From a small northwestern observatory…

Finance and economics generally focused on real estate

Stigma revisited, yet again…

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In 2018, I presented a paper at the American Real Estate Society titled “Stigma Revisited, Again…” It was a play on a seminal piece published by Peter Patchin in the Appraisal Journal some 30 years ago about environmental stigma and real estate value implications. Much was written on this topic over the ensuing decades, and I thought it was time to perhaps bring the literature up to date. As it happens, I and some fellow researchers found that the breadth and depth of the literature is too broad for just one paper. Instead, I’m aiming for a series of essays I’ll collect in a new book in early 2021.

In the meantime, it’s helpful to take a very brief glance at where we stand today. Fundamentally, stigma is the label we put on the loss in market value of an impaired property over and above any cost to remediate. My former business partner, Dr. Bill Mundy, is credited with introducing the term stigma into the appraisal lexicon with “Stigma and Value”, also published in the Appraisal Journal, in 1992. The scholarship in this field has been robust, with intertwined writings on the fundamental psycology of stigma, legal implications, methods, and valuation standards.

Stigma can arise from a property being directly contaminated, contaminated and then remediated, being adjacent to a contaminated (or remediated) brownfield, or even being proximate (that is, in the same neighborhood) as such a property. Kevin Haniger of the USEPA, Lala Ma of the U. Kentucky, and , and Christopher Timmons of Duke, writing in the Journal of the Association of Environmental and Resource Economists in 2016, documented the impact that a brownfield can have on residences within 5 kilometers of a brownfield, in the context of how remediation of that brownfield can impact the values of those surrounding houses. Zie Zhuang of Michigan State, along with a host of co-authors, wrote a piece in the American Behavioral Scientist, also in 2016, acknowledging that the behaviors of market participants, when faced with a contamination problem, were frequently at odds with the facts and even their understanding of the facts. Indeed, this is consistent with a stream of behavioral finance literature calling into question the rational expectations model.

Courts generally understand how stigma works. For example, In Re Bilmar Team Cleaners (Sup Ct of Vermont, 2015 WL 1186157) the Court acknowledged that a property could be stigmatized to the extent of future estimated remediation and other costs. In Harley-Davidson Motor Co. V. Springettsbury Township (Sup Ct of Penn, 2015 WL 5691056), the Court acknowledged that potential for future environmental claims constituted a stigma impact on the property’s value.

I’ll keep you posted as this next book progresses. Wish me luck!

Written by johnkilpatrick

September 11, 2020 at 2:19 pm

Posted in Uncategorized

ACCRE LLC, August, 2020

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A well curated real estate fund should enjoy both above-average returns AND some attenuation of the risk in a securities portfolio. As noted a couple of weeks ago, ACCRE has about a 56% correlation with the S&P, which means that when the rest of the market is charging ahead, we’re tagging along, albeit at a slower pace. However, when the rest of the market falls out of bed, we don’t do so badly.

Case in point was the month of August, contrasted with the first few days of September. August was a gang-busters month for the S&P, and real estate in general did OK as well. ACCRE overall returns continue to be well above the S&P, but it is a horse race! A dollar invested in ACCRE at the inception (April 1, 2017) would be worth $1.73 on August 31, compared to that same dollar in the S&P only worth $1.48. Of course, the overall S&P Real Estate index fell apart after the onset of the recession, and is only partially back in the black today.

All that said, as every investor knows, this week has been painful for the broader market, with the S&P down about 4% since Wednesday’s close (as of this writing, mid-day Friday). ACCRE is also down, but only by about half as much. We’re still fully invested, but of course watching our positions carefully.

I would note that our strategy has been selective both on a macro and micro level. We’re looking for real estate sectors which we believe will do well in this economy, then within those sectors, we look for both the best and worst players. Yes, this is a fundamentalist strategy, but we also pay close attention to what the market is telling us. After all, REITs tend to be a sophisticated investment, and we gain a lot of insight by seeing how other investors interpret the tea leaves.

