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C

Posts for simple-sums



On The Threshold: Three books for real estate investors to live by

By Alessandro Pasetti, 15 February.

There are books you read that never leave you, and following the huge swings in financial markets since early February, I was reminded of some of those when thinking about how real estate investors ought to consider their positions in relation of other forms of investment.

(Source: financialtalkies.com)

Is a financial meltdown around the corner? 

Watching financial market events unfold by the hour is bad for your blood pressure, but some lessons I learned from reading have often helped me make better choices.

I have closely monitored the ups and downs of the past 20 years, from the dot.com bubble at turn of the century to the real estate and banking crash a decade ago and, indeed, further back. When I was a kid the private equity binge of the 1980s culminated in 1987’s Black Monday, which remains a worst-case scenario in terms of making investment decisions. In those years junk bonds doped financial markets where stellar inflation rates were still dropping from the second Oil Shock in 1979. 

I have been thinking about how these events (most I read in the books mentioned below) shaped my behaviour in finance matters, and how correlated they were to prevailing interest rates trends of the times.

Ultimately, I want to help you filter all the nonsense written when the bears, with grand fanfare, point to the nearing collapse of the real estate market, driven by a financial meltdown — there have been many strange headlines in the British press in both regards lately, spurred by the recent fall in the FTSE 100.

One typical Inveztments reader recently argued that comparing, for example, the housing markets in Milan to London, and their historical trends, it was easy to predict a further 50% decline in prices in London over the medium term. The lesson this gentleman appeared to forget was to compare apples with apples; barring growth considerations, here we have two very different investment by liquidity (and location).

Which reminded me of When Genius Failed.

That book changed my perception of risk: a masterstroke of how the cleverest humans on earth made their fund implode because their binary trades, which were meant to be perfectly hedged, weren’t hedged at all. Masterminded by Irish-American fund manager John Meriwether and other brilliant fellas, Long-Term Capital Management (LTCM) used the work of finance scientists Scholes and Merton, who were awarded the 1997 Nobel Prize in Economics thanks to their option pricing modelling.

“Scholes’ work had inspired a generation of mathematical wizards on Wall Street, and by this stage both he and Merton were players in the world of finance, as partners of a hedge fund called Long-Term Capital Management,” the BBC wrote years ago.

Look at the demise of LTCM, and how it financed its trades — think of it as if you bought a property, remortgaged your equity shortly thereafter, and then with that borrowed money bought a risky investment where Bitcoin is the riskiest in the spectrum today. That, in 1998, was Russian debt, which plummeted in value during a very hot summer for many traders.  

Leverage clearly compounded problems of a fund that evaporated in a flash, just like this month the value of a security conceived by Credit Suisse – essentially set to trade against volatility — evaporated overnight.  

In late September 1998, LTCM was taken over by its lenders — in those days interest rates in the US rose 200 basis points to 4%, then reaching 6%. By comparison, in recent weeks US benchmark rates have risen swiftly from only 2% to 2.8%.

(Your cost of funding might soon go up more than that, depending on how banks react, increasing your  mortgage costs.)

They say real estate is risky 

In the 1990s it began with LTCM and ended with Enron, which declared bankruptcy in December 2001. Rates during the LTCM-Enron period — at the post-heights of the dot.com bubble — rose from 4.4% to 6.6%, more than doubling current levels. Enron shareholders, of course, were wiped out.

The classic tale of the Enron affair is The smartest guys in the room. It touched upon capitalism and side effects, I learned that accounts can easily be faked even though regulators should prevent retail investors — you and I — from being scammed. Enron (click here to see how its downfall began) was essentially a massive conglomerate of Chinese boxes where accounting fraud was the rule. The property market is a good example of transactions that are often opaque, and that is why due diligence is an affair you often need help for. The Team of Inveztments performs close scrutiny on builders, and their financials, and this is clearly a plus.  

Before we move onto the third book and why all of this matters to real estate investors, think about where the 10 US Treasury bonds trade – what’s their yield?

