this issue:
1) The Retail Investor
2) Long Equity Managers
3) Fundamental Hedge Funds
4) Short-term Equity Traders
5) Quants

For a PDF version of this newsletter, please look here:
http://www.scribd.com/doc/53945184/SegmentedMarketROR
Dear Friends, Colleagues, and Investors,

From the “Invisible Hand” to the “Rational Actor”, the “Electronic Herd”, or just the monolithic “Market”, we tend to think of asset prices as being driven by a uniform force. In reality, there are many different types of investors and traders who push and pull prices in myriad ways. The battle between these actors creates inefficiencies and profitable opportunities. I’ll discuss the most important market players and how their actions create distinct waves in asset prices. A rough estimate of the relative trading volumes:


1) The Retail Investor
The backbone of the stock market is the passive retail investor. Many people buy stock every year without giving much thought to valuation. Through the employer’s 401k, pension fund, or by consistent mutual fund purchases, these investors provide a relatively steady tailwind to the market. When the economy is doing well and they are optimistic, they invest more. During severe recessions they may produce net withdrawals. Even when their money is professionally managed by someone with great discretion, it tends to be invested in a way that is 100% long the market, and very diversified.

When these investors pour money into the market, the result is an indiscriminate rally that will lead to the overvaluation of some weak companies that are simply getting swept along. This causes the market truism, “a rising tide lifts all boats.” Over a 5+year horizon, their contributions will be influenced by the public attitude towards stocks and bonds in general. For example, for 20 years after the great depression, the American Public believed that stocks were inherently risky and unsuitable for most investors. Over a 10+ year horizon, contributions are also greatly influenced by demographics. As more Americans near retirement age, net investment into the stock market as a percentage of income will decrease. It’s also worth noting that passive investors are still relatively geographically isolated; American investors drive American stock market prices, and German investors drive German prices.

Over the long term, the valuation of a large country’s stock market is primarily determined by passive investors. To take advantage of opportunities created by the passive investor, we want to identify when they make poor choices. The simplest example is the passive investor’s exaggerated response to crisis. During a major war, recession, or natural disaster, public sentiment is likely to become extremely pessimistic. If the market has already sold off by as much as you think appropriate for the actual risks, it’s time to prepare for a contrarian trade. Similarly, we know that a young country with a growing economy will have a tremendous tailwind from a continuous flow of new earnings into the equity market. In the absence of a crisis, stock prices are likely to continue to rise regardless of valuation. As long as valuations are not obviously too high, we can ride the tailwind.

2) Long Equity Managers
These professionals consist of mutual fund managers and some pension and hedge fund managers. They focus on picking sectors that will outperform the market and individual companies that will outperform the sector. These managers usually have a 6 to 18 month investing horizon and they dominate the market in that time frame. They are driven by “ideas.” For example, a well respected analyst might put out a research report arguing that solar energy stocks are dramatically undervalued for various reasons. As this idea percolates through the market, fund managers overweight solar stocks in their portfolio. They tend to look for “pure plays”, stocks that are most directly tied to the investment thesis. They follow the dictum that it's better to fail conventionally than to succeed unconventionally, so they avoid “ugly” stocks, like those of companies embroiled in lawsuits.

It’s relatively easy to take advantage of these investors because their motivations are so clear. It’s sometimes possible to jump on a popular investment thesis near the beginning, but at the very least, you can avoid sectors that have already been pushed to bubble valuations. Because the fund managers look for “pure plays”, simple stocks are usually overvalued relative to more complex conglomerates. Conglomerates take more time to analyze and have less exposure to the trend, but frequently provide better value. Finally, these investors avoid “ugly” stocks because they don’t want to have to explain to their investors why they lost money on an obviously bad company. Ugly companies frequently provide the very best value investments for this reason. To borrow an example from the bond world, after Enron went bust in 2004, Seth Klarman of Baupost Group studied the company intensely and bought up a large portion of its bonds for 15 cents on the dollar. At the time he believed they were worth about 35 cents on the dollar and they paid off closer to 50. Most money managers didn’t want to risk losing money connected to one of the greatest stock scandal stories of all time; they were afraid to look stupid.