Best wishes to you all! As always, if you have any questions on real estate finance, economics, valuation, and such, please do not hesitate to drop me a line.

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com

Written by johnkilpatrick

September 4, 2020 at 11:16 am

Posted in Uncategorized

Hospitality and Covid 19

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Probably no real estate sector has been hit as hard as hospitality, which of course includes restaurants, hotels, and the whole travel and leisure field. It’s a big field, employing lots of folks, and occupying lots of space.

McKinsey and Company, a widely respected research and consulting firm, released a study in June on U.S. hotels. It’s already a bit dated, but contains some great insights into how business leaders are thinking about this, and the ramifications of various public policy decisions.

First, McKinsey constructed a common 3 X 3 matrix of low, medium, and high outcomes for Covid containment and economic impacts.

Graphic Courtesy McKinsey, See end for credits

They then surveyed a large number of business leaders — which one of these do you think will be the most likely outcome? In their April survey, 31% opted for A1 (right in the middle) while 16% opted for A2 (broad success on the epidemiological front, but muted outcomes on the economics). By May, these percentages had risen to 36% and 17%, respectively. Thus, a small majority of business leaders do not believe in an economic miracle. By the way, fully 31% in May opted for B1, B2, and B3 combined, with ineffective economic results. Only 10% of respondents thought that economic interventions would be “highly effective”.

Graphic Courtesy McKinsey. See end for credits.

So, what does all this mean for the hotel industry? McKinsey gamed this out, and under both Scenario A1 and A3, hotel revenues are down to between 35% and 45% of 2019’s totals. They then tracked likely outcomes out to 2023, and their model suggests that under A1, hotel revenues are still down by 20% compared to 2019. Scenario A3 is much better, with a near full recovery in 2022, and revenues actually up by 2% in 2023.

Scenario A3 assumed that travel restrictions were lifted for most U.S. domestic travel by June of this year, which was only partially true, and lifted for some international travel by July, which is a mixed bag. A3 assumes that after travel restrictions are fully lifted, buying behavior will be based on economic rather than health related factors, and that there is an effective, scaled-up treatment or vaccination. Of course, neither of these has come true yet. However, there is some hope that the outcomes they had looked for in mid-year may come to pass in early 2021, and so these forecasts can be shoved down the road 6 months to a year.

By the way, not all hotels are affected the same. Luxury properties and “upper upscale” saw revenue per available room (RevPAR) fall by nearly 90% by mid-2020, and these sectors will probably only recover to the 80% point by 2024 (again, given McKinsey’s scenarios). Conversely, economy chains fell by about 40%, and should recover to the 90% point by mid-2024. What’s worse, McKinsey points out that to cover costs, luxury hotels need occupancy rates 1.5X those of economy hotels. Many luxury hotels require a minimum of 100 employees just to open the doors. Economy hotels have much more flexibility in their cost structure.

McKinsey’s white paper is titled Hospitality and Covid-19: How long until “no vacancy” for US Hotels. The authors were Vik Krishnan, Ryan Mann, Nathan Seitzman, and Nina Wittkamp. Click on the title for a link to the paper itself. It’s somewhat aspirational now, but gives a great template for thinking about these issues.

Written by johnkilpatrick

August 28, 2020 at 2:12 pm

Posted in Uncategorized

Brief thought on a Wed afternoon

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For the quarter ending June 30, McDonalds (yes, the hamburger people) reported gross revenues of $3.76 Billion. Let that sink in.

Of that, only $1.59 Billion was from company owned restaurants. The rest, $2.09 Billion was fees from franchisees. (There was also some minor misc revenue, but not much.) So, of the $2.09 Billion from franchisees, $1.31 Billion was from “rents”. That’s slightly over 1/3 of their entire top line, and it pretty much all flows to the net income line. You see, McDonalds owns boatloads of real estate. They own the dirt under the franchisees locations, and rents that dirt (we call those “net ground leases”) back to the franchisees, as a way of controlling the locations.

