The Six Immutable Laws of Real Estate Investing

James Montier, the well known author of "The Little Book of Behavioral Investing" recently wrote an article called "The Seven Immutable Laws of Investing."  In this article he identifies seven principles for sensible investing in the stock or bond markets.  I was intrigued by the title so I read the article and somewhere along the way I realized that 6 of these 7 "immutable laws of investing" also apply to investing in commercial real estate.  So I thought what the heck, maybe I should take a stab at writing an article on the "Six Immutable Laws of Real Estate Investing."  So here goes:

1. Always insist on a margin of safety.  In other words the goal is not to buy at fair market value but to purchase with a margin of safety as property performance, market conditions, etc. may not live up to expectations.  In our world of real estate this means finding properties that are under performing the market but with a change in ownership will turn the property's performance around. 
2. This time is never different.  The four most dangerous words in investing - "this time is different."  The dot.com bubble that occurred about ten years ago is a perfect example.  Investors were buying stock in companies that hadn't turned a profit on the expectation that they would be the next Google, or Amazon.com.  Stock prices soared and even though it made no logical sense the argument that was bandied about was, "this time is different."  The same was true of real estate.  How many believed that house prices could never go down?  In both examples a speculative fever resulted in a bubble causing stocks and house prices to plummet in value.  Whenever someone starts saying this time its different, get out of that investment as quickly as you can.
3. Be Patient and Wait for the Fat Pitch.  As Mr. Montier states in his article, "Patience is integral to any value-based approach on many levels... However patience is in rare supply."  In commercial real estate there is a time to wait and there is a time to act.  When things go bad, like they have for the last three years the tendency is to dump our real estate holdings as quickly as we can when the prudent thing to do is wait.  Most investors suffer from an "action bias" - a desire to do something.  But often times the best thing to do is to stand at the plate and wait for the fat pitch.     
4. Be Contrarian.  Humans are prone to the herd instinct.  When everyone is buying they buy; when everyone is selling they sell.  Last year the value of BP's stock plummeted due to the gulf oil crisis.  BP stockholders were dumping their stock and only a few contrarians were buying.  Less than a year later those that fought the urge to follow the herd have made a handsome profit while those who sold lost money.  Now's the time to be buying commercial real estate, especially those that have been hardest hit - office, retail and industrial.  Years from now we will realize that that there were bargains to be purchased in 2011.  Or we can go along with the herd and sit on the sidelines.
5. Be Leery of Leverage.  I really shouldn't have to say much of anything on this topic.  In many instances those owners with properties that were over leaveraged have paid the ultimate price - the loss of their properties.  Those homeowners who used their homes as ATM machines learned the hard way too.  Three years after the the collapse of the housing bubble about 1 in 4 homeowners have no equity in their homes.
6. Never Invest In Something You Don't Understand.  This is just plain old common sense.  It's not uncommon for for me to talk with real estate investors that are clueless about their real estate holdings which puts them at the mercy of their real estate advisors.  Many times these advisors have a different agenda than the owner but the owner not knowing the fundamentals of commercial real estate is unaware of the conflict of interest.  It's a simple truth: If you don't understand the investment concept, then you shouldn't be investing in it.

I personally believe that now is the time to be investing in commercial real estate as long as you follow these six fundamental principles.  Cap rates have risen significantly, the frothiness of the market has long since disappeared and  interest rates are low... at least for the time being.  Or you can be a part of the herd that sits on the sidelines waiting for a better day, a day that will likely never come.  

Bill Gross Thumbs Nose at Bond Market

Last week Bill Gross, who runs the world's largest bond fund at Pacific Investment Management Co., sold all government related U.S. debt from PIMCO's $237 billion Total Return Fund.  You may be thinking, "Why is this tidbit of news important to us?"  Good question.  When someone who is as knowledgeable about the bond market as Mr. Gross decides to get out of U.S. bonds there's a good chance that something signficant is about to happen.  Gross is betting that the discontinuation of the Federal Reserve's Quantitative Easing program (QE2) in June will have a negative overall impact on the bond market. 

Let's back up for a minute and explain some things.  QE2 is the Federal Reserve program of buying U.S. government debt instruments for the purpose of stimulating the economy.  In a period of only 28 months the Federal Reserve has become the largest owner of U.S. Treasury Bonds ($972 billion as of December) surpassing both China and Japan who took decades to accumulate their bond holdings.  Yesterday, Mr. Bernanke, Chairman of the Federal Reserve confirmed that the Fed will discontinue QE2 as planned by the end of June.

Bill Gross wonders when the Fed stops buying bonds who will take their place?  The Federal Reserve is currently buying $75 billion in U.S. bonds a month.  That's a huge amount.  So what will be the impact when the Fed stops buying?  It all goes back to the law of supply and demand.  If the supply of U.S. treasuries remains the same but the #1 buyer of bonds is no longer buying, in order to get others to absorb the excess supply the market will demand a higher rate of return.  It's as simple as that.  Gross believes that the current interest rate on 10 year treasuries is at least 100 basis points below the historical average.

If Mr. Gross is correct the logical result will be a significant rise in interest rates and it should happen before the end of this year.  If true this could have a dramatic impact on the commercial real estate market.  Rising rates would require a re-adjustment in cap rates upward to offset the decline in investment returns due to higher interest rates.   

Years ago there was a TV ad by investment banking firm E.F. Hutton.  The ad shows an E.F. Hutton fiancial advisor about to give confidential investment advice to his client in a crowded, noisy room.  Before the advisor speaks the crowd stops talking and leans their ear to hear what he has to say.  The ad ends with the slogan, "When E.F. Hutton speaks people listen."  Mr. Gross has just spoken and his actions speak loud and clear.  Are we wise enough to follow his lead is the only question?  
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On a totally different note, treasury rates have plunged in the last few days.  The 10 Year Treasury rate at this moment is 3.20%, down 55 basis points since January.  On the surface this flies in the face of what is being predicted by Mr. Gross.  In reality this substantial dip in rates is being caused by the crisis in Japan.  Japan's stock market, has plunged 16% in the last couple of days and investors are taking their money out of their stock market and putting it into the safest investment they know: U.S. Treasurys.  How ironic.   

Sources: Gross Sees Trouble Ahead for Treasurys, The Oregonian, March 15, 2011; Pimco's Bet Against Treasurys Not Working (So Far), Wall Street Journal, March 15, 2011; Federal Reserve Enters Final Lap of Easing Policy, National Journal by Clifford Marks, March 15, 2011.