3) Fundamental Hedge Funds
The next economic actor at bat is the hedge fund that trades equities with a 1 month to 1 year time frame. Various hedge funds focus on long-short equity portfolios, predicting and trading around earnings announcements, medium-term technical analysis, and business cycle investing. The key feature of these funds is the timeframe, because they vary greatly in methodology and psychology. They are generally pretty efficient and rational in their investing process, but occasionally they fail spectacularly in ways that can be exploited.

In October of 2008, shares of the car maker Volkswagen soared 286%, making it briefly the largest company in the world. Many hedge funds had sold Volkswagen shares short because the company seemed generally weak and its stock overvalued. It was widely known that Porsche owned over 40% of Volkswagen shares, but Porsche had vehemently claimed they had no interest in acquiring more. Suddenly Porsche revealed they had secretly gained control of about 75% of Volkswagen, which meant that some shortsellers would be unable to find shares to cover their shorts. There was a stampede for the exits and as shortseller after shortseller bought back the stock, the price rose to the stratosphere. At that point, even hedge fund managers who wanted to remain short could not, because they were margin called and forced to buy Volkswagen shares. While equity hedge funds with a medium-term outlook are generally rational, extraordinary events can force them to create wildly mispriced valuations that we can trade against.

4) Short-term Equity Traders
Over a 1 minute to 1 month time frame, we have short-term equity traders. These traders are responsible for creating what we think of as the “efficient market.” They trade equities immediately after public announcements, natural disasters, economic releases, and even weather updates. When rumors float that a large hedge fund is getting margin called, these equity traders will fly like vultures over its corpse and take advantage of the resulting mispricing. Short-term equity traders try to anticipate the actions of the longer term equity managers and hop on “idea” trends at the very start. They ride the ebb and flow of bigger players’ orders.
These traders don’t frequently make “mistakes” that we can exploit as investors, but we have the advantage of a longer time frame. While they are rational at what they do, their disinterest in holding positions longer term means they leave a lot of money on the table. For example, after a subtle but strongly bullish announcement from a company, these traders will immediately buy a company’s stock, but if the stock price stalls, they may sell the stock out in an hour or a day. We can buy the stock from them and enjoy the gains over the next few months or years.

5) Quants
The last player in the equity game are “black box” hedges funds or “quants", and they represent about 70% of the trading volume. These traders program computer algorithms to trade in a time frame measured in microseconds to minutes. They immediately exploit simple arbitrages and use complex models to try to predict the actions of other market participants and jump ahead of them. For example, a computer program will notice that every 5 seconds, there is a purchase of 1000 shares of Microsoft stock. The program will purchase 10,000 shares and then sell the shares to the original purchaser every 5 seconds at a higher price. The quants make many basic mistakes. They overweight simple historical data and frequently fail to consider changing circumstances. For example, their programmers will estimate the impact of a good GDP number on stocks by looking at the impact of GDP reports over the last 10 years. However, they will likely fail to consider more subtle variables like current valuation levels, market sentiment, open stock option interest etc. Every once in a while, quants make eggregious, even comical errors. For example, during the “flash crash” of May 6th, 2010, quants sold the stocks of several large companies at $0.01.

It’s difficult to exploit quants unless you have access to similar technology. Even when the quants make eggregious mistakes, they are generally protected by the exchanges; the NYSE cancelled the trades in which the quants sold stock at $0.01. We can at least be mindful of their market impact. While quants are frequently thought of as “liquidity providers” in that they are constantly making markets and trade great volume, they become “liquidity takers” when the market is strongly trending. This means that a market with a high volume of quant trading is much more likely to experience a “flash crash.”