I point this out to remind you that yes, McDonalds is in the hamburger biz, but they are much, much, more in the real estate biz. For that matter, so is every business, they often just don’t realize it.

Oh, and I’ll do the quick math for you. That means McDonalds will collect approximately $5.2 Billion in rents this year. Let that sink in, too.

Written by johnkilpatrick

August 26, 2020 at 5:01 pm

Posted in Uncategorized

Real Estate Adaptive Re-Use

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On Wednesday, I’m appearing in a video for the Appraisal Institute on adaptive re-use of real estate. It’s a panel of leading experts designed to provide guidance for AI members and others on the impact of the pandemic. My own contributions will mainly be on the adaptive reuse of brownfields and other contaminated sites, and at the other end of the spectrum, high-end properties, such as historic structures, which are worthy of preservation.. However, I anticipate a wide ranging discussion from the panelists.

Consider a building which still has life in it, or perhaps needs to be preserved for architectural or preservation reasons, but the original uses are no longer economically feasible. One of my favorite examples is the old Greyhound Bus Station in downtown Columbia, SC:

1200 Blanding Street, Columbia, SC, Courtesy Google Earth

Built in the 1930’s, it was closed in 1987, but designated for preservation and named to the National Register in 1989. It was acquired by a local bank and adaptively re-used, with the old ticket windows becoming teller windows. The bank eventually left, and the building was adaptively re-used again, now as a plastic surgeon’s office. Clearly, the building still has life in it, and in fact contributes to the Commercial Historic District which is now also listed on the National Register.

Within the National Association of Realtors, there is a great organization called the Certified Commercial Investment Member Institute, or CCIM for short. The CCIM designation, awarded to Realtors who meet their exacting standards for ethics, training, and experience is analogous to the Appraisal Institute’s MAI or SRA designations. The CCIM Institute has been on the forefront of tracking adaptive re-use for quite some time now, as this is an important component of the real estate landscape. They issued a great report on this topic in 2018, and if interested, you can download it here.

The CCIM Institute is in the early states of developing an adaptive re-use index, focusing first on major CBDs such as Los Angeles, Dallas-Ft. Worth, Chicago, Atlanta, and Charlotte. Early sampling, reported in their study, suggests that as of 2018, adaptive reuse constituted 1% – 2% of all commercial real estate space in the U.S., and that figure was expected to grow to about 4% as a result of store and mall closings, e-commerce, and artificial intelligence. I would add that this growth rate will probably accelerate due to the impact of the pandemic and the resultant recession. While these numbers may not seem huge, the CCIM Institute suggests that adaptive reuse is in the early states of its lifecycle, and that this will become an important investment vehicle in the same way that historic preservation became investment-worthy in the early 1980s.

Note that Realtor is a registered trademark of the National Association of Realtors.

Written by johnkilpatrick

August 24, 2020 at 9:00 am

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ACCRE Mid-Month Report, August, 2020

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Diversification is an oft-misunderstood thing. In an individual business, diversification is generally not a good idea. Internal to the business, there is an old saying, “To Dominate, Concentrate”. Indeed, few businesses have succeeeded in more than one line of businesses (Microsoft, General Electric, and to an extent Apple are among the rare exceptions). External to the business, investors like to see an individual firm concentrate in a very narrow field. That’s a function of the way common stocks work. If I invest in a firm, and it succeeds, I reap the rewards, but if it fails, I only risk what I’ve invested. Heads I win a lot, tails I don’t lose that much. This may be the core secret to why capitalism works so well.