While it is true that regionalisation in the real economy poses a threat to globalisation, finance is global and all markets are intimately tied to the driver of value — the US, where the fall in stock and bond prices in the past few weeks shocked, and badly harmed, stock and bonds traded in Asia and Europe.  

Shorting Europe and the euro? A bad idea? 

Call it transmission effect: interest rates in the US matter, and no doubt the Bank of England is looking to catch up with the Fed and open the gap with Europe in terms of interest rates hikes. The Fed was the first brave bank to push up rates a couple of years ago, although interestingly, it has been slow since.

Finally, The Big Short is a thoroughly entertaining read, even if it does describe the near-complete demise of the entire financial system, and the world as we know it. When Lehman Brothers collapsed due to troubled bets on derivatives and real estate, interest rates fell from 3.8% to a floor of 2.2%, but the plunge had started earlier when rates were at 5%.

The allure of barring a Japan-like scenario is obvious, but there are similarities. (Seeking Alpha this week wrote: “Japan’s economy grew at an annualised rate of 0.5% in the final three months of 2017, capping an eighth straight quarterly expansion and the longest growth streak in nearly 30 years”). This could be a very long cycle, which gives more time to profit to investors and realtors.

So, if you are ready to bet on short-term capital appreciation in the housing market, make sure you gauge what kind of risk you are embracing before the US reaches the critical 4.5%-6% threshold at some later point — given the shape of the yield curve, and three likely rates hikes each of 25 basis points (0.25%) a year in 2018, 2019 and 2020, you’ll have time to reap the rewards before the next financial meltdown occurs. And by then you’ll also hold an investment with more defensive characteristics.

To contact the team of Inveztments and discuss the prospects of their flagship projects please click here.

(This post was written by Alessandro Pasetti. Ale is the founder of Hedging Beta Ltd. He writes about investment strategy and assets valuation for European clients as well as Seeking Alpha. Based in London, he previously worked for about five years at Dow Jones/The Wall Street Journal, producing analysis for the IB community. Prior to that, he contributed to the launch of London-based Loan Radar, where he worked for three years. He had stints in equity research at Bear Stearns in London, HVB in Munich, and Unicredit in Milan. 

It was edited by Gavin van Marle, managing editor of London-based The Loadstar. Gavin is also the author of the book Around the World in Freighty Ways: Adventures in Globalisation. He has won numerous awards, including the Seahorse Journalist of the Year 2011 and 2009, and Supply Chain Journalist of the Year 2010 and 2014. )

On The Threshold: Brexit's silver linings could turn out to be gold

By Alessandro Pasetti, 31 January.

Do not say you had not been warned about the possible benefits of Brexit, and luckily the window of opportunity remains wide open in the real estate market, because uncertainty is likely to continue, which is exactly when good deals could easily turn into the bargain of a lifetime if you pick the right assets. 

In the wake of the latest news concerning the health status of the UK, there is no need to feel bad if you didn’t see it coming – you were in good company.  

(Source: New York Times)

Even the experts at the Office for National Statistics recently admitted they misjudged domestic growth data, while a slew of City brokers I have talked to since the 2016 referendum have often raised concerns about the outcome of this Euro-British saga. Many pundits are unconvinced an amicable deal is on its way but in my opinion political repercussions and commercial risks will be manageable.

Moving parts

There are certainly many moving parts when choosing to invest in the UK and its property market, not least because the London real estate sector since last year has been less enticing than for two decades, and inevitably that negatively affects business “sentiment” — and, in turn, GDP growth estimates. But on the bright side, a top-down approach suggests that there is little to fear nationwide, as many other major big cities — where Inveztments operates — are in a sweet spot, while recently released fiscal deficit numbers for the UK were pretty good.

(Source: Trading Economics)

Other trends for net borrowings in the UK were not bad at all, either.

(Source: ONS)

Other encouraging signs have been visible since last year.