Friday, April 22, 2011

Understanding Value Creation in Real Estate--by Uncle Sherman (Guest)

In November of 2007, Isthismar, a Dubai based investor, bought 280 Park Avenue, a two tower 1.2 million square foot Class-A office building in Manhattan. They paid $1.2 billion for the building, or around $1,000 per square foot, a new record for a property of this size. A few months later, Isthismar flipped the building to Broadway Partners, a New York-based real estate investment company for $1.35 billion, a small profit. Broadway held the building until this March, when they announced that they were in over their heads and needed a bail-out.


The story is a familiar trope of the last recession—over-funded investors get caught up in a manic market and overpay. “Investors” isn’t really the right term though, since buying without any regard for real estate fundamentals is speculation rather than investment. But how do we know they overpaid? Is this just smarmy 20-20 hindsight? And what are “fundamentals” after all?

Real Estate Fundamentals

Owning real estate as an investment is like owning a car rental business (with very long-lived cars). You lend your car to someone who pays you to borrow it. That’s it. The value of your real estate is the value of the payments you can get when you lend it to someone. Of course many home owners and even some “professionals” don’t pay attention to lending or rental rates. Home owners often estimate value by how much pleasure they’ll get out of a home, or how much they believe they can get when they sell it. “Professionals” sometimes buy buildings for braggadocio, brand image or for the fees they get for investing money. There is nothing wrong with buying on those principles (unless you’ve promised your investors you’d do otherwise), but betting on what the next guy will pay instead of the cash income you’ll get for renting is the definition of speculation.

Real estate investment, as opposed to speculation, is the purchase of a property based on its income potential. Property income has two parts: “yield” or “current income”, meaning the income you expect to receive while owning the property, and “appreciation,” the increase in capitalized value of the expected future income, which you’ll get when you sell the property.

Like any other investment, real estate is risky. You may not be able to lease out your building, or if you do, your lessee may not pay their rent. You might also face non-leasing risks, such as capital risks (problems with the building’s structure), environmental risks, political risks (direct expropriation, an increase in taxes, or a modification of legal use which makes an expected income stream infeasible), technological risks (new technology or change in social habits which render your building obsolete), financing risk (not being able to refinance or repay your loan), and many others. As a result, good real estate investors approach acquisitions not only thinking about the income they’ll get with a property, but the riskiness of that income. After all, the 11% yield you’re buying on a property isn’t worth a whole lot if you stop receiving it when the tenant goes bankrupt in the second year you own the building.

Pricing Real Estate

Real estate investors think about the value of a building both in terms of what income you’d get if you owned it today (a “static” analysis), and what income you’d expect if you owned it a number of years into the future (a “dynamic” analysis).

A static analysis is useful to compare a property against other projects and opportunities with similar risk profiles. The most important number investors use to understand an investment on a static basis is a capitalization rate, or cap rate. Cap rates are the inverse of price/earnings multiples with stocks, although in real estate the convention is to divide “Net Operating Income” or “NOI” into a property’s price. Like earnings, NOI is composed of income (rents, other income) minus expenses (real estate taxes, insurance, property management, and any utilities and maintenance costs that can’t be passed through to tenants). Unlike earnings, NOI may or may not include capital expenditures on the building, depending on the property type. NOI never includes debt service.

Cap rates represent the cash yield in the first year of the investment and don’t take into account future expectations or changes in the asset or income stream. A higher cap rate represents a larger amount of income per the price paid, but if the property is openly marketed, a higher cap rate also suggests that the property’s income stream is riskier than similarly sized income streams of more expensive properties.

Here’s an example. Let’s say I can buy a condo for $100,000 and rent it out for $11,000 a year. Let’s say that all my expenses on the condo are $1,000. My cap rate is $10,000 divided by $100,000 or 10%. Now assume that at the same time I buy my condo, you buy a condo down the hall for $90,000. If you get $9,000 of income, you’re buying at the same cap rate as me, and the market considers your condo and my condo to be similarly risky. But if you get $10,000 of income, you’re buying at a higher cap rate and the market believes your property is more risky than mine. Why? If investors are willing to accept a 10% yield (as I did on my property), and your property receives $10,000 income, and if investors believe your and my properties are equally risky, someone would bid up the price to $100,000. If they do not, then you are paying less for a higher but more risky income stream, hence the higher cap rate.