But in a portfolio of investments, we want diversification, for two somewhat different reasons. If I pick 10 stocks at random, and half do well and half do poorly, I will be better off, from a probability perspective, than most managed funds. (The writer, Andrew Tobias, demonstrated this on television back in the 1970’s with a monkey throwing darts at the WSJ stock pages.) This explains the popularity of index funds. Second, if I have a well diversified portfolio, then the ups-and-downs of the various stocks will attenuate one another. My overall portfolio value will rise over time, but without the major swings of the individual components.

Now, that brings us to real estate (and my mid-month report). While it’s been well known and understood for many years that real estate is a great diversifier for portfolios, few investors — even the most sophisticated ones — understand how to take advantage of it. In my experience, the majority of investment advisors know very little about real estate, and hence steer their clients away from it (to the detriment of their clients!).

Anyway, ACCRE continues to outperform the benchmarks both on absolute terms (as noted in our end-of-month report) and on a risk-adjusted (Sharpe Ratio) level. Further, our correlation to the S&P is still right where we want it — in the positive direction, but well under 100%.

S&P 500:
Average Daily Excess Return0.0308%
Standard Deviation1.3537%
Sharpe Ratio2.2727%
ACCRE Fund:
Average Daily Excess Return0.0526%
Standard Deviation1.1405%
Sharpe Ratio4.6079%
Correlation (overall):56.3606%
Correlation (monthly):57.3961%
ACCRE Metrics as of July 31, 2020

The average daily excess return is the daily return minus the t-bill returns for that day. (For consistency, we use the coupon-equivalent daily T-bill price as promulgated by the U.S. Treasury.) The Sharpe Ratio is simply that daily return minus the standard deviation, thus adjusting for volatility risk.

As we’ve noted repeatedly here, these are complicated times for both real estate and investing as a whole. A well-curated real estate portfolio can provide above-average returns, diversification, and risk attenuation. If we can answer any of your real estate questions, please let us know.

Written by johnkilpatrick

August 17, 2020 at 9:20 am

Posted in Uncategorized

Eminent Domain and Severance Damages

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As I mentioned in my newsletter last week, several of our investment clients – and their attorneys – have called recently about eminent domain “takings” of their investment property.  Specifically, the acquiring agencies often fail to understand how a partial acquisition can impact the highest and best use – and thus the value – of the part remaining. 

Let’s take a very simple example, which is actually drawn from our files from several years ago.  A highway department wants to change the turn radius on a thoroughfare, and will “take” a slice of the front of a car dealership.  The before-and-after sketch looks a bit like this:

The highway department proposed that since they were only taking about 20% of the land, and none of the building, the highway department proposed a very minimal estimate of just compensation – about 5% of the total value of the site.  However, the dealer was able to successfully show that the highest and best use of this site was for a car dealerships, and those were valued heavily on the ability to provide road-frontage display of cars.  Hence, the loss of the ability to display 30 vehicles was a very real damage to the remainder.  The Court accepted the dealer’s theory on this, and the just compensation was significantly higher than originally proposed.

My good friend, David Matthews, and I wrote a chapter about “Rails to Trails” acquisitions in the Appraisal Institute’s 2019 book, Corridor Valuation.  In it we noted, that the severance damages to the adjacent properties can often exceed the value of the rail right of way being taken.  In a recent court case in Oregon, a landlord provided overflow parking for a rental house on an adjacent parcel, which was “taken” for a transportation easement.  The rental house itself wasn’t touched, per se, but now the tenants would have to park on the street.  The landlord was able to show that the loss of the adjacent parcel impacted the marketability of the rental house.  In Sweden, they have done exensive studies on the value impact of new rail lines on adjacent residential and commercial properties, and found that the noise has a statistically significant impact on value, even when no actual land is being taken. 

The examples go on, and while this may seem to be a situationally specific problem, there are extensive common themes and common methodologies which can be brought to bear to measure this.  You’ll probably see more about this from us in the very near future. 

