[This is an edited version of a talk I recently gave at a MOI Global event.]
I’d like to summarize some of the lessons I learned from helping to run a buy and hold real estate portfolio:
Lesson 1: Find a framework
Before my involvement, I had no prior experience in the real estate industry. So I needed a framework.
As you might know, my main investing model is value investing. So I chose value investing as my framework. I stopped viewing it like an isolated real estate operation, and started to view it like a regular investment.
Lesson 2: The need for a simple valuation heuristic
My second problem was, that I needed a simple valuation method.
I discovered a very simple one: the rent multiple. Basically, it’s comparable to a Price-to-Sales (P/S) ratio. You take the price of a property, and divide it by the yearly rent revenue.
After that, I needed a heuristic of what is expensive and what is cheap. In the current market condition you often see multiples of 25, and even 30 or more. This is quite expensive. In more calmer market conditions you see multiples of 20 or less. A multiple of 15 is reasonably cheap and a multiple below 10 might be described as deep value.
There are two ways to calculate this multiple. First, you can calculate it based on the most recent effective numbers, or secondly, you might use what might be called an intrinsic value multiple, where you take the realistic gross rent you expect, once you take control and implement the obvious quick wins. Of course, it’s more conservative to use effective numbers vs. the projections. Personally, I like to use both, and also like to apply a margin of safety.
After that, I needed to decide on what I consider fair value. In the end, I’ve decided to use a multiple of 20 as a proxy for fair value. The reason why I don’t mark-to-market is that it’s a buy and hold portfolio, so the owners are not interested in market gyrations. This gives the framework a certain stability, and takes the speculation out of the equation.
Lesson 3: You need comparable metrics
My next problem was, that I needed useful metrics to aid our decision-making.
It turns out that the real estate industry uses quite fuzzy metrics. You hear terms like gross yield, net yield, or return on investment. People that use those metrics often seem to exclude very key elements, such as financing costs, taxes, or the fair value of the employed equity. My best guess is that the purpose of these fuzzy metrics is to help the sellers (and their agents) inflate their numbers and make them look better than they are. This is supported by my impression that there seem to be enough real estate investors that keep using those fuzzy metrics, and don’t make the effort to find better ones.
Okay, so what was the job to be done? My main goal for finding a metric was to compare the real estate performace with the performance of a public stock portfolio.
I ultimately decided to use the after-tax return on equity. I want to stress after-tax, as a lot of people in the real estate industry seem to keep using pre-tax numbers.
To calculate the after-tax return on equity, I first calculate the after tax free cash flow. Again, without adjustments, and without exclusions of key elements.
On the equity side, I use my fair value proxy. A lot of real estate investors use their cost basis, because this boosts their returns. This doesn’t make sense to me, because I want to take into account the opportunity cost of the employed equity. That’s why I use my fair value multiple of 20.
So now, this allows me to compare apples with apples and have a useful framework for capital allocation decisions, especially between real estate opportunities and public stocks.
Lesson 4: What are the performance drivers of buy and hold properties?
The next question I had, was to identify the main performance drivers of buy and hold properties. Basically a simple checklist to help me evaluate new opportunities.
I see three main drivers of performance:
First driver: Untapped growth potential: the best buy and hold property is one with untapped growth potential, first in terms of development potential (e.g. turning unproductive spaces into new units) and second, untapped rent potential (meaning: that the current rent is below comparable market rent that you could charge).
Second driver: A reasonable purchase multiple: in the best case scenario, you want to purchase a property with a low multiple, which results in an instant capital gain when you mark it up to fair value.
Third driver: Leverage: the more debt you have, the less equity you have to employ, which of course boosts your after-tax return on equity. With debt, you also have a yield from paying back the principle. This builds up equity. But over time, this reduces your returns, so you might need to re-finance periodically to keep equity low. Personally, I’m not a huge fan of leverage. But if you operate with a large enough margin of safety, leverage makes sense and boosts your returns.
What’s important to note is that I don’t view price increases as a driver. For a lot of real estate investors, this is their main goal and their main performance driver. In contrast, my main goal is to grow the underlying fundamentals. When rent increases by 10%, the value increases by 10%, because I keep the valuation multiple constant. That means that I only consider value increases when there is a corresponding rent increase. If a value increase is not based on fundamentals, I view it as speculation and don’t consider it.
This change in attitude helps focus our energies on increasing the underlying value, and not on being distracted by the fluctuations of the market.