This example assumes there is market liquidity and market knowledge, and that investors are rationally seeking to optimize the risk-return profile of their investments. These assumptions are not always true, but most real estate investors know what cap rates their competitors are paying for properties, so they are at least aware when they are breaking away from the pack. Breaking away from the pack isn’t necessarily stupid either—the best money is made taking mispriced risks that others won’t.

As opposed to a static analysis, a dynamic analysis of real estate evaluates the estimated income stream over a multi-year horizon using a traditional discount cash flow model. In addition to considering rent changes, vacancy, sales expenses, capital expenditures, and leverage, investors also have to consider changes in interest rates. Over the long term, cap rates are driven by interest rates; the various real estate asset types each have a different spread over “riskless” treasuries. That’s because if cap rates get too close to treasuries, investors can (in principal) shift their money out of real estate and into government bonds, driving cap rates up until the risk/return profile makes sense. Again, this idea assumes more liquidity than probably exists in real estate, and it doesn’t take into account the asset allocation models which drive so many institutional investors today. As a result, cap rates changes may get dislocated from treasuries in the short term, creating investment or sales opportunities. But in the long term, as Ben Graham says, the market is a weighing machine, and cap rates return to proper risk-associated levels.

Common Investor Mistakes

Understanding and modeling real estate income streams or risks is worthy of books, to say nothing of a blog post. There are two points however which non-real estate investors often miss entirely in evaluating real estate investments but which are critical to profitability.

The first is capital expenditures, which for buildings in good repair consist of leasing commissions and tenant improvements (TIs). Buildings with higher capital expenditure requirements relative to their cost (office buildings and restaurants, as opposed to industrial warehouse buildings) suffer disproportionately during periods of high turnover because their cost structure is more variable relative to rollover risk. Although investors across asset classes may conservatively underwrite expected capital expenditures into their purchase price, investors with high cap-ex buildings pay a larger cost for being wrong. This problem is particularly true with TIs.

In most real estate asset types, a building owner gives a tenant a TI allowance to “finish” shell space to the tenant’s preferred specifications. These improvements generally include carpet, painting, or even new walls, among other items. The TI allowance can be given as a cash payment toward contractors, or as a loan amortized into the tenant’s lease. The amount of TIs depends on the market conditions and the product type. In both strong and weak leasing markets, tenants request improvements.

Although they are considered “capital improvements” and can be added to a building’s basis, TIs generally don’t outlast a tenant. This is a critical point--since each new tenant demands new TIs, the more frequently tenants move in and out of a space, the more a landlord has to spend on capital expenditures. The idea seems obvious, but it is often lost in acquisition underwriting, which often models “down” scenarios with low rents rather than with high turnover. In weaker leasing markets where it is harder to fill space and where tenants default more frequently, owners must pay TIs more frequently to keep the space filled, and more generously to attract tenants away from competitive space. And during a down market, an owner must foot this bill while accepting a lower lease rate. As a result, while higher TI asset classes may look as good on paper and perform as well in “up” markets, they are much more risky in down markets.

The second issue that non-sophisticated investors often overlook is the impact of changing interest rates on real estate investments. Interest rates hit the bottom line in a number of ways. First, depending on rates at any time, a significant percentage of commercial real estate loans float at variable rates, and interest rate changes quickly hit the bottom line through debt service. Second, even if owners have the cash to cover mortgage payments, they may incur a “technical default” if their coverage ratio reaches a certain level. A technical default may require acceleration, imposition or other fee consequences. Third, as mentioned above, interest rates ultimately drive cap rates, which play a more significant role in asset value than any other factor.

