July 15, 2009

Value Traps

DEAR FRIENDS OF CARDINAL GROUP INVESTMENTS (CGI),

As active real estate investors and market analysts, we receive mountains of research data and commentary daily. Every once in a while a topic will come up that incites heated debate among our partners, associates and clients. To inject a little civility into these discussions, we have decided to put out a regular newsletter. After all, we have the pleasure of working for and with some of the smartest people in the business and we’d hate to miss an opportunity to learn. 




This quarter we’re taking a look at real estate valuation traps from two vantage points: the private market for direct property investment and the public market for REIT stocks. The big debate today in real estate circles is how to value investment real estate in the face of all the uncertainty and upheaval in the financial and property markets. 




The world is changing quickly: In the last 18 months we’ve seen the collapse of several major financial institutions, fraud committed on a truly epic scale, an overhaul of 100-years of business regulation and the evaporation of more than $10 trillion of household wealth.




To invest profitably, we need to develop an analytical framework for dealing with this uncertainly. At CGI, we prefer to keep things simple—to seek out tangible anchors in all of the noise created by anecdotes, overwhelming statistics and the chattering class of pundits and market forecasters[1] that are so prevalent these days. So here’s a quick primer on our internal thought process and how we’re trying to navigate our way in these uncertain times. We hope you’ll join the conversation.




                                 
                            
Value Traps

 IN THIS ISSUES


       QUOTES AND COMMENTARY ON THE MARKETS


       PRIVATE MARKETS: WHERE HAS ALL THE VALUE GONE


Student housing is a great investment because it’s market neutral and holds up regardless of the economy. When the economic outlook is dim, enrollment picks up, units stay full and your investment is safe... Right?  Not so fast! 


       PUBLIC MARKETS: THE RISK OF SAFETY IN REIT STOCKS, A CASE STUDY 
The real estate market is a disaster these days—that much is common knowledge.  But there seems to be pockets of the market that are not only surviving, but thriving in this new era of lost wealth and diminished income.


Quotes & commentary on the markets




                   “There is a clear trend home price declines are moderating – another sign the beleaguered housing market is stabilizing, according to data released Tuesday. While the Standard & Poor's/Case-Shiller index of 20 major cities tumbled by 18.1 percent, it marked the third straight month the decline was not a record.”  From a June 30 Associated Press Story


                   This analysis sums up that peculiar American optimism that makes our economy the envy of the world. It’s like saying that even though it’s a 100 degrees outside, it’s not that hot because it’s not a record.




***


                    A few quotes on inflation, currency and crisis:

                   “Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” –John Maynard Keynes

                   “When I look back into history, almost every experiment with fiat currency has ended poorly. Actually, the thing that disturbs me the most is Bernanke’s academic comfort in the fact that his printing press has enough ink. His Keynesian ideology works best in a vacuum outside of the real world. The fact that he thinks stealing money from the savers in his economy and confiscating it through the hidden tax of inflation/currency debasement should scare everyone.”
                                           
                   –Hayman Advisors, L.P. Manager Kyle Bass in his annual letter to limited partners

Inflation is something that we take very seriously, as it’s the sworn enemy of all savers and investors. The best defense we can think of is fixed rate financing and investments with elastic enough pricing power to increase with the general level of inflation (real estate).

***

“Financial Accounting Standards Board proposed an overhaul of fair-value accounting that may improve profits at banks…by more than 20 percent. The changes proposed…also known as mark-to-market accounting, would allow companies to use “significant judgment” in valuing assets and reduce the amount of writedowns they must take on so-called impaired investments, including mortgage-backed securities.” –Bloomberg News

Anytime a system is configured in such a way that it can be manipulated by universal and powerful human failings, it will be. This accounting change will artificially inflate the capital base of banks and other companies, in effect further leveraging their already over leveraged balance sheets. There’s a very well known psychological condition that we all suffer from called the Excessive Self-Regard Tendency, wherein we think things are worth more than their intrinsic value just because we own them. Taking away the brutal but ultimately objective and quantifiable valuation measure of market-based pricing and replacing it with the more subjective “judgment” principal is just asking for trouble.


***

“Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States” –Ray Dalio, CIO of Bridgewater Associates, on deleveraging the U.S. economy.

It would be pretty arrogant to think we could improve on Mr. Dalio’s analysis so we’ll just leave it at that.