“UK budget deficit narrows to lowest September level since 2007,” was the headline of a story published by The Guardian at the end of last year, which did not overlook that fact we have returned to pre-2007 crunch levels.

Comparables 

Some headwinds remain but there is no better time, I reckon, to assess the conditions of a market where prices could easily move in lockstep with the growth rate of domestic inflation — see the CPI chart below — for years to come, and compare the credit risk embedded in property with other asset classes.

(Source: Trading Economics)

Say you are keen to invest in equities, and you have been looking for a global brand that traditionally offers steady income in the form of dividends and, possibly, some capital appreciation at the right entry point.  

For example, how about General Electric, a company I have closely followed for years?  

(Source: Bitcoin News. The chart above shows the correlation between GE’s stock price and Bitcoin until late 2o17)

In the week commencing 22 January, the stock of this American behemoth, which has a strong investment grade rating – this means the rating agencies believe its business is highly cash generative and able to withstand cyclicality — has been as volatile as any other highly risky assets, such as Bitcoin.

(Note for the reader: GE is rated above Spain and Italy, the fourth- and third-largest European economies, and is considered healthier than either country based on many financial/cash flow metrics. Incidentally, it recently halved the dividend to $0.12 quarterly.)

Did you notice how the two trended last week?  

(Source: Yahoo Finance)

This has a lot to do with real estate investment as well as a key concept, known in economics as opportunity cost, according to which your paper loss in not only the capital appreciation you forgo if you pick the wrong asset, but also, adding insult to injury, the loss of possible gains stemming from a better-performing asset class (or, in GE’s case, the stellar performance of the shares of virtually all its industrial rivals in the US).

Say you don’t fancy exposure to equities: It is risky, and a comparison with the real estate market is a bit of a stretch because GE’s asset portfolio renders its associated returns more cyclical. But let’s stick with GE and imagine you have already opted for a safer investment profile, one closer to long-term real estate assets, given its seniority in the capital structure — its bonds.

But with these you would also have faced volatile trading conditions. If you had acquired its 2042 bonds with an annual coupon of 4.125% (the yield is higher), which are a decent comparison for real estate investment given their duration – investing in real estate puts you in a similar position to a bond trader seeking “durable liquidity” along with the upside, although GE would have given you good reasons to be a bit worried about capital appreciation.

(My full coverage of GE for Seeking Alpha since November 2015 can be found here.)

(Source: boerse-berlin.com)

The bonds are under pressure, while GE equity has lost about 50% of its value in less than one year — roughly the same percentage Bitcoin shed in less than three months — and bondholders now wonder whether the liquidity profile of the company is sound.

(Source: MarketWatch)

GE has disappointed investors, particularly those who did not do their homework properly. 

(If you are invested at the long-end of the yield curve of Italy’s BTP or any similar debt obligation, you might want to reconsider your options, too, unless massive gains accumulated over the past few years lead you to want to stay put to avoid a large tax liability.)

Sound advice

The problem goes to the heart of risk perception and due diligence. A senior analyst who covered GE in the heydays of Jack Welch twenty years ago recently told me:

“It is extraordinary how many GE shareholders deliberately chose to stand flat-footed and disinterested over some or all of the past 18 years as their investment drifted away from the performance of the market averages, but, instead, clung to their own unchallenged opinions and convictions. Layer on top of this their utter incapacity to even understand the underlying financial dynamics of GE is just as odd. Yet, of course, this hasn’t stopped one of them from screaming they’ve been robbed and cheated.” 

Following remarks from the ECB President Mario Draghi last week, the yield of German debt spiked, which meant a paper loss for its holders. Given that quantitative easing prospects have dramatically changed in less than six months, more losses could be on their way for several fixed-income securities.

Where to invest, then, if you are looking for a safe haven?

Convictions

We all hold convictions, and all we are trying to do on this platform is to stimulate debate and sketch out a first round of due diligence before any real estate purchase is actually made, just as we would do with any other asset classes.

So, with a critical view, what could be so wrong about the UK and property? 