Buying at a 5% cap rate for example, which many real estate investors are doing today, is risky business. Ten year treasuries historically yield around 5%, and real estate, depending on the asset type, is considered a minimum of 150-200 basis points riskier than treasuries. The tables below are simplified as they do not include traditional deducts for vacancy, sales costs and a number of other items, however they still demonstrate the disproportionate impact of interest and cap rates versus rental increases. Notice that if treasuries go back up to 5% and cap rates go up to 7% or 8%, you don’t even make a 5% return unless you get 5% annual net operating income increases and hold for a minimum of 7-10 years. If interest rates go up to 7% or 8% and cap rates hit 9% or 10%, it’s almost impossible to make your money back unless you hold for 7 to 10 years, even if rents increase at 8%-9% annually for that entire time. Given that current interest rates cannot go lower and that inflation seems poised to strike, buying at a low cap rate seems to have a one-sided risk reward profile.

This is likely the discovery that Broadway Partners made in 280 Park Avenue, which reportedly sold at a cap rate below 4%. When you buy at a historically low cap rate, and cap rates rise even slightly, there is almost no way to escape losing money. Isthismar was equally culpable for speculating, but they managed to flip the building before they got in trouble.

In future posting, I will cover other overlooked phenomena of real estate investing.

IRR Returns

Buying at a

5%

cap

Going out Cap


6%

7%

8%

9%

10%

11%

12%

Annual NOI Inflation

2%

1%

-4%

-7%

-11%

-13%

-15%

-17%

3%

1%

-3%

-7%

-10%

-13%

-15%

-17%

4%

2%

-3%

-6%

-9%

-12%

-14%

-16%

3 Year Hold

5%

3%

-2%

-6%

-9%

-12%

-14%

-16%

6%

3%

-1%

-5%

-8%

-11%

-13%

-15%

7%

4%

-1%

-5%

-8%

-10%

-13%

-15%

8%

5%

0%

-4%

-7%

-10%

-12%

-14%

9%

5%

0%

-3%

-7%

-9%

-12%

-14%

10%

6%

1%

-3%

-6%

-9%

-11%

-13%


6%

7%

8%

9%

10%

11%

12%

2%

3%

1%

-1%

-3%

-5%

-6%

-8%

3%

4%

1%

-1%

-3%

-4%

-6%

-7%

4%

5%

2%

0%

-2%

-3%

-5%

-6%

5 Year Hold

5%

6%

3%

1%

-1%

-3%

-4%

-5%

6%

7%

4%

2%

0%

-2%

-3%

-5%

7%

7%

5%

2%

0%

-1%

-3%

-4%

8%

8%

5%

3%

1%

-1%

-2%

-3%

9%

9%

6%

4%

2%

0%

-1%

-3%

10%

10%

7%

5%

3%

1%

-1%

-2%


6%

7%

8%

9%

10%

11%

12%

2%

5%

3%

1%

0%

-1%

-2%

-3%

3%

5%

4%

2%

1%

0%

-1%

-2%

4%

6%

4%

3%

2%

0%

-1%

-1%

7 Year Hold

5%

7%

5%

4%

2%

1%

0%

-1%

6%

8%

6%

5%

3%

2%

1%

0%

7%

9%

7%

5%

4%

3%

2%

1%

8%

10%

8%

6%

5%

4%

3%

2%

9%

10%

9%

7%

6%

4%

3%

3%

10%

11%

9%

8%

6%

5%

4%

3%


6%

7%

8%

9%

10%

11%

12%

2%

5%

4%

3%

2%

2%

1%

1%

3%

6%

5%

4%

3%

3%

2%

1%

4%

7%

6%

5%

4%

3%

3%

2%

10 Year Hold

5%

8%

7%

6%

5%

4%

4%

3%

6%

9%

8%

7%

6%

5%

5%

4%

7%

10%

9%

8%

7%

6%

5%

5%

8%

11%

10%

9%

8%

7%

6%

6%

9%

12%

10%

9%

9%

8%

7%

7%

10%

13%

11%

10%

9%

9%

8%

7%