***

“The government cannot give to anybody anything that the government does not first take from somebody else. When half of the people get the idea that they do not have to work because the other half is going to take care of them, and when the other half gets the idea that it does no good to work because somebody else is going to get what they work for, that my dear friends, is about the end of any nation. You cannot multiply wealth by dividing it.” –Dr. Adrian Rogers (1931-2005)

There are some proposed changes to our tax code that could have the perverse affect of disincentivizing saving and risk taking. While we usually don’t subscribe to any stubborn ideological position on tax policy, it has been our experience that things that you don’t pay for, either through sacrifice or money, have no value.

The Private Markets: Where has all the value gone?

Student housing is a great investment because it’s market neutral and holds up regardless of the economy. When the economic outlook is dim, enrollment picks up, units stay full and your investment is safe... Right? 

Well, sort of. Fundamentals have held up extremely well thus far but pricing has taken a considerable hit, offering buyers a unique opportunity to buy strong assets on sale. The key is not just buying cheap, but buying right. If this downturn has taught us anything, it’s that all markets are not created equal. It’s crucial to carefully examine every opportunity to avoid value traps and come out of the other end of this cycle with a full head of hair and a healthy portfolio.


VALUATION 101

For out-of-work finance jockeys looking for a new job, here’s an idea: teach real estate valuation to brokers. Most brokers (and many investors) fell asleep in their real estate valuation classes after day one when cap rates are taught. After an 80% drop in commercial real estate transaction volume, many brokers are finding themselves with plenty of time to develop reasons to believe their deals are worth anything close to what they promised their clients could be delivered.

Here are three of our favorite rejoinders:

  • “This is really a long-term hold.” 
    • Translation: If you hang on to this long enough your grandkids will be able to get out whole.
  • “This seller is rich and can take the loss; they don’t really need to sell.”
    • Translation: I have never met a rich person, because if I had I would know that they didn’t get rich by holding losing assets.
  • “This deal will probably sell to a local buyer who really understands the market.”
    • Translation: I am wishing, hoping and praying that someone who doesn’t own a calculator is sitting on a pile of cash and really likes the new paint in the living rooms.
The reality is that everything in this environment has a certain level of distress. Nobody is selling because now is the optimal time to cash out. They need the money! The real question is, “Does equity remain in the highly leveraged assets many bought at the top of the market?” Sadly, the answer is often “no.”

With the run in real estate over the past decade, many investors forgot that when you invest in real estate (or anything else) you are paying upfront for a stream of uncertain future cash flows. Some of those cash flows come from operations and some from appreciation. The required return is driven by the degree of risk involved and the likelihood of actually collecting those future cash flows. Investors have gotten the message, but most sellers have not; there’s still a large disconnect between buyer and seller expectations.


THE VALLEY IS WIDE BUT THE RIVER IS DEEP

The gap between buyer and seller expectations is greater today than at any time in recent memory. Our valuations are typically 25-40% below the seller’s target pricing. For months the gap kept widening, as sellers waited for a greater fool to bail them out. The problem with that logic is that those buyers no longer exist and the only players remaining are those who were disciplined enough not to overpay in the first place.

While the gap in pricing remains at unprecedented levels, the depth of opportunity emerging from the turmoil is equally unprecedented. Suddenly you can buy great assets for a fair price, good assets for a good price and weak assets are practically being given away. It’s not that  investors are getting outsized gains, it’s more that pricing is returning to a point where deals make sense on a fundamental basis.

The question property owners keep asking themselves is “How did my property lose 30% of its value in one year when my cash flow has improved?” The answer is found in a number of factors:

1.       Cap rates[2] don’t matter: Cap rates are an appropriate way to gain an initial read on a stabilized property in a market with consistent growth. The problem today, though, is that few deals are truly stable, no markets are expected to have consistent growth, and leverage is unpredictable. Cap rates are simply inadequate (and frankly always have been) to tell the story of how an investment is likely to unfold in a fast-moving market.

2.       Cost of capital has increased: Underlying interest rates are at historical lows, but risk premiums are at all-time highs. The net effect is that the cost of capital is 50-100 basis points higher than 12-24 months ago. Gone also are the days of higher loan-to-values (LTV) and interest-only loans. By reducing the LTV from 80% to 70%, increasing the interest rate by 50 basis points, and requiring a 30-year amortization instead of interest only, the price of an asset has to come down by 8-10% to achieve the same returns. Furthermore, lines of credit for capital improvements are largely unavailable, requiring, more equity for the average deal.

