Changing Values - Axia Real Assets

Changing Values

European Investment Journal, Fall 2021
Josh Varghese
November 25, 2021 • 13 min read

In a previous life not too long ago, I managed a C$5B global REIT portfolio, one of the largest in Canada. For the first half of my investment career, I was a disciple of the classic Benjamin Graham bottom-up value focused investment school, later to be modernized by Martin Whitman in his book “Modern Security Analysis”, and it worked well. The specific strategy was a simple one: identify real estate companies, almost regardless of the underlying real estate, trading at large discounts to their net asset values (“NAV”) and that were going through some form of positive change – a new management team, a new strategy, an activist investor, as examples – that analysts and investors were reluctant to give credit for but that we viewed as large enhancements to the entity. Here, we were able to invest in companies at large discounts to the value of their underlying real estate, and if we were right on the positive changes at the company, our reward came in the form of a significantly higher stock price, a privatization, or some other corporate action at a sizable premium to our purchase price. The analysis was, over a three-to-five-year time frame, in our downside scenario, due to dividends collected and growing NAVs, our return was flat. In an upside scenario, annual returns would be 15-20%. This risk/reward skew made things compelling.

REIT by REIT, the thesis played out and much alpha was generated. The strategy worked remarkably well from 2010 until sometime in 2015.

And then the strategy stopped working so well.

While we didn’t lose money for our investors, the REIT portfolio significantly underperformed both broader equity markets and REIT indices for almost two years. The fact that my downside scenario of flat returns was playing out offered no solace in a world where public market investor time horizons continue to shorten, and a flat return in a world of 10-20% returns was akin to going bankrupt.

The decision to act swiftly took about a year and a half to make. During that year and a half, I fell into the classic value trap, which I will define as convincing oneself that the market is wrong and that the individual investor is right, while misreading all the surrounding signals. However, after my 18-month journey to climb out of that trap, I gutted virtually the entire portfolio and started fresh. It is not a fun day selling investments at 20-30% discounts to NAV in order to buy companies at 10% premiums. But it worked. The premium companies continued to compound capital at a much more accelerated rate than their peers, earning continued premium and improving their cost of equitys which allowed them to outperform their peers and completely decimate the returns of their value-stock counterparts.

What is Value?

If we boil it down to the simplest of terms according to financial theory (likely a vast oversimplification), “value” is the present value of future cash flows. Breaking this down further, the discount rate applied to generate that present value is comprised of 1) the risk-free rate and 2) the risk premium on the asset. It is these factors that are implicitly being calculated when a capitalization rate or “cap rate” is applied to a real estate asset. The difficulty, however is not the math involved in the calculation, but in the assumption applied to these two factors to generate the appropriate discount rate. Adding significantly to the complexity is the fact that these two factors constantly change, meaning that value itself also constantly changes. And sometimes structural changes alter value significantly. The risk-free rate is a relatively straightforward one to identify, albeit one that changes constantly. The risk premium is another animal. It will change based on investor sentiment, monetary and fiscal policy, credit worthiness of companies, economic growth, technological changes, among many other things. The less attractive an asset becomes after considering these factors, the higher its risk premium will be for investors, and therefore the higher the discount rate will be, all things equal. If the risk premium rises, all else equal the value will fall, and vice versa.

Macro Environments Matter

I learned that our value strategy had only thrived because of the bigger picture environment that permitted it. This five-year environment was characterized by low economic growth, (relatively when compared to today) muted global technological disruption, and interest rates around the world that had been cratering. It was this environment that defined what value really was.

The world and the businesses within it were largely operating normally, and central banks were driving the bus adding to ultra-low interest rates and a scarcity of yield. From a real estate perspective, owning assets leased to tenants whose businesses are intact with no risk of business disruption supported by exceptionally low borrowing costs, there is hardly a better environment to be in. This meant that one had very few impediments to earning solid returns on one’s real estate, whether the asset be a warehouse, a mall, an office, or other. This meant that real estate transaction markets were robust, and that asset prices continued to climb. This in turn meant that REIT NAVs were “real”, and well supported by an active transaction market in private real estate. This, then meant that a REIT trading at a large discount to NAV was bound to trade closer to its net asset value should 1) it improve its business model and 2) investors continue their unwavering confidence in NAV. This was all driven by 1) low risk-free rates and 2) low risk premiums.

So what changed?

Well, the world.

