Adjusting Estimated Real Estate Exposure for Leverage

I realized that because the URF.AX fund, which is invested in New York and New Jersey real estate, is highly levered, my exposure to real estate is much greater than I previously estimated. The market value of this investment is AUD 51, but the underlying value of the real estate assets is almost AUD 1/2 million.

Based on this, the share of real assets in the portfolio is 17.28% currently, which is above the target share of 15%. The asset allocation pie chart now looks like this:

 In recent months the share of real estate increased a lot:

First Investment through Domacom

 

 

I made my first investment using the Domacom platform. I bought some shares in a cattle grazing property in Victoria. Mostly, I just want to see how the platform works, so this is a very small investment. I also have made "pledges" for three "campaigns". Activity seems low on the platform in terms of either trading or crowdfunding campaigns. It's not surprising that the company seems to be focusing on other ways to generate funds under management. The platform provides quite a bit of information but I think deals mostly are a bit too nebulous to commit a lot of money to any one. For example, these are the financials for another farm property in Victoria:

What exactly are the outgoings? If there are finance costs, then how big is the mortgage on this property? The "position" has no loan listed. Was the loan paid off? But last year there were no finance costs. It's hard to understand the financials of most properties I looked at.

What farming activity is generating the rent? The pds says: "It is intended that this property will be used to derive income from mixed agriculture use including the farming of sheep and the growing of trees producing nuts." I'm doubtful about the latter. Is it happening? 

Most residential property listed on the site has fallen in value since the initial investment was made. Are initial valuations over-valuing the properties?

I think if this platform is going to be successful it needs to have much more transparent information.

Second New Property Investment: Domacom

I made a second property investment application today. This one is to Domacom which is a fractional property investment or crowdfunding platform. I have been an investor in the company itself for a while.  It is now looking quite a bit more stable than it did when I wrote about it before. It's still one of my most speculative investments. The way it works is that you put cash into an interest paying account and then bid on various crowd-funded projects. You can also get a syndicate together to invest in a property using their platform. They have a variety of other products like housing equity release for seniors – selling part of your house, rather than doing a reverse mortgage – Islamic financing for buying houses etc. Their model is supposed to allow SMSFs to invest with leverage because you buy units in a fund rather than buying a property directly. 

The focus is on residential property, but there are also more unusual opportunities like solar power and rural farmland.

New Investment: Australian Unity Diversified Property Fund

This is the first new investment in our SMSF. Real estate is the area where we are most underinvested relative to our target allocation. The SMSF already has an investment in US residential real estate via URF.AX. I sold our existing investment for a capital loss and bought a larger holding in the SMSF. So, this investment covers Australian commercial property. This fund has a very good track record (better than Charter Hall in my opinion) and is diversified across industrial, retail, and office properties. Coles and Woolworths are the biggest tenants. We are investing AUD 50k in this fund.

I have a definite preference for direct investments in property rather than listed investments. REITS tend to move up and down with the stock-market and so don't provide as much diversification as direct investments. On the other hand, actually buying property myself is not something I want to do as the required size of investment is too large. Well, we could easily buy an apartment to rent but we couldn't access commercial property easily. So pooling investments with others makes sense. 

If a REIT is trading a lot below NAV, like URF is, then I am interested in buying. URF is a pretty risky investment, though US residential property seems to have turned the corner. Financial Samurai even said he wanted to buy Manhattan Real Estate.

We already have exposures to US and Australian commercial real estate through our employer superannuation funds, the Wilson Alternative Assets Fund (WMA.AX) and the TIAA Real Estate Fund.

Crowdfunded Real Estate

A relatively new investment concept is crowdfunding real estate investments. The idea is that an individual could directly invest small amounts in a range of properties or development opportunities thus reducing their risk. Rather than a fund manager picking the properties, investors could evaluate deals themselves.