3.       Expectations of future growth reduced: In the short-to-mid term, investors see flat or declining revenues, and the possibility of increased taxation and energy costs. Investors still need to hit their returns, and consequently pricing takes yet another hit.

4.       Expectation of rising interest rates and cap rates: Because of the government’s $787 billion stimulus package and aggressive monetary policy, there is a real threat of inflation over the coming cycle. Inflation will bring higher interest rates and in return push cap rates up, reducing expectations of future property values upon ultimate sale.

5.       Lenders won’t let buyers overpay: The conduit market is gone. Life companies have halted lending. And the only places to obtain financing are through Fannie/Freddie or local banks. With losses mounting, limited capital to deploy, and shareholders breathing down their necks only the strongest opportunities are being funded.

The loss in value is a painful truth for many, but sellers are beginning to get the message. There have been no winners in this downturn, only losers. Or, to put it another way, the pie just got smaller.

Motivated sellers are starting to surface and deals are sporadically transacting. Acquisitions specialists have turned into educators, constantly explaining to sellers why their property is not worth as much as they believe. We have seen pricing come down 30% overnight after presenting our analysis to sellers and explaining how the market views their asset. We are also seeing deals that we killed months ago circling back at prices that are at or below our original offers. Patience truly is proving to be a virtue.


DON’T STEP IN THE…

We are in a period of economic crisis and in the chaos everything looks cheap. With the ground shifting beneath our feet, how can we decipher between investments that are a bar of gold covered with mud and those that are really just a pile of crap?

The swell in pricing over the last cycle was driven largely by cap rate compression as yield-hungry investors used cheap debt to buy everything in sight and drive up pricing. Buyers were bailed out by appreciation as they passed the hot potato on to the next greater fool. But, the music has stopped and assets without strong underlying fundamentals are being exposed as risk premiums and underwriting make a comeback.

The following are some highlights to the ways we are evaluating and mitigating risk, from underwriting, to market research, to market positioning:

1.  Underwriting: Cash Flow is King
As we enter these uncertain times there are two things that all investors want: (1) A big wad of cash in their pocket, and (2) More cash coming in. As the Baby-Boomers enter their retirement years they are looking to replace income with cash flow to fund their comfortable lifestyle and pay for their Echo-Boomer kids to attend college.

A focus on cash flow is hardly a new concept, but it was largely ignored over the past cycle as appreciation became all the rage. The market downturn has provided an immediate catalyst to return the focus to cash flow, but the shifting needs of the Baby-Boomers are creating a long-term shift in investment priorities.

We have always focused on cash flow, but with the changing tide, we are putting a more acute focus on how it affects our investments. A key barometer we are now focusing on in our proformas is the percentage of total profit coming from cash flow vs. appreciation. During the past cycle, the ratio on most deals was around 20/80. Today, we are shooting for closer to 50/50.

2.  Market Research: Not All Markets are Created Equal
One factor that separates student housing from other real estate products is that the key metric of demand is not job creation but enrollment. It is true that enrollment ticks up when the economy ticks down, but our research indicates that not all universities benefit in the same way. High school grads tend to go to college no matter the economic conditions and the rate of those attending keeps increasing. And, frustrated job seekers flock to grad school to increase their worth when the market recovers – but the schools they choose to attend depend largely upon their available resources.

Schools where enrollment holds up best have common factors: (1) They are large, public universities (2) They have strong academic programs and rigorous admissions standards, and (3) They are inexpensive.

CGI has developed the Cardinal College Ranking System, tracking statistics at nearly 600 universities across the country to determine where enrollment is likely to hold up during tough economic times. The rankings considered everything from admissions standards, to tuition costs, to average salary upon graduation, to off-campus housing demand and athletic prowess. While these rankings don’t tell us where to invest, they are one of the many ways we are evaluating risk. (Cardinal Ranking: University of Michigan: 3, Pepperdine University: 504)

3.  Market Positioning: Follow the Footsteps
To explain the power of market positioning as a way to mitigate risk, we will explain another classic student housing value trap. Let’s say you find a building built in the 1970s just a few miles from campus with historically strong occupancy, but is currently half vacant. Sounds like a classic management/marketing play – just clean the place up, update marketing, give it some paint and you can create a lot of value… not so fast.

To understand why this could be a trap, we must first take a step back and examine the evolution of traditional college towns, which have looked remarkably similar throughout the country. The school is the anchor. Six to eight blocks away is a downtown district with the bars and restaurants and in-between is a hodgepodge of rundown houses and older student housing properties. The only quality place for a student to live is five miles off-campus where REITs have built new product on the outskirts.

