I just got back from an advisor conference in Denver Colorado last week. Well, technically I was in Aurora, but I’m rounding. I have been to Denver several times over the years and with each visit I’m saddened to see the rapid sprawl and over-development of such a beautiful place.
Our conference was held in brand new Gaylord conference center near the airport. The facility was beautiful but it stuck out on a prairie and looked so out of place, like a massive goiter jutting up from the ground.
See the picture that I took from the hotel lobby looking west towards the majestic Rocky Mountains in the background, then the respectable Denver business skyline and then a ghastly housing development in the foreground. What a weird place to build an expensive resort hotel.
One of the conference speakers recounted a remarkable story about how the A&W fast food restaurant chain tried to take on McDonalds and the Quarter Pounder head-on in the 1980s. They rolled out a one-third-pound burger for the same price as the Quarter Pounder. The A&W burger even beat the Quarter Pounder in several blind taste tests. However, the product flopped and A&W’s perplexed management team hosted focus customer group sessions to learn why.
Per A&W’s CEO at the time, a common reason given was many folks deemed the “3” in 1/3rd to be smaller than the “4” in 1/4th and thus incorrectly assumed the A&W burger was smaller than the Quarter Pounder and an inferior value. Defeated by the American public’s lack of understanding of fractional math, A&W dropped the burger product altogether.
Our planning process is rooted in statistics and it has been said that five of four Americans don’t understand probability either (just kidding). My takeaway is the affirmation that financial illiteracy is a national problem, which is in part due to the erosion of basic math skills. Perhaps that’s why the US has racked up twenty-two trillion in national debt and growing.
In the investment world, we like real estate math. We consider investment real estate to be a key asset class that can materially diversify investment portfolios. Investment real estate does not include your house, which is not a financial asset. It also does not include publicly traded real estate investment trusts (“REITs”) and real estate mutual funds, which behave more like income stocks and can be quite volatile.
Investment real estate is directly owned and/or non-traded realty assets that pay recurring rental income and which will, ideally, appreciate in value over time. It can be an especially attractive tax shelter due to depreciation and interest expense tax deductions; the federal income tax code is kind to investment real estate in general. Direct-owned real estate can also serve as an effective inflation hedge at times.
We like direct-owned real estate because its performance over time has been mostly unlinked to stocks and bond performance. For example, the correlation of direct-owned real estate to US stocks has quite low over long periods of time. “Correlation” is a fancy statistical term that measures the degree to which two asset classes perform similarly. Low correlation assets reduce risk in an investment portfolio and, historically, direct-owned real estate has generated excellent risk-adjusted portfolio returns.
Conversely, publicly traded REITs and real estate mutual funds maintain a high correlation to US stocks. In fact, publicly traded REIT stocks were one of the worst-performing asset classes in the great bear market of 2008-2009. That’s the exact opposite effect of portfolio diversification.
Now, before you run out and buy an apartment building, it should be noted that US real estate in general aint cheap anymore. Cheap money from really low interest rates and easy lending has driven up asset prices of all stripes, including US real estate. “Cap rate” is the math term that real estate professionals use to value investment real estate. It is expressed as a percentage and is essentially the net operating income produced by the real estate asset divided by its market value. A low cap rate can suggest undervaluation, inasmuch as the realty income production may be sub-standard.
Retail real estate is an example of a realty sector with deceptively lower cap rates today due to its underperformance - e.g. the rising number of empty malls and retail store fronts – and not due to overvaluation factors. However, the retail realty sector is the exception to the trend across most other US real sectors that have low cap rates to due full valuation or beyond.
Accordingly, we have adjusted our real estate investment approach and are looking at global real estate as a relatively more attractive asset class. The current lackluster economic conditions around the developed world, especially Europe, coupled with a strong US dollar makes international real estate investing more affordable and interesting.
Remember the buying frenzy by Japanese investors of US real estate assets in the 1980s? They purchased a lot of US real estate, including the iconic Rockefeller Center and Pebble Beach golf course because the Yen currency was so strong relative to the US dollar. When the value of the US dollar eventually rallied and the yen fell several years later, the Japanese sold their US real estate holdings at enormous profits.
We believe there are similar opportunities for US investors to capitalize on higher cap rates and the strong dollar by investing in real estate abroad. We can handle the fancy math!
Until next time, be well……Tim