Notably, the pound recently hit its highest level against the US Dollar, while it is consolidating a level significantly higher than 1.13 against the euro as government bond prices continue to fall, pushing up rates whose ascent had to be expected – all these factors bode incredibly well for real estate investors, until a critical threshold of over 3% for 10-year rates is reached (we are currently at about 1.4%).

(Source: BBC. Sterling appreciated further to flirt with the 1.43 level against the US Dollar at the end of the week commencing 22 Jan)

(Source: Yahoo Finance. GBP vs EUR, year to date)

(Source: Yahoo Finance. GBP vs EUR, six months)

Oil prices, meanwhile, are the fear gauge in many respects but could also propel inflation and perhaps benefit a real estate market where, as the Financial Times recently wrote, the value of UK’s housing stock grew by a third to £7.14tn in the past decade.

As far as the risks in the financial market are concerned, I warned readers at the end of 2017 on the prospects of homebuilders, gauging their risk profiles against Bitcoin and other asset classes. In October, I wrote it was possible that profit-taking would put some pressure on these stocks, but the homebuilders’ fundamentals are rock-solid, and remain so. Look at how the shares of the main players in the UK have fared since before Carillion imploded. 

Market specialist Savills says its UK estate agency branches enjoyed a strong finish to 2017 despite “uncertainty”, while in a trading statement, one of the UK’s largest house builders said the market remained “solid” despite wide economic uncertainty, which also weighs on the Eurozone given that this year Italy goes to the polls.

(Source: Taylor Wimpey)

The recent demise of Carillion was not a Black Swan event per se, but rather a one-off event that the government is still assessing — perhaps Downing Street could have done more to prevent its collapse, given Carillion’s working capital and debt maturities, but neither the exchange rates nor interest rates (see the chart below) were affected this month.

(Source: Bloomberg)

Which again proves that while some may fret about Brexit, there are deals being done and money being made by investor who can recognise the sound of opportunity knocking.

(If you want to know more about how to manage risk and the full details of the latest projects, please contact the team here.)

(This post was written by Alessandro Pasetti. Ale is the founder of Hedging Beta Ltd. He writes about investment strategy and assets valuation for European clients as well as Seeking Alpha. Based in London, he previously worked for about five years at Dow Jones/The Wall Street Journal, producing analysis for the IB community. Prior to that, he contributed to the launch of London-based Loan Radar, where he worked for three years. He had stints in equity research at Bear Stearns in London, HVB in Munich, and Unicredit in Milan. 

It was edited by Gavin van Marle, managing editor of London-based The Loadstar. Gavin is also the author of the book Around the World in Freighty Ways: Adventures in Globalisation. He has won numerous awards, including the Seahorse Journalist of the Year 2011 and 2009, and Supply Chain Journalist of the Year 2010 and 2014. )

 

On The Threshold: Simple sums

By Alessandro Pasetti,  December 2017. 

I was lucky enough in a previous career to work with a brilliant writer for the Wall St Journal who once sagely advised me when life periodically took a wrong turn: “There are some problems you can blame on the government; the rest you can blame on your wife.” I have since used that as prism – if neither applies you can only blame oneself… and frankly, if you can’t see the opportunities in the Inveztments portfolio neither the government nor your marriage is at blame; it’s more likely simple maths.

Arithmetic

Inveztments managing director Tonino Montesanti has reassured me about the returns that investors today can expect by deploying capital in two types of real estate picks contained in its portfolio. 

Tonino Montesanti, Managing Director of Inveztments

It’s pretty simple arithmetic: you shell out £120,000 at 7% for a residential investment or unit, and in year five you’ll have pocketed £42,000. With a capital appreciation of 5% per year (amounting to £30,000 by year five, assuming the value of the initial investment was £120,000), and you would have recouped 60% of your initial investment by 2022 — in addition, it is very likely that you’ll be able to sell the asset at that point, while dictating the price for the unit/apartment.