When the subject property was built in the 1970s it was likely the most highly amenitized property in the market. But now, with newer product delivered down the street, the property is just a 30-year-old building in a weak location. Absent a massive capital improvement campaign, the newer product will continue to cannibalize renters and the subject property will have a hard time ever regaining market share. The size of the student body compounds this problem at small-to-mid-sized schools. 

To avoid this trap, we focus our acquisitions in the core pocket where students can walk to campus as well as the entertainment district. We focus on quality of location — rather than quality of product — because the product can always be improved but location cannot.


SPOTTING THE OPPORTUNITIES

As the market struggles to find its equilibrium, we continue to scour the landscape for opportunities. We strongly believe that patience will be rewarded. We allow others to tie up deals at pricing we know is unachievable, while keeping in contact and waiting for the deal to fall apart. Then, we move in once the seller has gotten a dose of reality and we are in a strong position to negotiate.

Our most powerful tool is our ability to quickly step into a market and gain the trust of local players. Many of these owners have substantial portfolios and are looking to retire and peel off all, or part of their holdings. We are also working closely with lenders, hedge funds and our deep brokerage contacts to get the first shot at opportunities as they arise.

Lastly, we continue to bolster our research efforts to make better decisions, act quickly and position ourselves in front of the next cycle. Right now is the off-season, and we are in the gym lifting weights so that we are ready to compete as the next buying season approaches. We believe the next 24 months will present many attractive buying opportunities with solid cash flows and strong risk adjusted returns.




ThE PUBLIC MARKETS: THE RISK OF SAFETY IN REIT STOCKS, A CASE STUDY


The real estate market is a disaster these days—that much is common knowledge. But there seems to be pockets of the market that are not only surviving, but thriving in this new era of lost wealth and diminished income. You can find these pockets of relative calm by comparing the valuations of publicly traded Real Estate Investment Trusts (REITs) who invest in different market niches. At a time when even the biggest and most stable companies are trading at all time lows, there are a certain real estate companies who’s valuations look down right frothy.  A quick look behind the curtain at a few of these companies reveals a wealth of inefficiency and inconsistency.

When you buy a REIT it’s generally understood that you are buying a business that’s good at figuring out the most efficient and profitable way to either develop buildings or buy existing buildings and lease them at a profit. So the prices that these professional investors and operators are willing to pay for real estate should reflect the true value of property. The second layer of valuation is what individual investors are willing to pay for shares of the companies that own this real estate. By allowing more investors to buy small stakes in the operating companies with low transaction costs and high trading volume, the ongoing valuation of the underlying property becomes much more efficient. Or so it would seem.

One of the companies we follow closely is American Campus Communities (ACC). We do this for two reasons: 1.) people who invest with us decide that they want some exposure to multifamily real estate that focuses on serving student populations and this publicly traded security is generally their only other viable alternative for doing so; and 2.) there is very little information available on student housing outside of what we dig up on our own, so tracking the performance of ACC’s portfolio gives us better insight into what’s happening in the student markets.

As of May 20, the price for one share of ACC stock was $22.46, which implies a market capitalization (total value of the company) of $988 million on 44 million shares outstanding. A couple of other basic inputs[3]:

  1. ACC reports $2.2 billion of assets (property) and $1.4 billion of debt, both secured against the properties as well as revolving unsecured lines of credit, implying shareholder equity of approximately $775 million, or 27% less than their market capitalization (i.e. they trade at a 27% premium to book value).
  2. ACC owns 86 properties, consisting of 17,212 units and 52,817 beds, for a valuation of $127,817 per unit and $41,653 per bed given the current share price.
  3. The entire portfolio was 96% leased for the 2008-2009 school year. ACC anticipates this to remain stable for the following school year and we have no reason not to believe this.
  4. In 2009, these properties are expected to produce $262 million in gross income, less about $126 million in operating expenses, for total net operating income (NOI) of $136 million.
That’s a pretty nice cash flow stream and one that won’t likely go anywhere in the near future given U.S. demographic trends and the undeniable competence of ACC’s management team. So that passes our first test of valuation: a durable source of ongoing income. Our second test of valuation is the price we have to pay in order to acquire that cash flow stream. At $22.46 per share, this exercise presents some problems.