Written by johnkilpatrick

August 6, 2020 at 2:41 pm

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ACCRE LLC, July, 2020

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It was a great month for the market as a whole and real estate in particular. ACCRE earned 7.08% in July, and is now back up above where it stood on Jan 31 (roughly, before the short bear market). Comparatively, the S&P earned 5.51% in July, and the S&P Global Real Estate Index earned 3.08%.

Why is real estate doing well? In part, because the market as a whole is doing well, and there is a lot of liquidity flowing into blue chips and safe vehicles. Further, the soft sectors in real estate were obvious from the beginning — big retail, hospitality, and such. Those tanked early. ACCRE was out of those sectors before the melt-down, so didn’t suffer as badly as the Global Real Estate index. Successful RE fund strategies this year have been fairly obvious — data centers, some industrials, selected office funds, and infrastructure. Of course, not all strategies are alike — some apartments, for example, are heavily weighted in student or senior housing. Some industrial are tied more closely to retail. Some offices are doing well, and others are exposed in the wrong areas. It’s all in the details, as they say.

Anyway, we hope your investment strategies are doing well. We’ll be back mid-month with our diversification report. Until then, best wishes, and stay safe!

Written by johnkilpatrick

August 3, 2020 at 10:10 am

Posted in Uncategorized

Seven Biggest Real Estate Mistakes — Part 6

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To bring new readers up to date, I began a series back in the winter on real estate investment mistakes. This was a follow-up to my new book, Real Estate Valuation and Strategy. Before the Covid-19 pandemic, we’d planned on a speaking tour to promote the book, and so these blog posts would serve as the notes. Well, that hasn’t happened yet!

Anyway, let’s get started with today’s entry. (At the end, I’ll give newbies a quick link to the first 5.)

Mistake #6 — Getting Emotionally Involved

I was on Wall Street nearly 40 years ago at the beginning of the “behavioral finance” era. Before then, we considered two investment laws to be sacrosanct: efficient markets and rational expectations. The first law told us that investors, by and large, had good information and made use of that information. The second told us that you couldn’t out-guess the market, because, on the whole, investment prices properly reflected the present value of all future benefits. Over the years, behavioral finance has taught us that both of these so-called “laws” are just wishful thinking. People may have all the information they need, but they make scant use of it. Further, investment prices may wildly vary from true intrinsic values. This is particularly true of real estate, for which prices and values may be two completely different things. Understanding that fundamental truth is key to successful investing.

But why? Why don’t investors properly price assets? Why do they buy assets at the wrong price, or more to the point, why don’t they sell assets (or buy more!) when the prices and values differ? One major reason is emotional involvement. Simply put, people fall in love with something, in this case, an real estate investment. It’s why they overpay for something, and why they fail to dispose of it (or convert to something else) when the values and prices diverge.This doesn’t just happen with individual investors — it also happens with large entities, such as corporations, trusts, pension plans, and the like. Indeed, since the dollars are usually larger with these institutional investors, and the penalties for mistakes aren’t necessarily felt by the people making the mistakes, the corporate screw-ups can be markedly worse. For example:

One shopping center developer had a set of very specific rules for chosing a new site, and fell in love with those rules to the point of ignoring any contra signals. They bankrupted the entire company by choosing a site based on those rules even though there were other signals pointing in exactly the opposite direction.

This problem is probably worse with homeownership, but indeed spreads to commercial property no less frequently. One investor we know accumulated considerable real estate in support of his business interests. He eventually called us in to evaluate his portfolio, and we found that many — perhaps most — of his holdings were no longer useful for his business. The obvious recommendation was to sell and redeploy the cash into more focused and business-related holdings and diversification for his family portfolio. However, the investor had held these properties for so many years, and had come to know the long-term tenants on a near-family basis. In the end, the investor simply held on to a smorgasbord of unrelated properties that required considerably more effort to manage than they were worth.

One long-established and successful family real estate fund dissolved over a minor cash-flow hic-cup. The individual family members did quite well in the dissolution, but were so in love with the family real estate holdings that they ended up in pointless and expensive litigation over the matter.