That unwavering global confidence in all things real estate started to wobble in 2016, and in some real estate asset classes, ended up completely derailing. The 2016 election of the new U.S. President of kicked this off, as commitments to economic growth, tax cuts, and repatriation of cash to the U.S. marked a broader “growth on” mentality in the markets, with accelerated capital flows into cyclical and growth sectors. Some of the most emergent, unproven corners of the market had stratospheric performance such as Bitcoin in 2017. Interest rates began to reflect this environment as they more than doubled in the U.S. from their lows in 2016 to their highs in 2018. The global economy was in good shape and safe investments were not as valuable, so why buy real estate when you can get a 10-bagger in crypto or Canadian cannabis, or at least a 50% return in a FAANG stock?

The capital flows side of the equation was a negative for broader real estate values. But there was a bigger, structural issue at play – the technology enabled disruption to our use, need, and therefore value for real estate. It changed risk premiums negatively and positively, depending on the asset.

It started with E-Commerce and Social Media

E-commerce kicked things off, really started by Amazon, and then followed by almost every other successful retailer, with low-to-mid-teens percentage annual e-commerce penetration growth in the U.S. since 2010. Social media platforms Facebook and Instagram (not to mention Google and Apple) played no small part in this success. Capturing the constant attention of billions of humans globally, enabled by artificial intelligence and big data that they had generated monitoring the use of these humans over the past decade, these platforms had an enormous advantage. Competing against this type of access to customers and knowledge about them, traditional advertising channels were found flat- footed. How successful would a large poster in a mall of a couple wearing Gap khakis, that only updates every six months be in a world where Instagram will show its users fashions from Europe, Asia, Africa and the Americas that are tailored to their tastes and refreshes daily? Social Media influencers emerged. Tyra Banks in a magazine shoot is not going to tell you what to wear, just go to Kim Kardashian’s or <insert random influencer’s name here>’s IG page to see what you should be ordering. One’s personal Facebook and Instagram network also played a role. Instead of being limited to seeing 5-7 friends in real life, we were now able to see 2000 of our closest friends and humbly evaluate our lives against theirs. These friends would also serve as marketing models showing us the latest fashions that they are fond of. This ease of access to trends and products fueled society’s impatience as well as its need and expectation that people should be able to get what they want, when they want it, however they want it. The demand side of the equation was changing fiercely and individuals were in the driver’s seat.

The customer demand, more fragmented than ever was being met by more fragmented supply. Ease and declining costs of technology, and platform software companies like Shopify enabled the creative, fashion forward individual to launch their own line of merchandise, from dresses to mattresses to protein shakes. Individuals were able to earn supplemental income by launching new e-commerce companies, and if they were successful, could grow them into a full-time business.

None of this would have been possible to capitalize on, had the infrastructure and supply chain not adapted significantly to match this supply and demand, which it did.

With the ability to see new trends and products in an instant, the accessibility to hundreds of retailers, big and small in a few taps, and the ability to receive product in 1-2 days, what was one’s motivation to walk through a mall? Mall owners tried to address this problem by adding more “experience” to the centres, which could range from restaurants to waterparks. However they began to realize that the “experience” industry is much more competitive and fragmented than the retail industry, and this seemed to only work for the very best malls, and would require heavy capital investment. The combination of lack of visibility of tenant demand, and lack of visibility on capex in the asset began to increase the risk premium in the assets, negatively impact the values of malls.

The Effect of Decentralization

Technological advancement is enabling societal change that is going to have structural impacts on how we use real estate, and what type of real estate is valuable. The example of technology’s impact on brick and mortar retail is emblematic of a larger force – the decentralization effect that digitization is having on how humans interact.

If one can shop from anywhere, what else can one do from anywhere? As it turns out, many things. Watching movies, working out, ordering food, transferring money are some quick examples. These activities have all seen impacts to the value of the brick and mortar locations that used to house them.

What else? Medical consultations? Buying and selling stocks? Dating? Hanging out with friends? Sure, easy.

Not only can people consume from wherever they want, they can create from wherever they want. From a computer screen one can mine a digital currency, stake an NFT and earn money, design a videogame and generate revenue, or start an online retailer. Thousands of retail investors can mobilize to move multi-billion dollar company share prices without ever having to meet one another. People can choose to not work for a company and instead work for themselves by offering their talents as a freelancer in many different fields, in control of their own hours. WeWork, with all its previous flaws, was early-stage evidence of a new work environment forming – one that focused on flexibility and creativity that was empowering individual workers more than ever before. A sort of democratization of everything has been taking place.

Covid of course unleashed many of these trends that were previously emerging on the fringes. Overnight, the world was forced to go digital, like it or not. Companies who had the proper technological infrastructure, had a relatively seamless experience migrating their operations to the cloud. Companies who did not, had to adapt quickly or disappear. Throughout the period, employees were hired, employees were fired, new projects were started, new business was won, new companies emerged, M&A happened, and the corporate world soldiered on. For all the complaints from CEOs who had been chomping at the bit to get their employees back into the office for fear of “lost productivity”, the work from home experiment seems to be going ok, if the S&P 500 at all-time highs is any indication.