I read about Fundrise on Financial Samurai. It seems to actually be closer to a traditional unlisted real estate managed fund, except there is more of a property development angle. They allow investments in both real estate debt and equity. They claim very high historical rates of return. I find it hard to understand how they could be so high. Equity investments could have leverage but debt investments must return the interest rate on the mortgage minus costs? I didn't feel that there was enough transparency around how returns are generated. In any case, unfortunately, it is not open to non-US investors.

So, I looked for crowdfunded real estate opportunities in Australia. This is what I found:

Crowdfundup – I only found one active project on the site.

Estatebaron – This website has more active deals. It focuses exclusively on property development. There seems to be very little information about each project and the site is much less polished.

Brickraise – The link seems to be dead.

Domacom – This is an ASX listed company. The company looked like they were heading to bankruptcy before a recent fundraising. The new money will only last just over half a year as their burn rate is AUD 5 million a year. They will need more than AUD 0.5 billion assets under management to break even given a 0.8% of NAV management fee. However, they have the largest number of deals on their site and have high quality information. Deals include a wide range of projects including solar farms and bioenergy as well as more conventional real estate. This is something I might consider when we have an SMSF up and running if it looks like the company will survive.

Based on this, real estate crowdfunding is not well developed in Australia. Do you know of other better websites?

New Investment: BlueSky Alternatives Fund

I had read back in April about BlueSky's battle with activist hedge fund Glaucus. As a result, the share price of the management company (BLA.AX) collapsed and they undertook a thorough review and independent valuation of all their investments. Listed investment company (closed-end fund) BAF.AX, is a fund of funds, investing in BLA managed investments in real estate, private equity, agriculture, and water rights. The price of this fund also fell, though not as dramatically. The valuation of all but one of its investments is now complete and the net asset value is AUD 1.13 per share. On Friday the stock was trading around AUD 0.80. The company is buying back a lot of stock which is supporting the price. I made an initial investment today and could add more if my thesis that it should rise, plays out.

Houses, Shares, Taxes...

After looking at another couple of houses at the weekend and not agreeing on which we preferred we have changed direction and are now looking to rent a house or townhouse as a midway step to buying a house. Snork Maiden's mom is probably coming to visit for a while (months) and though we previously reorganized this apartment to accommodate her and her now deceased husband we aren't prepared to do that this time. We are much better off now and so have other alternatives. One option would be to rent her a furnished apartment nearby, but she's not keen on that... So we have four houses lined up to look at in the next three days. Rents range from $A570 to $A650 per week compared to $A490 in our current apartment. One ($A650) is actually nearer to the city centre, the others a little further out. One house is almost identical to another we looked at to buy a few doors down. Snork Maiden didn't like the small garden or lack of trees in the (new) neighborhood. But if we're not buying permanently...

I also just put in four orders to buy shares in listed funds here in Australia. Two have already executed (OCP.AX and AOD.AX). My margin loan was down to only $A15k. But if we are not likely to buy a house very soon then I don't need the extra borrowing capacity. We are still keeping a huge amount of cash on hand. You never know when the ideal property would show up. If we rent a house though it would be a 12 month lease. You can get out of that but it could be costly. With high occupancy rates still, it shouldn't be too hard to find someone else to rent in these locations.

The financial year here in Australia ends 30th of June so we are again in the run-up to filing tax returns (deadline 31 October). I've done a preliminary assessment and both of us probably owe more tax. For me it is over $1,000. This is going to mean that I will need to pay quarterly taxes in future :( The reason it is so high is that as we still don't have private health insurance I need to pay 1% of my income as the Medicare surcharge. On top of that my interest earnings are more than $3k due to our house-buying cash stockpile. On Friday I'm meeting a health insurance salesperson (sorry, consultant) who is offering a lower corporate health insurance rate. So, hopefully in future I can avoid the quarterly tax payments. It's also an incentive to increasing the margin loan again. I tried to do Snork Maiden's taxes using the ATO's E-Tax software now that they have a Mac version. It was a frustrating experience and I gave up. Crazily, you can't download a pdf of the main tax form! Only a sample copy. You have to get a hardcopy from the ATO in the mail or from their "shopfront". What I would really like is a web-based tax form that I can just fill numbers into without dealing with all the silly questions in E-Tax, or a typable pdf. I am going to get a hardcopy and again submit paper tax returns until they get the system more user friendly.

