Einstein’s theory of relativity is pretty straightforward, at least at face value: E = MC^2. Even the definition is pretty easy to understand, again, at least on face value: All motion must be defined relative to a frame of reference and that space and time are relative, rather than absolute concepts, except that the speed of light in a vacuum is the absolute maximum speed. In reality the theory is far more complex and led to many scientific breakthroughs, including the development of the atom bomb.
My own theory of relativity is very similar to that of Einstein except that my theory doesn’t have a second, deeper level that will lead to scientific breakthrough or an investing method as revolutionary as “the bomb”. The difference between his theory and mine is due mainly to our relative brain capacity (pun intended). Luckily for me, and probably for many of you, understanding relativity in investing will create more financial benefit than understanding Einstein’s law that changed history forever.
Relativity in the financial markets is not a new concept, at least as it relates to the level of one investment’s return versus another. This is called alpha. Alpha is the risk adjusted return above (or below) the rest of the market for investments with the same level of risk. I believe the importance in understanding relativity is much broader than that. A couple different conversations with investors are what triggered my recent mental foray into this topic.
Before getting into the specifics of using the conversations as working examples, I should propose a definition for my own theory of relativity: Investors that make investment decisions based on the best expected outcome to their portfolio relative to other expected outcomes for the same portfolio will do better over an investing career than investors who focus only on absolute returns. Another way to say it might be: absolute returns grow a balance sheet, relative returns outperform the market and increase the utility provided by the balance sheet.
On to the stories:
A group of us were discussing various investments across different real estate investment segments. One particular investor, who I believe has a strong competency in multifamily investing, made the comment they were pulling out of multifamily completely (including liquidating their sizeable positions to cash and paying the taxes) and instead was moving to investing in another real estate asset segment. Their reasoning was that cap rates on apartments were going to go up because interest rates were bound to rise, and with increasing cap rates valuations would be damaged. Like Einstein’s claim regarding light in a vacuum, in a vacuum this line of reasoning makes sense. But in the real world it quickly falls apart. If cap rates on apartments rise due to the increase in the cost of debt, then cap rates on other real estate will also rise, and roughly at the same proportion as the multi family cap rates. There is no relative difference in the performance across various real estate classes due to rising interest rates.
There are a couple scenarios where his strategy makes great sense and would provide relative returns higher than what would be expected in his current investment portfolio.
The first is if he timed the market and went to cash close enough to a major decline in values that he could then buy back in at the lower values. This would presuppose that the loss in investment income (yield and loan amortization) would be less than the benefit gained of buying in at the lower price. If a market were timed perfectly, this might be the case. The further the timing is off the worse the relative returns of going to cash become. A $1 million dollar property without debt at an effective 10% cap rate produces $100,000 in income each year. If that property was sold and cashed out and the market dropped 1 year later, the same (or equivalent) property would have to be purchased at $850,000 to produce the same return as owning that asset EVEN THOUGH THE VALUE OF THE ASSET DROPPED BY 15%. This is due to the $100,000 loss of income and the approximately 5% transaction costs associated with the sale of the property. This is before even calculating in capital gains that may have been owed from the sale of the property.
Even if I thought a large market price change was coming I would have to have a really strong conviction of that slow down to bet it would be a 15% price recession within 12 months. Note #1: This reasoning applies to income producing investments. Negative cash flow changes this dynamic entirely. Note #2: It often happens that an investor will go to cash because of an upcoming crash only to get antsy sitting on the side line and reenter the market. The only difference is prices have gone up in that time so there are less assets purchased per investment dollar AND the calendar has turned that much closer to the inevitable slowdown. If you do go cash, own it, and be patient.
The second area where the strategy of moving from multifamily to another real estate class makes sense is if the relative returns expected to be provided by the alternative are higher than multifamily returns after taking into account the transaction costs of making such a shift in an investment portfolio. How might this occur? Mostly if the rents were expected to increase faster than multifamily rents. Secondarily, because real estate is not a perfect market, there might be instances where opportunity presents itself to an investor in one segment more than another. In this case the “great deals” that can be obtained on an individual basis provide higher relative returns than what could be obtained on a segment wide basis in the segment where the investment was originally housed.
Unfortunately for this particular investor I am using as an example, his reasoning was not that he thought rents would increase faster in the other segments, or that he has a pipeline of opportunity elsewhere that didn’t exist for him in multifamily. His vacuum strategy may be sound, in relativity I don’t believe it to be.
Conversely, a great example of “Forrest’s theory of investment relativity” in practice is a friend of mine who moves every few years into houses that he buys and remodels. He recently sold his okay but nice home in an okay but so so area at the absolute top of the market. He turned around and purchased a beat up home in a fantastic location for less than he sold his previous home for. The new home is 33% larger and on a property that is almost 400% larger than the house he sold. Even after the work needed to improve the house to fulfill his potential his cost basis will be only marginally higher than where he sold his previous property, but on a property that is now worth twice as much as the previous property.
All within the same market this friend made a huge relative improvement in their home ownership by selling at the top and (nearly) simultaneously buying at the bottom. When someone asked him whether he was concerned about the possibility of the market crashing and dragging down his value his response contained the wisdom that I hope to emulate:
“I have to have a place to live so unless I want to rent I have to own my home. If the market crashes and the price drops on this new home it will also drop on my old home. Except now I have far more equity than I would have had if I had stayed in my previous home. This equity, my understanding of the real estate market, and ability to provide a product (house) desired in the marketplace allows me to sell at the top of the market, whatever the condition of that market might be. If the market crashes and I still sell at the top of that crashed market, it puts me in position to buy back in at a lower basis from someone that is desperate to sell. Just like I stepped up the value [FJ – note that this is different than price] of my home in the current decent market by selling high and buying low, I will be able to do that in a bad market but end up with far great value and utility in my replacement home.”
The key in the above story is that this investor continues to accumulate value relative to the market. Unless he was cashing out of the market entirely and moving to a different market, the price of his asset(s) isn’t nearly as important as the relative utility provided by the assets. Put another way, and reverting to the above discussion regarding moving investment to a different real estate segment, if a property is held for cash flow and that cash flow is being achieved, does it matter if there is price “noise” in the marketplace? The expected returns are still being achieved and the results of those returns are most likely better than an alternative move that could have been made. In fact, the value of owning as investment, that is to say returns expected to be produced by that investment, are actually inverse to price. If a $1 Mil property is producing $100,000 in annual income (10% cap) and the market changes so that the properties market price is “only” $900,000, the property at market price is now producing an 11% cap rate. All other things being equal, an 11% cap rate is better than a 10% cap rate, regardless if you are wearing the lens of absolute returns or utilizing the ground breaking new Forrest’s Theory of Investing Relativity.
Will the real estate market go down again at some point in the future? Yes, of course it will. Will it do so in the couple next years? I don’t have a crystal ball so I have no absolute answers, but I don’t see a broad based real estate crash on the immediate horizon. The underlying economics continue to point to the opposite (high demand, low supply). Especially because of those economics, if it does go down there are big problems across the economy, meaning investment returns in other vehicles will also get hammered. Hence I believe real estate, and in particular Altus Equity Group as active participants, can continue to produce returns that are relatively better than other places we can place our money. And my thoughts on the stock market? Now that is a topic for another article.
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 email@example.com.