The current Wall Street “story” surrounding ACC is that they are a great defensive play for nervous investors looking for stable returns. The world certainly does not want for nervous investors right now, making this a believable thesis. So we can assume that ACC’s rental income stream is not likely to diminish, but how likely is it to go up? There are really only two possibilities for this: 1.) increase rents at existing properties greater than expenses; and/or 2.) invest new capital at a higher rate than you borrow it. The first option seems easy enough, requiring a lot less creativity and much more administrative skill. The second option is the tough part. We know this because we spend all day trying to figure it out.

ACC’s $988 million in market capitalization suggests that investors are valuing the company’s portfolio of properties at approximately $2.38 billion, or $138,740 per unit. This works out to an implied capitalization rate of about 5.7% at the current share price. Given the fact that we are seeing institutional quality student housing properties listed at 7%+ cap rates (and selling, if they do sell, at 8%+ cap rates), this figure is a little troubling. For instance, if we apply even a 6.5% cap rate to value ACC’s buildings, they are worth only $2.0 billion, or $15.73 per share—a 30% haircut.

Maybe it’s the dividend yield that’s attracting investors at this price. ACC has paid a dividend of $1.35 per share for the last three years and is expected to continue this payout rate in the future. At $1.35 per share, that’s a 6.2% dividend yield on a $22.46 share price. Not bad. Never mind that ACC had to borrow or sell assets to pay that dividend the last two years. They are expected to cover it with cash flow this year, though by a pretty slim margin.

The dividend payment is not likely to increase given the fact that ACC is paying out a very large chunk of their free cash flow each year to meet this modest return. We won’t even mention the potential debt maturity bombs lurking on the balance sheet—for the purpose of this analysis we’ll just pretend they don’t exist (I’m sure ACC’s owners would like to as well). So if you’re happy with a 6.2% cash-on-cash yield with pretty shaky coverage from a company that’s only been public for five years, you’re a buyer. If not you’ll need to find another way to justify paying this price.

One of the latest consensus growth figures is that ACC will increase its NOI at a rate of about 4% per year through 2010. If assume this is true then in five years, they will have NOI of about $159 million. If the market valuation stayed at a 5.7% cap rate and ACC pared back some debt, this would produce a tidy profit of about $20.50 per share, or a 15% Internal Rate of Return including dividends over the five years. But if that valuation metric increases somehow to a 7% cap  rate, which is much more in-line with historical pricing, particularly of student housing, then you’re looking at a 7% IRR, or an $8.67 profit per share. And that assumes that operations go perfectly as planned and it’s just the market that sobers up.

In our investing activity, we’re constantly looking for a Margin of Safety—the “wiggle” room built into the price we pay for something in case things don’t turn out quite as we hoped or more likely we mess something up along the way. In our estimation, there’s a much higher likelihood of cap rates increasing 100-200 basis points from a 5.7% basis, than decreasing even 50 basis points. In fact, average apartment cap rates in the U.S. in 2005 (a particularly exuberant year) were 6.49%[4], meaning that a 5.7% exit-cap rate has a significantly higher standard deviation than does a 7% target rate. So in one sense, buying ACC at the current valuation is like betting on a horse that has 3-1 odds of winning but only pays out 2-1.

Given that rosy analysis of future value, what would we pay for a share of ACC’s portfolio of otherwise terrific properties run by excellent managers? We will answer that with another example, but this one much shorter. We recently bid on several fully stabilized ACC properties that they put up for sale in California at a fast growing university. We were short-listed as one of the groups to offer a best and final bid based on our preliminary offer, which indicated our underwriting was in-line with other student housing investors looking at the same assets. Our price? About $40,000 per bed or a 7.8% cap rate on 2008 NOI. Even if you assume a hefty premium for the whole company to account for the diversification benefits and liquidity, it’s hard to imagine the sum of the parts worth what retail investors seem to be willing to pay today. While we generally don’t advocate short selling—the market can usually stay irrational longer than you can stay solvent—we will say that at this valuation you should probably be more nervous to invest than not to.




[1] We offer this punditesque newsletter without so much as a hint of irony.
[2] Capitalization Rate: Year one Net Operating Income (NOI) divided by the purchase price.
[3] Data Source: J.P. Morgan
[4] Source: A Cross-Sectional Analysis of Cap Rates by MSA, Journal of Real Estate Research, Vol. 30, No. 3, 2008. This article was co-authored by the head of the Burnham Moores Center for Real Estate, where two of CGI’s humble partners matriculated. It’s definitely worth a read if you have a high tolerance for opaque econometric models and ever wondered by cap rates vary across different cities.  

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