Australian House Price Index

The US has the Case-Shiller indexes and now Australia has a potentially tradeable house price index too.

Invest in Multifamily Houses in Jersey City?

I saw an ad in the Australian Financial Review today to invest in the US Masters Residential Property Fund. I already invest in US property through the TIAA Real Estate Fund, which does include apartment complexes but not small multi-family or single family houses like this fund does. The supposed advantages are a high yield relative to investing in single family homes in Australia, the low price of housing currently in the US, and the high value of the Australian Dollar. The fund is not hedged, so if the Australian Dollar falls the value in AUD terms will go up. Also it is cheap to borrow in the US, though currently the fund is not borrowing. The management fee is about 1.6% per year. There are a few possible downsides:

1. The fund is currently trading at $1.64 on the National Stock Exchange (formerly the Newcastle Stock Exchange), but it's NAV is $1.54.

2. The application fee amounts to 4%. Combined, this means that you lose more than 10% of your money right away.

3. Selling units would mean trading on the NSX. Neither CommSec nor Interactive Brokers trades on this exchange.

4. All the houses bought so far are in Jersey City, which isn't very diversified. At least it isn't Michigan I guess...

Point 3, rules out buying units in the market unless I was to set up an account with Macquarie say... So I think I'll pass on this. What US REITs invest in this investment class that I could buy through my Interactive Brokers account?

Crazy Chinese Property Prices

As everyone knows by now property prices are crazy in many parts of China. When compared to incomes they are far far higher than in countries like Australia where property prices are already ridiculously high. My mother in law reported that in their neighborhood (picture above) prices have reached RMB 14,000 per square metre. This is the usual way of measuring prices in China. This price is AUD 2300 per square metre or USD 190 per square foot. A 100 square metre apartment is, therefore, about $200k. This would be cheap in Australia and a decent price in cheaper areas of the US. But incomes in China are much lower. She claims that her apartment is 170 square metres. So it would sell for USD 350k or AUD 390k. This is in the suburbs of Tianjin, which is one of the wealthier cities in China (after Shanghai, Beijing, and Shenzhen). But still. When they moved there in 2002 prices were RMB 3400 per square metre so the unit would have cost USD 85k. They didn't actually pay this. My stepfather's workplace gave them the apartment as part of a retirement package which involved them giving up their old apartment.

EDIF

In the ongoing Everest Financial saga, the "direct investments" in the EAIT fund of hedge funds is being separated out into a standalone fund as of 31 July. 62% of this new fund is invested in Babcock and Brown European Ports Investments and the other investments are also in infrastructure or real estate. Therefore, I'm classifying this as a real estate investment as well as a "passive alpha investment" and as the investment is in my understanding hedged I'm going to continue to count it as an Australian Dollar investment.

Challenger Infrastructure Fund Removes FX Hedging

Challenger Infrastructure Fund (CIF.AX) announced today that it has closed its foreign currency hedges yielding a profit. As it is now unhedged and invested entirely outside of Australia (mainly in the UK) I will now regard this investment as part of my "global currency" investments (not AUD or USD). This is good as our AUD exposure is rising (though the investment is just 1.3% of net worth). The investment is included in our "real estate" investments and under the "passive alpha" category as I don't expect it to be highly correlated with the stock market in the long run.