Multiply £72,000 (£42,000 plus £30,000) by two, and – in what is effectively a worst-case scenario given historic trends for capital appreciation – you should be looking at a pre-tax gain of £24,000 in year 10. Even with minimal capital appreciation, in a decade you’ll have covered the majority of your initial invested capital, whilst also owning the underlying asset. £84,000 will have covered 70% of your investment. 

(These calculation excludes tax considerations, management fees, service charges and ground rent, which Inveztments estimates could amount to about £1,050 yearly, based on the aforementioned example. A £11,600 tax allowance acts as a shield on the annual yield. An excel calculator is available upon request for clients.)

Base-case scenario

More realistically, your yield will work as if the real estate investment were a fixed-income security, one rated almost investment grade, “but yielding more, and your capital appreciation will likely be higher, considering trailing trends”, Tonino pointed out. 

(Source: Trading Economics, UK House Price Index. “House prices in the United Kingdom rose 4.5% year-on-year in the three months to October 2017, following a 4% gain in the previous period, in line with market expectations. It was the steepest increase in house prices since February but still below a peak of 10% recorded in March 2016,” according to Trading Economics. Other data on house price inflation can be found here.)

Let’s try another calculation. Rather than applying a 5% rate to the initial investment, what about a more modest 3% growth rate annually (it’s the magic of compounded interest vs simple interest)? The total amount investors will fetch in year 10 is over £240,500, for a respectable compound annual growth rate (CAGR) of 7.2%, on an all-in basis (capital appreciation plus yield) against roughly 2% previously.  

The above is modelled on the North House (Liverpool) investment, part of Inveztments portfolio, and full details can be found here.

“Yes, that is a good proxy indeed,” Tonino told me.  

(Full details and break-down by geographical areas are available here, with data from 1973 on.)

Irons in the fire 

The team has other irons in the fire, with student accommodation properties also in a sweet spot.  

A smaller investment amount of £60,0000 for a unit will yield 9% annually, and over five years gives you £27,000 in total coupons, which covers almost half of your initial cash outflows on a pre-tax basis. Again, if we apply a 5% rate to the possible appreciation of the capital invested on day one for the entire duration of the investment (and also assuming inflation will likely remain subdued for some time despite all the quantitative easing we have witnessed over the past decade), the numbers look very appetising – and if you apply annual market rates, your CAGR will be just awesome.  

Newcastle-under-Lyme’s Orme House is a top student accommodation development we currently offer, and it’s rather appealing,” Tonino said. 

Of course, a key question concerns the liquidity profile of the investment – and one gauge here is to check the “project turn” based on the total number of projects managed by Inveztments against how long they stay in the market for. in other words, how long it takes for each unit or apartment to be sold since the day it entered the portfolio.  

It is difficult to set this in stone but usually the window of opportunity shuts down after six months, based on the internal data I sighted, which is pretty good.

There is appetite for finished properties as well as new developments, but the ultimate choice depends on your risk profile.  

As a final side note, the latest Budget (November 2017) is likely to be a net-net positive for the industry, as it might boost first-time buyers’ appetite despite certain tax considerations that could harm short-term returns.

Want to discuss further this topic and other investment opportunities in real estate? Please contact our team here.

(This post was written by Alessandro Pasetti. Ale is the founder of Hedging Beta Ltd. He writes about investment strategy and assets valuation for European clients as well as Seeking Alpha. Based in London, he previously worked for about five years at Dow Jones/The Wall Street Journal, producing analysis for the IB community. Prior to that, he contributed to the launch of London-based Loan Radar, where he worked for three years. He had stints in equity research at Bear Stearns in London, HVB in Munich, and Unicredit in Milan. 

It was edited by Gavin van Marle, managing editor of London-based The Loadstar. Gavin is also the author of the book Around the World in Freighty Ways: Adventures in Globalisation. He has won numerous awards, including the Seahorse Journalist of the Year 2011 and 2009, and Supply Chain Journalist of the Year 2010 and 2014. )