From a small northwestern observatory…

Finance and economics generally focused on real estate

Archive for October 2020

Trophy Property

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As you all know, earlier this year I put the finishing touches on Real Estate Valuation and Strategy, published by McGraw Hill. (The link to the right takes you to the Amazon.Com page, but it is also available thru Barnes & Noble, Books-a-Million, and other regular business book retailers.) While finalizing this, I was simultaneously outlining my next two, one tentatively titled Stigma: Revisited Again and one on Trophy Property Valuation. The former is still in the outline stage, but the Trophy Property book is coming along nicely. Of course, dealing with Covid and assorted ramifications has slowed down a lot of things on my agenda, but hopefully I can move forward this winter.

The genesis of the trophy property book came from the work I did in the valuation of historic property, architecturally valuable property, and historic districts, mainly back in the 1990’s. I actually started writing Trophy Property with an eye to just those narrow niches, but came to realize that there is more of a need for a broader book, examining “preseravable” properties in the context of top-tier, collectable real estate.

My former business partner, and good friend Dr. Bill Mundy, wrote a series of articles for The Appraisal Journal some years ago on this very topic. At the time, his focus was mainly on collectable ranch lands and western “open space”, but the general paradigm holds for all manner of high-end, collectable “trophy” real estate. His definition of trophy property, broadly speaking, was the top 2.5% of any property in any given sector. Thus, one could have trophy residences, trophy forests, and even trophy commercial property. This last category is particularly fascinating — consider the top-tier office building or buildings in any major city. For example, consider Rockefeller Center or the Empire State Building or the Chrysler Building in New York City. Each of these, and many more like them, are owned not just for the direct income but also for the “halo effect” that owning such a building can have on a portfolio. Of course, the owners of such buildings expect top-tier rents and returns over time, consistent with the reputation of such properties.

Right after the 9/11 attacks, I was called in by some real estate investors to discuss the very special security needs — and thus valuation implications — of “trophy” office properties. While every major office building in the world faces heightened security today, as compared to 20 years ago, it almost goes without saying that high-amenity “trophy” buildings can be of particular concern.

Valuation of such properties is a challenge, and requires a significant level of experience, expertise, analysis, and often unusual data. Several years ago, I was asked to value an island off the coast of New Zealand. While such islands trade hands regularly, this particular island had been developed as a trophy “get-away” by a Forbes-400 family. Normal valuation metrics hardly applied, and the value of the island had to take into account the global market for such complex properties.

With that in mind, there are some generalities that transcend all sectors of trophy property investing, valuing, and curating:

  1. The market for a trophy property is often global, not just local. Valuation of any asset usually requires consideration of recent sales of comparable properties. However, what is comparable? For that matter, what is the market?
  2. Trophy properties often require care and maintenance above and beyond the norm for non-trophy properties. Again, consider just the security concerns. Consider also that “trophy” properties often have life-spans well beyond the economic norm. One great example are homes of ex-Presidents of the U.S. or other famous individuals, which are carefully maintained, at great expense, even though they are usually well beyond their economic or structural lives.
  3. Income producing trophy properties, such as offices or high-end retail establishments (think “Tiffany’s”) have very different capitalization metrics. Much like distressed properties have higher equity ROI expectations, trophy property may have much lower or even non-existent equity dividend rates, because…
  4. Value expectations are either in very-long-term growth prospects, subjective benefits, or halo effects. As a result simplistically determined market values may be very far different from more complex investment values. Indeed, more often than not, trophy properties sell at investment values rather than a more quantitatively determined market value. This point confounds professionals in the valuation field. If trophy properties trade at investment (rather than “market”) values, the don’t these investment values BECOME the market value? Indeed, this is a troublesome question, of no small concern when considering point 5…
  5. The tax implications for trophy property can be enormous. Many trophy holdings are curated to provide tax credits, and thus come burdened with easements with implications for down-stream owners. However, determinations of the bases for such credits requires a stylized measure of “market value” and defending this can be a challenge when similar properties are sold for complex purposes.

Point 5 gets even more complicated when dealing with a pure tax credit as opposed to a sale (or swap) of property to the Federal government. As it turns out, different valuation rules apply, and so even “market value” may be two different numbers, depending on the intended users of the valuation.

I know this is a scattershot of information about trophy property holdings, the implications for valuation, and the potential benefits. Acquisition, management, and value optimization are all dynamic elements. Real Estate Valuation and Strategy dealt with these topics in the context of overall real estate investment, and hopefully I’ll have the chance to drill down on these issues more closely in the next book. In the meantime, and as always, if you have any questions, I invite you to reach out.

John A. Kilpatrick, Ph.D., MAI —

Written by johnkilpatrick

October 26, 2020 at 10:30 am

Posted in Uncategorized

ACCRE: REIT Investing and Mid-Month Report

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This is normally the point in the month when I provide the portfolio stats for ACCRE, specifically the Sharpe Ratio and the correlations with the S&P. I’ll do that at the end. First, though, some questions I’ve received over the past month lead me to provide a primer — perhaps more of an abstract of a primer — on REIT investing in general. Note that during troubling economic times, investors regularly look to real estate as a safe haven. REITs can provide that pathway, but only if investors understand a few of the basics.