Net Asset Values of Infrastructure Funds are not Exaggerated

Often I read in the media that the values of real estate and infrastructure assets owned by listed and superannuation funds are exaggerated. That really these funds couldn't realise as much as the carrying values of the assets if they sold them. Today, Challenger Infrastructure Fund sold a £100 million stake in Southern Water at carrying value. Given this, this fund is extremely undervalued. NAV was estimated at $3.75 per share in June but the shares were last trading at only $1.60. Given the fall in the Australian Dollar and this sale at carrying value, it is unlikely that the NAV has fallen from this last reported figure.

"22 December 2008, Sydney - Challenger Infrastructure Fund (CIF) today announced that it has sold £100 million of Southern Water (representing one-third of CIF’s stake). The stake will be managed by UBS Global Asset Management, the manager of the UBS International Infrastructure Fund, on behalf of a major institutional client. Financial close occurred on Saturday, 20 December 2008. The sale price of £100 million (approximately $221.4 million1) for CIF’s equity interest was completed at the 30 June 2008 Net Asset Valuation (NAV). Proceeds from the sale will be utilised to repay 50% (or £50.4 million) of the redeemable preference securities (RPS) on issue, fund an on-market buy-back of CIF securities and potentially fund future opportunities within CIF’s existing assets or fund further capital management initiatives. CIF also announced an estimated interim distribution of 12 cents per stapled security for the six months ending 31 December 2008. The interim distribution, which will be fully funded from operating cash flow, ensures a clear alignment of securityholder returns with the underlying performance of the fund’s assets. Chief Executive of CIF, Steve Bickerton said: “Over the course of 2008 CIF has undertaken a number of capital management initiatives designed to maximise securityholder value. The first example was the sale of three minority assets at a collective premium to NAV earlier this year, highlighting the embedded value in the portfolio and reducing CIF’s net proportional debt by over $1.1 billion. The sale of a third of our interest in Southern Water at NAV is another example of CIF’s capital management efforts, resulting in de-risking and de-leveraging of the fund and a further $560 million reduction of CIF’s proportional net debt. “The sale of a third of Southern Water at NAV is a pleasing outcome for CIF, particularly in current volatile equity and financial markets. The transaction has given CIF financial flexibility to undertake an on market buy-back, repay 50% of the RPS and furthermore arm CIF with the capacity to fund future opportunities from within our existing assets. CIF will continue to actively manage its capital position for the benefit of securityholders,” concluded Mr Bickerton."

The Rich Don't Focus on Real Estate

The Australian data above from the Tax Review as well as US data I've seen before refute a myth popular in get rich quick circles that the rich focus their investments in real estate. The table shows that only 4% of rental income is received by the richest 1% of income earners which is less than their share of salaries - 5.3% (i.e. salary income is 5.3 times average salaries in the top 1% of taxpayers). The bottom 20% of income earners collected 18.8% of rental income compared to their 2.4% share of wages. The bottom 50% of the income distribution share of rent was twice their share of salaries.

OTOH the richest 1% had 38 times the average level of capital gains and and 35 times the level of dividends. Their business and partnership income was 22-23 times the average. The lowest quintile lost money in business.

The truth is that people mostly get rich from incorporated or unincorporated business and mostly invest their wealth in businesses not in real estate. The average landlord is right in the middle of the income spectrum. The average stockholder (weighted by shares held) in the top couple of percent.

Listed vs. Unlisted Property

Listed property includes REITs and other companies mainly involved in property that are listed on stockmarkets such as Westfield. Unlisted property and mutual and funds that are not stock market listed. The performance of these two types of investments can differ radically. Returns of unlisted property closely match those of direct investments in property while the listed investments fluctuate with the stock market and sometimes fluctuate more than the stock market. So much so, that these are almost two separate asset classes. According to Mercer Australian unlisted property returned 19.5% in the year to 31st March 2008 and 2.3% in the March quarter. On the other hand, the index of Australian REITs (shown above and which is dominated by Westfield) returned -22.8% and -17.8% respectively! Over the last 10 years A-REITs returned 9.8% vs. 12.8% for unlisted property.

