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Investment Theory Musings

August 2016 Insight

We currently have a lot going on at Altus, all of it good.

  • Three apartment complexes currently in contract (~600 units)
  • We are in the middle of a Fannie Mae refinance on an apartment complex we own in Northern California (a 41% increase in value in 2 years, a 12 year fixed rate loan below 4.25%).
  • We’ve come to an LOI agreement to lease one of our office buildings to to an A rated medical tenant and are working through the lease negotiations and permitting associated with that agreement.
  • Multiple complex upgrades still in process.
  • As of today, we have an offer in hand on an apartment complex we are selling in Sacramento at 25% higher than our purchase less than a year ago.

Because of all the activity this Insight is going to be shorter than most, which will make many of you very happy indeed.

This month I am going to go a little more esoteric than normal and will have scant references to outside resources. Why my thinking has been along these lines I don’t know for sure, but I suspect it is due to the considerable amount of driving I have done over the past couple months and the things my mind does when I drive. What? You don’t spend time philosophizing about investment strategy? Most people probably don’t, but it is this oddity of mine that sometimes leads to interesting insights. Whether they have any value beyond purely being interesting (at least to me) I will leave to each of your individual judgment.

Why do we invest? Seriously, why do we invest? The first answer seems relatively straightforward but then raises more questions…

  1. I invest to increase my net worth, provide income, or both. Why?
    • I invest to increase my net worth to be able to provide additional future income. Why?
  2. I invest for income or for increased future income so that the income can be used to buy things or services. In economic speak, this is called “utility”.

Acknowledging that the utility we are trying to achieve may be for our children (college/inheritance/etc.) or to help others (charity/provide jobs/etc.), we invest to have more of something tangible at some point in the future, even if that future is after our life here is over. This is all presented with the caveat/understanding that as serious investors it is our intent to be able to live off the income provided by our investments and not the liquidated sales proceeds of those investments. One is sustainable and builds wealth. The second, while often necessary, is not, and contrary to the advice of many so called wealth advisors, shouldn’t be a person’s investment goal (in my humble opinion).

Consider the following two investments scenarios. For this exercise we will assume the risk and volatility of cash flows are the same for both and that these can never be sold but will be passed down through the generations:

  1. $10 Mil in equity, 2% cash on cash return or
  2. $2 Mil in equity, 10% cash on cash return

At first glance Option 1 above looks far better, right? In reality both options provide the same benefit to the investor ($200,000 of annual cash flow). Let’s take it one step farther.

  1. $10 Mil in equity, 2% cash on cash return on a bond portfolio or
  2. $2 Mil in equity, 10% cash on cash return on a NNN lease portfolio with 3% annual increases

The ten year returns are $2 M in cash flow for the $10 M investment and $2.3 Million for the $2 M investment, or a 15% more income over the ten years. The difference continues to grow with 20 year returns on the $2 Mil investment 34% higher over twenty years versus the $10 M investment.

So with this clarity we can understand that the value of our investments isn’t nearly as important as the benefit (usually defined as post tax cash flow) our investments provide or eventually will provide.

Why is this important? As has been discussed in previous Insights, we will have a correction to asset prices at some point in the future. When? Who knows, but we do know it will happen. And, if history is any guide, we can expect the correction to be sizeable. How are we going to react when that correction occurs?

Unless we know when the next correction is going to occur, or at least have a high probability of being correct in our prediction of when that correction is going to occur, going to cash is probably not a great option. Too long on the side lines and the lost returns outweigh any price losses during the correction. This is even more true with cash flow producing assets than assets held purely for appreciation. But if we are to remain invested, what is our strategy for dealing with the correction? And not just the physical movement of equity between investments but the psychological issue of dealing with our fear. How do we take a different outlook to protect us from ourselves and allow us to benefit from changes in the market?

Last October (click here) I wrote what my egocentric self considers one of my best articles on the subject of relative value. We have talked ad nauseam through many articles about the benefits of being invested in assets that can be expected to provide cash flow even during periods of correction. I continue to believe both focusing on cash flow and analyzing investments based on relative value are pillar strategies for uncertain times, but the combination of the two might be even more powerful.

If we own a quality asset and market prices drop, what happens to the value of our asset? In most cases the price will go down but because in times of turmoil most investors response is a “flight to quality” the price of assets viewed as quality assets will drop less than price of assets viewed as not having as much quality.  Often substantially less. Likewise, the cash flow being produced by quality assets should drop less than poor quality assets (hence one reason for the reduced drop in price as well). This creates a situation where not only are the returns of the quality asset strong compared to the market, but there will be opportunities to trade those quality assets into assets with quality potential at a relative value premium. Continuing with the example outlined above, if an asset is producing $200,000/year of income, and if the purpose of the investment is income, does it matter if the price of the asset is $2 Mil or $10 Mil? Taken farther, if an asset is held for price appreciation, by default it is being held for future income. If that asset’s price drops, but as a result more future income can be obtained, should we care that the price dropped?

Taken even one step farther, if we have the courage to part ways with our quality assets when they are most in demand and turn around and buy considerably more asset that may not be thought of as highly, then we can put ourselves in position for huge pay days. And by that I mean massive increases in cash flow, present or future. This thought of moving into lower quality assets isn’t nearly as scary or concerning when a strategy can be employed to turn the new investment also into a quality asset. By the way, unlike most points in history, asset prices across investment classes are currently highly correlated. This means when stock prices crash so will bond prices (yields will rise). With rising yields investment real estate will also be faced with rising cap rates, and thus falling prices. This means asset reallocation will be an option across asset classes in a way most of us have never seen in our lifetimes.

Thinking like the above has led Altus to further refine its investment strategy. We still look for all the things we have been looking for over the past several years, but we also are now putting increased value on properties with unique features or close to urban cores. Especially properties that have opportunity for improvement. Age is less important to us than it may have been in the past, and we are now placing more emphasis on how well established an area is. This is admittedly a strategy that is in conflict with many investors who are looking for newer and nicer properties in areas of new and growing development. We just believe that price points associated with older properties can’t be replicated with new construction and specifically as it relates to housing, there are legions of quality tenants who can’t afford the prices new construction must achieve to justify itself. Additionally, older construction, when well located, has upside through improvements that doesn’t existing in newer properties that have no room to move upward. That forced upward value enhancement, even in the face of falling prices, results in increased value. It is the value that provides future cash flows that we are looking for, not price.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at


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