Investment Ideas in Real Estate Markets

As a member of the Chartered Alternative Investment Analyst (CAIA) Association, I am fortunate enough to attend various learning events.  Last week, I listened to four investment professionals about their views on the Real Estate Markets.  Real estate may be termed the original alternative asset.  They were Rod Hinze, Founder and Portfolio Manager of Keypoint Capital Management;  Richard Adler, Managing Director and Co-founder of European Investors Inc;  Michael Stratta, Investment Analyst of Aviva Investors and Scott Yetta (sic) of Cerberus RMBS Opportunity Fund at Cerberus Capital Management.  They have different viewpoints on the markets.  Hinze manages an equity long/short hedge fund.  Adler invests in REITs and directly in real estate.  Stratta manages funds of funds and private equity funds.  Cerberus has launched a fund that invests in structure finance.

Keypoint's portfolio is market neutral.  It seeks absolute return by investing in real estate related securities.  Hinze was long on several subsectors such as student housing, data centers and movie theaters.  He was short on big box retailers, toxic debt structures in mortgage REITs and the standard overvalued securities.  Last year, the real estate appeared correlated to the equity markets.  But if the subsectors were analyzed, there was much variation.  Class A malls and self-storage were up and banks were down.  Keypoint's beta or correlation to the markets ranges from 0.1 to 0.2.

On the private equity side, Stratta is seeing a continuation of a trend for better liquidity terms for investors.  The preference is for an open-ended fund with quarterly availability for redemptions.  The classic closed-end fund with a ten year lockup is losing its popularity as more investors are looking for yield and dividends; not for appreciation.  Stratta covers the Americas and has investments in Brazil (Sao Paolo and Rio de Janeiro).  He is already looking at opportunities in what he terms the next emerging markets:  Panama, Peru, the Dominican Republic and Colombia.  Canada is divided into two parts:  Vancouver and everywhere else.  Asian banks control most of the real estate transactions in Vancouver.  Other banks cannot crack the market.

European Investors Inc's regional allocations are:  overweight in Asia, underweight the US and standard weighting for Europe.  Adler invests in REITs and real estate.  They have a portfolio of $1.5 billion in direct investments.  He spoke extensively about the increased volatility and correlation to financial stocks of REITs.  Due to the new ETFs on REIT indices, electronic arbitrage trading is causing large market moves in the same manner as the equity markets.  Regarding investment ideas, he is positive on Thailand, the Philippines, Turkey, Israel and Brazil because the general or macro conditions are favorable.  Mortgage REITs, such as Annaly Capital Management, have a 15% interest rate.  He expects that to retreat to the upper single digits - which is sustainable over the long term.  There is a also a new REIT asset class with the single family house rental as the underlying.  These homes may be a straight lease or lease to buy.  In five years, there are projected to be two to three million homes in this category.  The expected returns for this investment is 8%.  The first deal in this REIT was in April 2011 in a deal co-sponsored by Fannie Mae and Credit Suisse.

The final speaker from Cerberus Capital had recently launched a $1 billion hedge fund focused on Residential Mortgage Back Securities (RMBS).  For a fund manager, he gave a surprising amount of detail to non-investors.  He split his investment universe into agency and non-agency securities which are a $10 trillion market.  Agency securities are created by government sponsored entities such as Ginnie Mae, Fannie Mae and Freddie Mac.  Their main risk is pre-payment of loans and mortgages.  Non-agency securities have credit and interest rate risks.  The fund managers analyze RMBS based on a number of factors:

• Yield is analyzed based on the behavior of the borrowers.  Of the universe of borrowers within an RMBS, they look at how many will pre-pay (i.e. re-finance), pay late, get loan modifications or default.   Scott is seeing value in borrowers with hybrid loans such as the 5/1 homeowner loan where the first five years are fixed rate and then the rate floats.  The most interesting borrowers are two to three years into the floating rate period.  They are pre-paying their loans by re-financing into fixed rate loans at historically low rates.  Many of these loans may be found in a mezzanine tranche.
• The recovery value of houses liquidations is viewed on a state by state basis because of differing state foreclosure laws.  A house in California can be foreclosed without going through court approval;  not so in New York and Florida.  The shorter the period, the higher the rate.
• Built in expectations that there will be another 10% drop in real estate
• Investors need conservative assumptions on the above three factors as a cushion for credit risk.  2011 returns were down because of two macro events:  the Eurozone crisis and the delay in the selling of Maiden Lane II, a huge loan portfolio of the Federal Reserve Bank of New York.  In the third and fourth quarters, funds hedged against a drop in RMBS - anticipating that Maiden Lane II would cause an oversupply of this product.  They hedged using residential indices such as the ABX and Prime Index, commercial index (CMBX) and high yield/investment grade indices.  Paying for the loss protection caused real estate hedge funds to underperform the market.
• Documentation and loan servicers are understaffed and large institutions are selling their units
• Government policy directly affects agency securities.  Cerberus has some insight into the federal government by having Dan Quayle and Jack Snow as staff and by owning GMAC.

Thank you, CAIA, for organizing this great event.