We have a mixture of listed and unlisted property. I have 5% of net worth in the TIAA Real Estate Fund in my 403b. Since September 2002 it's averaged 11.1% p.a. with a Sharpe ratio of 3.8! It's only had three marginally losing months. The (unlisted) fund is directly invested in all kinds of property mainly in the US (one property in the UK at Canary Wharf). 13.5% of Snork Maiden's superannuation (Public Sector Superannuation Accumulation Plan) is in unlisted direct property. Besides that we have listed property investments including NCT (a mortgage fund in fact), CIF.AX (UK and global infrastructure) and about 3% of our holding of the Colonial First State Conservative Fund. In total we have 8.2% of net worth in property. The listed investments have been very volatile and erratic.

An article in the Australian Financial Review yesterday highlighted how much A-REITs have fallen recently but still argued that they are overvalued. I started to think about putting some money into them, but after this analysis (and given we already have a little via the CFS Conservative Fund, I'm less sure but may begin to put some of our contributions to Snork Maiden's managed funds into a listed property fund.

Covered Real Estate Shorts

Kept the Beazer puts though. Thought about putting a hedge on the US portfolio (BRKB, FLIP, HCBK, IBKR, NCT, RICK, SAFT) for the rest of the day but the odds seem in favor of more rallying today so I didn't. Off to a couple of meetings with grad students - the first is trying to sort out one of my students committee going forward after I've left. There is not much enthusiasm to take her on. The other is a farewell lunch with grad students.

House Prices and Interest Rates

Mortgage borrowing conditions are getting much tougher and interest rates, especially for large mortgages, seem to be going up. An interesting paper on Irish house prices uses a new approach to model the relation between interest rates and house prices. Most previous macro approaches (including my own published research on house prices - I worked as a real estate market analyst back in 1990) found a small effect for interest rates. They contrast this research with the "finance approach" which takes a very similar approach to my recent blog posts in comparing house prices to rents and alternative investments. The finance approach finds a strong effect for interest rates but can't model the effects of demographics etc. The new approach which combines elements of both finds that if interest rates had been 2% higher in Ireland than they were in fact, then house prices would have been 22% lower. A 25% cut in house prices in high end markets does not seem too extreme. It's already happened in some places like Florida.

The Returns from Housing

Following up from my recent posts I thought it would be useful to write down a simple equation that really sums up a lot about the decision of whether to buy a house or not: Rate of Return = Rent Yield - Costs/House Price + Rate of Appreciation The return from owning a house is the rent you would otherwise have to pay minus costs that include insurance, maintenance, and property taxes plus the gains in the price of the property. I'm not including mortgage interest here so I can compare the return on a house with the return on other unlevered investments. The investment decision comes down to whether this rate of return is higher or lower than the return on other investments with similar levels of risk (yeah it is more complicated than that as I'm ignoring the correlation with other assets etc.). Rates of return in bubble areas such as most of California, the coastal Northeast US, Sydney Australia, and probably the UK among many others can only be high enough to pass the investment hurdle if the rate of expected price appreciation is high enough. Enough Wealth pointed out in a comment on one of my posts that high end real estate can appreciate in the long-run faster than the rate of economic growth, but it is hard to imagine that the average house can. In fact Robert Shiller's research has shown that the average house in the US has appreciated slower than the rate of economic growth in the long-run. It is very likely that prices have overshot and that future rates of appreciation will not be as high as in the recent past. In order to restore equilibrium house prices have to fall in order to raise the expected future rate of return. This is the housing bubble argument in a nutshell. So what about mortgage interest? It makes sense to borrow money to buy a house if the expected rate of return (assuming no uncertainty in this return) is greater than the interest rate on the mortgage. And this only if you have passed the investment return hurdle. I think this makes sense though I'm kind of thinking out loud :)