What is a REIT? — The modern-day Real Estate Investment Trust (“REIT”) is a creature of the Tax Code, and specifically (and I still find this humorous), an amendment to the 1960 Cigar Excise Tax. Without boring you too much, if a real estate trust is structured in a certain way, then the income from that trust can be passed thru to the investors without paying corporate taxes. Now-a-days there are a lot of ways of accomplishing this tax feat, but w-a-a-a-a-y back in 1960, only REITs were a viable solution to this problem. Remember that the maximum tax on unearned income back then was 70% and in some cases 90%. Figuring out a way to make this income a pass-thru without double-taxation was (and still is) a big deal.

In the early days, REITs were mostly “captive” of big corporations or other entities. A retail business might move all of their real estate (and mortgage debt) into a REIT just to get it off the books and thus make the returns look better. The REIT existed only to hold all that paper. Nothing really changed. However, over the years, REITs began spring up as for-profit entities on their own, to specialize in certain property types, and to get listed on the New York Stock Exchange (or later NASDAQ). In many ways, the mid-1990’s was saw a real shift in REIT management style, and the modern day REITs are now largely stand-alone investments. (There are some exceptions, but they are rare.)

REITs and Liquidity — REITs basically fall into two categories: Public and Private. Private REITs are fairly similar to private equity funds or hedge funds, and provide very little in the way of liquidity. There are a lot of reasons to organize a private REIT, but trade-offs require a high degree of investor sophistication. Conversely, public REITs trade just like stocks. They are liquid, marginable, and often can be “shorted” or have options just like stocks. Specialists or NASDAQ firms make a ready market, and they often trade in the after market. Settlement terms are the same as for any other stock.

REITs Specialization — Long ago, a particular REIT may own a smorgasbord of assorted property. There are still a few that do that (“diversified” REITs). However, today, REITs largely specialize into several sectors:

  • Industrial
  • Office
  • Retail
  • Lodging
  • Residential
  • Timberland
  • Health Care
  • Self Storage
  • Infrastructure
  • Data Center
  • Diversified
  • Specialty
  • Mortgage

Within these sectors, individual REITs tend to focus on specific areas. For example, Regency Centers (REG) is a Retail REIT focused primarily on grocery-anchored centers, usually thought of as “neighborhood shopping”. Tanger Factory Outlet Centers (SKT) is also a Retail REIT, but, as the name indicates, invests in outlet centers (currently 39 of them in 20 states and Canada).

REIT Information — The National Association of Real Estate Investment Trusts (NAREIT) maintains a wealth of info on 195 publicly traded REITs. Note that there is also some data there on a limited number of private, and “public but non-listed” REITs. Further, your favorite data sources, such as your trading platform or Yahoo Finance will also be great sources of free information.

Unfortunately, real estate in general is not well understood by financial advisors, and REITs are simply a highly liquid way of investing in real estate. Thus, an advisor may know a lot about, say, pharma or tech, (or both, for that matter) but ask him or her about the retail sector or housing or even something as tech-related as data center warehouses, and you will all-too-often get a blank stare.

As always, if we can answer any questions, either on big stuff or small stuff, let us know. We’re here to help.

And now on to our mid-month report. September, as you know, was not a great month for the market in general. The S&P 500 pulled back over 6% last month, and has only recovered a bit of that so-far this month. Generally, we aim for ACCRE to be only partially coincidental with the S&P 500, thus providing some attenuation during down periods. However, for reason’s I’m still exploring, ACCRE fell much closer to lock-step with the broader market downturn in September.

S&P 500:
Average Daily Excess Return0.0327%
Standard Deviation1.3451%
Sharpe Ratio2.4315%
Average Daily Excess Return0.0455%
Standard Deviation1.1540%
Sharpe Ratio3.9436%
Correlation (overall)56.4666%
Correlation (monthly)73.4120%
ACCRE Metrics as of September 30, 2020

Notably, the previous monthly correlation was only about 52%. That’s a point of some interest, and we’ll want to get the correlation, on a month to month basis, back to that level.

Well, that’s about it for this week. Please note that any mention of any particular investment or investment sector is not to be interpreted as a recommendation. Greenfield Advisors, ACCRE, our team members, or our clients may or may not currently have investments which are consistent with or adverse to those mentioned herein. As always, any specific investment should only be made upon consultation with your advisors. Stay safe, and stay in touch!

John A. Kilpatrick, Ph.D., MAI —

Written by johnkilpatrick

October 19, 2020 at 11:21 am

Posted in Uncategorized

Distressed Real Estate

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In 2021, and perhaps beyond, the market is going to be flooded with distressed real estate. On the residential side, we learned a lot of lessons about collateral and loan underwriting in the 2008/10 debacle, but nonetheless, a lot of homeowners will fall into trouble by the sheer length and depth of this recession. As of this writing, this recession is only about a half year old, but most analysts forecast continued economic doldrums for at least a year or more to come, even if we get some immediate COVID cure. Generally, it takes months for residential foreclosures to begin hitting the market. With that, one can readily see a significant number of foreclosures, short-sales, REOs, and distressed listings on the market for many months to come. In some sectors, such as hospitality, full recovery (however one defines that) may not happen for several years.