Of course, emotions often drive investment decisions. We consider family and estate issues, building wealth, and eventual retirement or other goals. All of these are fraught with emotional content. As such, it’s easy to fall in love with an investment, particularly if it has performed well until now. Remember a few adages about investing:

An investment doesn’t care who owns it. Hence, you may fall in love with a particular investment, but it doesn’t love you back!

It’s often easy to brag to friends about particularly attractive or up-scale properties. Nonetheless, less attractive shacks may be better performers, both for income and for capital gains.

Behave like Mr. Spock, not Dr. Spock. The former was a Vulcan who was ruled by logic, not emotion. The latter dealt with cute, cuddly babies. Too often we think of our investments as cute, but we need ruthless Vulcan logic to succeed in real estate.

Before we go, I’d promised to give you links to the first five of these tips. In a couple of weeks, we’ll conclude this series with the seventh and last big mistake. Until then, stay safe, and as always, reach out if you have any questions.

Mistake #1 — Misuse of Leverage

Mistake #2 — Over Paying

Mistake #3 — Not Realizing You Own Real Estate

Mistake #4 — Trying to Catch a Falling Knife

Mistake #5 — Right Property, Wrong Location

Written by johnkilpatrick

July 24, 2020 at 10:14 am

Posted in Uncategorized

ACCRE Mid-Month Report

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We started ACCRE back in 2017 with two ideas in mind. First, we wanted to “beat” the S&P 500 by 2 times. As of the end of June, a dollar we invested in ACCRE at the inception was worth $1.59. If we’d invested that same dollar in the S&P, it would only be worth $1.31. So, we’re two cents away from our goal, and that’s not too shabby. By the way, real estate in general has taking a pounding this year. That same dollar invested in the S&P Global Real Estate Index grew to $1.28 by January 1 of this year, and has now fallen to $1.03. OUCH!

Our second goal was to provide diversification and more to the point attenuate the risk in our overall portfolio. We measure that in two ways. The first way is to compute the Sharpe Ratio, which looks at the daily “excess returns” (the daily return over and above what we would have earned if we put the money in T-Bills) and divide that by the standard deviation of those returns (a common measure of risk). A higher Sharpe Ratio means that we are getting more bang for the buck when adjusted for risk. You can theoretically get very high returns if you a willing to risk high volatility, and the Sharpe Ratio accounts for that.

The next way of measuring diversification and risk attenuation is to measure the correlation with the S&P 500. In other words, does our fund move in lock-step with the rest of the market, or is it uncorrelated? Uncorrelated in this case is good — it means that we can use ACCRE to smooth out the variability in the rest of our portfolio without sacrificing returns. By the way, we compute correlation both from the inception of the fund and on a month-to-month basis.

S&P 500:
Average Excess Daily Return 0.0250%
Standard Deviation 1.3648%
Sharpe Ratio 1.8306%
ACCRE Fund:
Average Excess Daily Return 0.0455%
Standard Deviation 1.1412%
Sharpe Ratio 3.9850%
Overall Correlation 56.515%
Monthy Correlation, June, 2020 60.394%
ACCRE Metrics as of June 30, 2020

As you can see, we’ve consistently beaten the S&P 500 both on raw average daily excess returns but also on the Sharpe Ratio. Note that the standard deviation — the measure of volatility — is significantly lower for ACCRE than for the S&P. The correlations are positive, but considerably less than 100%, which suggests that while both have benefitted from this long Bull Market run, the two have followed somewhat different paths to profits.

These are complicated times for real estate. That said, a well selected and properly curated real estate portfolio, either in hard assets or securities, can provide above average returns, diversification, and risk attenuation. If we can answer any of your questions, or you just want to chat, please let me know.

Written by johnkilpatrick

July 16, 2020 at 12:10 pm

Posted in Uncategorized

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