Housing Preferences

Been taking another look at Australian real estate sites for our desired location. We should be able to pay $A350-$A450 per week in rent ($US1300-$US1700 per month). These are for houses and apartments in what is known as Inner North Canberra. Snork Maiden and I currently pay $US750 and $US600 in rent each. Of course we could pay less if we either went for a smaller apartment or were prepared to live in a more remote suburb. But we want plenty of space - at least two bedrooms and preferably three, to allow each of us to have our own office space and we want to live close to Snork Maiden's work and to stores etc. so we don't need to use a car on a day to day basis if we don't want to. What I noticed was that rents on apartments in new buildings with perceived luxury features such as granite countertops and gyms/pools in the building etc. can go for rents that are higher than older but larger apartments and houses in equally good locations. So this is where we have room to be "frugal" in getting good value of money.

For example, take this one bedroom two year old apartment (In an ideal location IMO almost in the city center just across the street from where I used to live):



or this three bedroom house:



which is one block from a small local shopping center and within walking distance of Snork Maiden's work.

Which would you choose?

Buying a property of this type would cost around $A500k ($US425k) which assuming a real cost of carry of 8% would be about $US2800 per month. There is no mortgage interest deduction in Australia for owner-occupied housing but there isn't any capital gains tax on it either.

Real Estate Investments

Continuing in the "passive alpha" theme we get today to my real estate investments. These include the TIAA Real Estate Fund, Newcastle (NCT), Challenger Infrastructure Fund (CIF.AX), and Hudson City Bank Corp (HCBK). The TIAA fund, which TIAA-CREF call very confusingly a "variable annuity" - it can be automatically converted to a variable annuity when you retire as I understand it - is effectively an open-ended mutual fund directly invested in real estate. They own office, retail, industrial, and residential properties around the US (and one overseas investment). Currently I put 50% of my incoming 403b contributions into this fund. It has performed excellently since September 2002 when I first invested with an annualized 11.4% rate of return and a very low variance. It's had only two slightly negative months. As a result, its Sharpe Ratio is an almost unheard of 4.5! My annualized rate of return is 12.9% as I've changed my contribution rate over time. It also has only a 0.078 correlation with the returns of my overall portfolio. I'm thinking to roll over my 403b into a Roth IRA when I one day quit my current job, but it is certainly tempting to hold onto this fund!

I've held the other investments for shorter periods and they haven't been as good as this one. I bought into Challenger Infrastructure around the time of its IPO (I couldn't participate due to being non-resident in Australia) in August 2005. It's returned 9.7% annualized since then. CIF is a closed end fund that is invested in infrastructure assets in Britain - gas distribution networks and broadcasting towers etc. It is supposed to be a global fund but ended up only investing in the UK for some reason. It's accounts have been pretty impenetrable. I originally bought 3000 shares and when the fund was trading below NAV I bought 2000 more. Later I sold 3000 due to the factors I mentioned above. I like to understand how an investment makes money and be confident in management's strategy. I didn't sell all my shares as I believed the investment was still udnervalued but I sold some to reduce my risk. Maybe I should think about selling the rest? One thing I do like about this investment is that the management company is heavily invested in the fund itself.

NCT and HCBK have both lost me a little money so far. Newcastle is a mortgage REIT managed by the Fortress Investment Group (FIG). It is mainly invested in commercial mortgages. I figured that in a real estate slump this fund could gain by buying assets cheaply. The assets it already held were high quality. And it has begun buying up assets from distressed institutions. So I'm going to hold for now. It also has a very high dividend yield - 9.9%. HCBK's main assets are high end residential mortgages. It also has immense amounts of cash and stockholder equity for a bank. So it has been buying back shares and I figured it too could win in a real estate slump. Also I anticipated it being added to the S&P 500 index. This has now happened but was a non-event as far as the stock price went.

The only passive alpha investment left to discuss is Berkshire Hathaway... and I don't think I need to explain that one! :)