June 2014

“Because that’s where the money is.”

- Bank robber, Willie Sutton, when asked why he robbed banks.

Okay, so to be clear, we do not support robbery.  We do, however, support investing where the money (read: return) is. 

Long-time readers are very familiar with our three-year (and current) strategy of investing in large cap, dividend paying, multi-national equities sporting strong balance sheets. 

We have stressed broad diversification, but in only a few asset classes.  And while over the long-term we want solid, reliable returns, we also want some assurance that “we will get our money back” before committing investor funds.

This blog, however, will not go down that well-worn path.  As strong as we have pounded the table on certain equity sectors, we also believe there are superior returns ahead in certain real estate sectors, and we favor real-estate over bonds by a long way.

Many investment advisors want a slice of their clients’ pie chart to say “real estate” so they can show diversification without really knowing the details of their real estate position.  The concept seems to be more important than the facts and metrics behind the investment.

We are not fond of that approach.

Just as we favor direct investments in companies versus mutual funds, we invest in real properties versus Wall Street created Real Estate Investment Trusts (REITS).  Like Mutual Funds, REITs offer some positives—among them diversification, liquidity, and professional management.  Those features, however, can also come with very high price tags, suspect holdings, and increased volatility….all things we seek to avoid.  Plus, we like transparency over opacity and knowing the details of the assets inside a REIT is difficult at best….not to mention the chunk of expenses between you and the properties.

To make our point, perhaps the best way to draw the distinction is to compare an investment in the home you own vs. a portfolio of homes in your neighborhood.

You probably don’t think much about the price of your home (or any other real estate investment) on a day-to-day basis.  You may have a vague understanding that the value has gone up or down, but you don’t fret at night over the price.  Only when you decide to sell it does the value become a top-of-mind topic.  In short, you are a long term investor in your real estate, and chances are over the past few years the value has gone up along with the stock market…and with a lot less stress.

Unlike your home (or other real estate), REITs are priced every day.  Frequently, analysts argue over how REITs will perform given some event that is dominating current headlines.  Investor funds flow in and out based on a news story, an upgrade or downgrade, or a slight change in the yield curve.  Unlike a home, a publically-traded REIT is packed with day-to-day emotions and short-term thinking--- and therefore increased volatility. 

So here is the problem from our perspective.  Let’s say one investor invests in a local apartment complex that is paying a 6% annual cash return.  Let’s say another investor chooses a REIT paying 6% “yield” as well.  Now, say that interest rates begin to rise.  In that scenario it is very likely that the REIT will lose value as investors decide yields may be better elsewhere.  And while the cash flow of the REIT may be just fine, the stock price may fall significantly.

With a direct investment into a multi-family project, however, you don’t really know the day to day price.  You’ll only care about the price when you get ready to sell.  In the meantime, you’re content to take the 6% income checks, which should slowly rise over time with inflation. 

So, while taxable bonds, munis, and REITS are very different “fixed income” investments, they may actually trade in a correlated fashion.  This is not necessarily so with individual properties/real estate assets.

But there is even more to this strategy in the value equation.

Assuming you can “lock in” in long-term debt at today’s low rates, you have a two-fold advantage.  First, any competitor who builds a competing apartment complex has to find competing financing in coming years to compete with yours.  

Second, rising interest rates are often a function of increased inflation.  That generally allows rents to rise while the fixed-cost of long-term borrowings remains the same.  So, cash return on investment rises along with inflation.

In short, while money may be exiting REITs for the potential of better “all in” returns, individual properties have a good chance of both value and income gains….the opposite of what happens with bonds.  In a rising rate environment, bonds are likely to be the biggest losers—just as they were the big winners in the falling interest market from 1980-2012.

Therefore, in place of bonds, we believe the most reasonable “fixed income” investment today should be in direct ownership of quality income producing properties—specifically, income-producing multi-family, hotels, small retail centers, and commercial office buildings.

Graphically, if you could invest with the advantage of hindsight, it would look like this graph.



See this investing stuff is easy!

As with stocks, the question investors should always circle back to is, “Am I going to get my money back?”  In real estate the odds of a successful investment go up when you can buy a solid property, using historically cheap money, that allows for the ability to raise revenues over time.  Plus, you would like to have a healthy growing economy underneath it all.

While current economic data is mixed with low-single digit annual GDP growth, the attached chart from the Wall Street journal shows that the net worth of US households and non-profits has steadily risen since the last recession and is up 14% in 2013 to $80.66 trillion, exceeding the pre-recession high of $76.59 trillion.  There appears to be a solid revenue source to support the types of real property investments that we favor.




So, who knows?  Maybe bank-robber Willie Sutton would turn a new leaf in 2014 and become a deep value investor in either stocks or real estate.  After all, that is where the money is.

Happy investing!


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