What technology has been doing is transferring control from centralized incumbents to a distributed network of people. We have more options than ever to carry out more functions and continue to become less reliant on centralized locations. This certainly has and will continue to impact real estate positively and negatively.

The Virtual World's Impact on the Physical World

While the physical world shut down throughout most of 2020 and into much of 2021, the virtual world thrived. Cryptocurrency, which needs no central location to be created, mined nor to be transacted, hit the mainstream, with institutions beginning to embrace the new asset class, and Bitcoin reaching over $1 trillion as this is being written. As mentioned earlier, stock markets reached all-time highs and this time, the retail investor, powered by Robinhood and online chat platforms could participate. No one shook a single hand yet thousands were able to mobilize to move a stock in whatever direction they wanted. Many Netflix movies were watched. Peletons were ordered. Cottages and vacation homes were purchased as people could world and communicate virtually. Far too many Zoom calls were had. Non- fungible tokens were created and traded. The Metaverse was (not so) quietly growing.

The Metaverse will compete with the Physical World

The Metaverse, in all its sci-fi rhetoric and potential, is really just an advanced extension of what we are all currently at least partially living in, a digital world. Mainstream to the tech world, and a fringe theme to the rest of the world, the Metaverse is being crafted in large part by the video game industry via companies such as Epic Games and Roblox who reach userbases in the hundreds of millions, with others jumping on board such as Facebook with its rebrand to Meta. If an Instagram user can click on an ad as they are scrolling their feed, what can a videogame player or metaverse participant do when they are emersed in a virtual 3D world, step into a virtual mall, see a customized ad for a new item, and try it on their avatar? How about when they are able to purchase items with cryptocurrency or tokens that they have earned in the video game? What happens to the value of virtual real estate in this digital world when more companies realize that they can buy advertising space and reach this customer base and are willing to pay for it? Will digital real estate have value? It appears it is already happening with $1M paid for digital real estate on Decentraland. This is early. The user experience in the Metaverse is not yet there for the mainstream user, but it is evolving. As digital worlds evolve it will continue to challenge the incumbents in the physical world. Both sides will compete on experience. Many inconvenient activities that we had to do in the physical world will be transferred to the more efficient digital world (examples: shopping, learning, banking, and in many cases yes, working) and activities we want to do will continue in the physical world. If one wants to go skiing, the digital world will have a tough time competing at present. If one wants to start or operate a company, the advantage of the physical world is a lot less clear.

The Implications for Real Estate

Much of the real estate value in the modern era depended on providing a centralized space for people to gather to carry out their functions. Malls, offices hotels, and apartments all are more valuable when more people are inside them. However this notion of centralized real estate continues to face competition enabled by the digital world. Some of these risks are: Malls (online shopping), Offices (work from home), Hotels (shared accommodations), Apartments (potentially less demand for urban smaller space due to work from home). It does not render these assets obsolete, however it does impose an additional burden of requiring owners to rethink their businesses in the context of a rapidly evolving technological environment. Capex will likely have to significantly increase to repurpose or reinvigorate buildings. Money will have to be spent on technology and data analytics to better attract and service users. If done right and in the right location, revenues may increase significantly as well. If done wrong, or not at all, asset values will significantly decrease.

On the other hand, real assets that enable digitization and decentralization will continue to thrive. Assets like warehouses that enable e commerce, data centers that enable digital communication and storage, last mile supply chain solutions like grocery stores can be expected to be critical components of the new world.

With increasing amounts of activities being offered online, irreplicable real-life experiences will continue to have more value such as beachfront property, cottages, single family homes with more space, ski resorts (let’s refrain from getting into climate change for now), exotic travel, cycling, pickleball, vineyards, pubs, and restaurants as humans, hollowed by life in the virtual world continue to desire real life.

"Value" is an Evolving Concept

During my tenure managing REITs I learned that determinants of value constantly change, and it is important to adjust one’s view of value by taking macro changes into consideration.

What I thought were stocks trading at discounts to intrinsic value, turned out to be stocks that reflected the true value that investors, customers and society in general were to place on those assets in the future. Conversely the assets that appeared expensive, were expensive because of the role that investors, customers and society were to place on them. What appears to be “cheap” or “expensive” can often be a mirage if the bigger picture environment is not properly understood. In a low yield, low economic growth environment, it for now appears evident that investors will continue to seek alternative assets to allow them to reach their wealth accumulation goals. However, in such a rapidly changing technological environment that is driving major societal changes, it is also becoming clear that the real estate assets poised for better returns in the future will likely be far different than the ones from the past.