On the commercial property side, business failures — particularly in retail — are already being documented. A recent report by the accounting/consulting firm BDO documents 29 major retail chain bankruptcies thru the end of August, spanning 5,998 individual stores. In addition, 18 major “healthy” chains, such as Starbucks, AT&T, and Office Depot announced 4,228 closures in the first half of 2020. Add to that the untold number of small chains and individual “Mom&Pops” that are going under and we can readily see a lot of commercial landlords with problems on their hands. One estimate, from Yelp, put the current business closures (both temporary and permanent) at 132,580, and those are just the ones that are tracked by Yelp. In June, the proportion of these which will be “permanent” passed the 50% mark.

Graphic Courtesy YELP Economic Report, 2Q, 2020

Of course, the Yelp report focuses on consumer oriented businesses, such as restaurants, shopping & retail, beauty & spa, bars & nightlife, and fitness centers. As everyone knows, office work has shifted significantly to “on-line” and home-based work. Technology such as Zoom, Go-To-Meeting, and Webex have been a God-send, but from a commercial real estate perspective, this creates a significant level of distressed property.

At Greenfield, we’ve worked on a myriad of distressed property situations over the years, including contaminated property litigation, business failures, brownfield redevelopment, and natural disasters. We’ve made a few observations that may prove handy as our clients and friends tackle these problems going forward.

  1. The Highest and Best Use of a property may significantly change. I was interviewed recently for a magazine article on adaptive re-use of retail property for low-end housing. This can be a distinct possibility in some situations, but this use change will have a major impact on value, and even on the mechanism for determining value. In the case of adaptive re-use, the cost of adaptation may exceed the post-change value. Hence, while the change may be desirable, and perhaps even necessary, the financial feasibility of this re-used is under water.
  2. Markets are slow to re-absorb properties after a severe disruption. If one house goes into distress, I might be able to buy it and turn it into a rental. However, if 25% of the houses in a market go into distress, the absorption period can be enormous. Many investors, even sophisticated ones, fail to take this into account.
  3. A really pretty hotel may turn into a very ugly condominium. In 2006, the famed Watergate Hotel in DC was converted into condos, and at the time the value-add was enormous. However, the cost was nothing to sneeze at, either. I once looked at a hotel that had, in its life, been an assisted living facility, an off-campus student housing apartment, and an extended stay hotel. Each of these uses required different amenities, services, and upgrades. By the end, this hotel was a maintenance nightmare, as different systems never fully integrated with each other.
  4. Physical adaptability may hinge on minor flaws. Consider parking, for example. Downtown CBD offices may require little parking, particularly if most of the workers commute by mass transit. However, conversion of that building to condos, apartments, or a hotel may be a completely different problem, and rendered infeasible by the cost of a simple parking problem.
  5. Environmental issues can be a snag. Some uses (offices, for example) may have a different environmental concern or impact than, say, housing. City governments which counted on high-tax paying commercial properties, demanding little in the way of consumer services, may balk at a conversion to a use with a different array of environmental impacts.

This list goes on, and can be very specific to the property in question. Often, the impacted landlord simply does not have the resources to study or enact a conversion, and so has to sell. However, property sales incur a dead-weight cost on top of the already realized loss in value. Transactional attorneys, brokers, appraisers, and others will need a new level of creativity to deal with this mess. Even if we get Covid under control soon, and we all hope that we do, the real estate disruption will linger for years to come.

Written by johnkilpatrick

October 9, 2020 at 1:36 pm

Posted in Uncategorized

ACCRE, September 2020

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Best of months… worst of months… Most months — indeed, nearly all months — ACCRE’s goal is to attenuate the downturns (thus providing important diversification in the portfolio) and fully enjoy the “bull markets”. Most of the time this works just fine. However, the double whammy of an overall down market, coupled with continued concern in the real estate sector, put us in a bear squeeze in September.

We’ve been in business for 42 months, and and a dollar invested at the inception would be worth $1.63 today, or an annualized ROI of right at 14%. That’s not bad, but certainly could be better. By comparison, if that same dollar had been invested in the S&P, it would be worth $1.42 today, for an annualized return of about 10%. We’re certainly doing well, but the negative currents in real estate have made 2020 a tough year indeed. By comparison, had that same dollar been invested in the S&P Global Property Index, it would only be worth $1.06 today.

I’m sure we’ll revisit our portfolio makeup this month, and as usual, our premium subscribers will receive notification as soon as any such trades are made. In the meantime, if you have any questions about this or any other real estate related matter, please let me know.

John A. Kilpatrick, Ph.D., MAI —

Written by johnkilpatrick

October 2, 2020 at 10:53 am

Posted in Uncategorized

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