Stock selection is one of four strategies available to fund managers to achieve their investment objectives. The basis of stock selection is to acquire a property at a price below its worth in the portfolio. Such undervalued investments are acquired to deliver superior long-term risk-adjusted returns. This webinar explored where value can be found: through identifying the current rental value, growth potential or through expert management?

Implementing strategy

In this ongoing series of real estate asset management, Malcolm deals with the second phase of implementing strategy. That is, stock selection. To recap, Malcolm explains that the general idea in asset management is to devise a fund strategy that can deliver a client’s investment objectives. There are four broad areas for delivering an investment objective. Namely, asset allocation, stock selection, asset management and leverage. In the context of real estate, stock selection is essentially acquiring individual properties that are expected to outperform other properties of the same type.

In acquiring a property, one must first understand the difference between value (worth) versus price. A Warren Buffett quote is helpful in explaining the distinction between the two terms: “price is what you pay, and value is what you get.” In other words, when acquiring a property, you have to decide whether the worth (value to you) of the property is greater than its current price. If the worth is greater than the price, then holding that property for the long-term has will generate a superior risk-adjusted return. The alternative to that philosophy is trading property i.e., buying cheap and selling high. However, Malcolm warns that the problem with trying to sell on an asset to deliver a higher return is that you are left with the property if you cannot do it. Critically, if the property does not perform over the long run, you will likely generate a lower return.

Worth=Net Present Value (NPV)

At this stage, you may be asking yourself what exactly is ‘worth’? Simply put, ‘worth’ is the net present value (NPV) of the cash flow received from owning the property. To arrive at your NPV value, you have to project forward your future cash flows and apply a discount rate to the cash flows. Your discount rate can be thought of as an investor’s required rate of return.

Next, Malcolm provides an overview of the components of the cash flows. The first component is rent. Within rent, an analyst has to model the current rental value, rental growth and consider the lease terms/ rent review provisions. For example, the current rental value is an estimate of what the property would let for in the market today. You would then apply the rental growth to the current rental value, adjusting it for provisions listed in terms of the lease. For example, you might have an index-linked lease or upwards-only rent review.

The second component is dealing with vacancies. At the end of the lease, you should include a potential vacancy period. Within this, you should consider the tenancy rollover rate and the letting period. You may also get a vacancy in the middle of a lease if there is a tenant default. Thus, the tenant defaults risk will also affect cash flows.

The third component is deducting irrecoverable costs. As Malcolm explains, irrecoverable costs are linked to the level of vacancy. When your building is fully let, you have much lower costs than when the building is vacant. Moreover, other costs to consider are capital costs. Malcolm describes capital costs as those “year on year costs that are associated with just maintaining the fabric of the building.”

Next, Malcolm explained the discount rate components, i.e., the required rate of return for the investor. In this context of discounted cash flow analysis, the discount rate refers to the interest rate used to determine the NPV of the building. This discount rate is composed of a risk-free rate and a risk premium. The components of the risk premium include volatility, liquidity, and transparency. Firstly, the volatility of the cash flow.

Simply put, investors require a higher return for more volatile cash flows. Moreover, the volatility risk premium will be specific to the individual investor. Secondly, there is a liquidity premium—the more liquid, the lower your return requirement. Thirdly, transparency. That is the transparency of the property market. In this sense, transparency can be understood as a country-risk premium. For example, developed countries are considered more transparent than developing countries. Thus, the transparency risk-premium component is likely to be lower in a developed versus developing country.

Stock Selection

Next, Malcolm provided an overview of where stock selection tends to work. According to Malcolm, there are three different types of stock selection:

  • passive stock selection
  • active management of the property
  • simply knowing more than your competitors

These are essential strategies to consider when trying to determine the worth of a property.

Next, Malcolm walks through the cash flow and discount rate analysis when conducting a real estate appraisal. As mentioned before, the first step is to any assessment is determining cash flows. According to Malcolm, the goal is to find a property you can let for more than everybody else thinks they can achieve. Consequently, this requires knowing or having more information than your competitors. Malcolm emphasizes that investors must be wary of the current rental value because there is a high degree of uncertainty about its value. Moreover, capital costs are routinely underestimated by investors, who fail to consider how expensive assets are to maintain. Ultimately, if you can estimate those better than your rivals, then you can achieve superior returns on your stock.

Turning to the discount rate, you can get a situation where the market applies a much higher risk premium to specific properties than justified. Thus, if you can spot that, you can potentially deliver superior stock selection or risk-adjusted returns.

The Winner’s Curse

To conclude, Malcolm provided insight into the “Winner’s curse.” As Malcolm explains, acquiring commercial real estate is ultimately a bidding/auction process. You have lots of people working on their individual cashflows trying to work out what properties are worth. Therefore, the bidder with the highest amount likely has the most optimistic assumptions. Malcolm describes how this creates the “Winner’s Curse” i.e., the tendency for the successful bid in an auction to be greater than the true worth (intrinsic value) of an item. The bidder, must by definition, have had higher expectations or lower return requirements than all the other bidders.

Nonetheless, Malcolm believes there are five primary ways to alleviate the curse. Namely through possessing the following: superior information, superior management skills, access to deals no-one else has seen, and/or the ability to execute complex deals.

 

Author: Khathutshelo Nematswerani