On July 27, Cole Credit Property Trust II (CCPT2) filed an 8-K with an updated value of $9.35 per share. This is an increase of more than 16% over the valuation estimate of June 22, 2010. The filing gives a detailed explanation of the methodology, but leaves out the specific metrics and multiples used in arriving at the valuation.
I did a couple of quick desktop valuation estimate based on CCPT2's most recent 10-K and 10-Q. I applied multiples based on data available at REIT Watch, Realty Rates, and NNNEX. Book value of the shares is about $7.45 per share. Capitalized NOI suggests a Net Asset Value of approximately $7.72 per share. However, the public value estimate is between $9.02 and $9.58 based on $118 million of Funds From Operations and multiples of 16 to 17. The FFO multiples are consistent with the trading ranges of National Retail Properties (NNN) and Realty Income Corp. (O), the two publicly traded REITs with objectives and properties similar to CCPT2.
It would make some sense that the share valuation would come in close to the valuation metrics of publicly traded comparable. The REIT announced on June 28 that it was exploring exit strategies to execute within the next twelve months, and it is specifically considering the listing of the shares. As part of the due diligence process, management would be expected compare the values to be received under different strategies and pursue the one that provides the greatest net benefit to shareholders. My quick and dirty analysis suggest that the public listing, or something close, is likely to provide the highest valuation.
Special Thanks: The Rational Realist
Friday, July 29, 2011
Thursday, July 28, 2011
A Discount Rate Primer
Bloomberg has an essay about an alternative means for discounting future events. The author provides a link to his blog, which includes a link to the paper on which the Bloomberg essay is based. The gist of the paper, and thus the essay, is that discount rate may not be consistent throughout the discounting period, and the discount rate may change over time. The paper then develops a more complex discounting mechanism which specifically accounts for the uncertainty of the discount rate.
The discounting function is the fundamental equation of finance. It provides the comparison yardstick by which we can evaluate the wisdom of current expenditures for future benefits. The concept of a discount rate underlies such ideas as a required rate of return, cost of capital, and bond duration. The one number represents all of the factors which make a future event less valuable than an immediate one.
We can agree that the market prices different discount rates for different discreet periods in the future. The sloping yield curve of the bond market is evidence of that. The market also gives us very precise measures of the discount rate related specifically to the time value of money for up to thirty years: the US Treasury STRIPS market. The market can also give us some indications and estimates of a discount rate for longer periods (corporate bonds have been issued with up to 100-year maturities) but these throw in some default risk and reinvestment risk premiums which are difficult at best to identify individually.
In the context of evaluating appropriate discount rates for very long term analyses, which seems the purpose of the exercise of considering alternative means for arriving at a discount rate, we don't need an estimate for the entire period. The STRIPS market already tells us that the value of a good thirty year on the future is 25.255% of a good today Now the estimate need only be made to that point thirty years from now. And no matter what discount rate is applied from that thirty-first year forward, the current price, the present value, of the good will be less than 25.255% of the ultimate value of the good. For example, if the second thirty years was to be discounted at 1%, one would be willing to forgo only 18.74% of the value of good today in return for the promise of the full value of the good in 2071.
So let's not get confused: Receipt of a good in the future is always less valuable than receipt of the good currently. No matter what the discount rate, a good delivered in the distant future will always be significantly less valuable than an immediate good. There are empirical means for determining a precise discount rate for up to thirty years, and very good estimates for many years more. And even if we agree on the weaknesses in our estimation methodologies, more sophisticated calculations are not going to change these fundamental relationships.
The discounting function is the fundamental equation of finance. It provides the comparison yardstick by which we can evaluate the wisdom of current expenditures for future benefits. The concept of a discount rate underlies such ideas as a required rate of return, cost of capital, and bond duration. The one number represents all of the factors which make a future event less valuable than an immediate one.
We can agree that the market prices different discount rates for different discreet periods in the future. The sloping yield curve of the bond market is evidence of that. The market also gives us very precise measures of the discount rate related specifically to the time value of money for up to thirty years: the US Treasury STRIPS market. The market can also give us some indications and estimates of a discount rate for longer periods (corporate bonds have been issued with up to 100-year maturities) but these throw in some default risk and reinvestment risk premiums which are difficult at best to identify individually.
In the context of evaluating appropriate discount rates for very long term analyses, which seems the purpose of the exercise of considering alternative means for arriving at a discount rate, we don't need an estimate for the entire period. The STRIPS market already tells us that the value of a good thirty year on the future is 25.255% of a good today Now the estimate need only be made to that point thirty years from now. And no matter what discount rate is applied from that thirty-first year forward, the current price, the present value, of the good will be less than 25.255% of the ultimate value of the good. For example, if the second thirty years was to be discounted at 1%, one would be willing to forgo only 18.74% of the value of good today in return for the promise of the full value of the good in 2071.
So let's not get confused: Receipt of a good in the future is always less valuable than receipt of the good currently. No matter what the discount rate, a good delivered in the distant future will always be significantly less valuable than an immediate good. There are empirical means for determining a precise discount rate for up to thirty years, and very good estimates for many years more. And even if we agree on the weaknesses in our estimation methodologies, more sophisticated calculations are not going to change these fundamental relationships.
Wednesday, July 20, 2011
The New Market Timing
I am really disappointed in the product description outlined in an article in Investment News. It advocates an investment process focused on evaluating asset classes and sectors for valuation, allocating capital when the valuations are attractive. When valuations get "extended," capital is to be allocated to alpha-generating strategies.
This is just a market timing scheme dressed up with some new nomenclature. The object is to be in a "risky" asset (e.g. stocks) when they are going up, and a risk-free asset (e.g T-Bills) at all other times. Substitute some equity sector options and maybe some commodity exposure for a stock fund, and an absolute return fund for the T-Bills, and you have engineered the suggested strategy. Unfortunately, the empirical evidence is that the strategies do not add value, either underperforming or taking excessive risk, or both.
The use of the alpha-generating strategies introduces an element of risk that few are willing to acknowledge. These absolute return strategies are highly susceptible to fat tails. And the leverage used on the strategies makes encountering the fat tail extremely dangerous., Just ask Long Term Capital Management.
I will continue to advocate a strategic asset allocation approach for individual investors. Creating the lowest risk portfolio that will achieve the goals and educating the client on the relationship between risk and return ultimately will provide the most successful relationship.
This is just a market timing scheme dressed up with some new nomenclature. The object is to be in a "risky" asset (e.g. stocks) when they are going up, and a risk-free asset (e.g T-Bills) at all other times. Substitute some equity sector options and maybe some commodity exposure for a stock fund, and an absolute return fund for the T-Bills, and you have engineered the suggested strategy. Unfortunately, the empirical evidence is that the strategies do not add value, either underperforming or taking excessive risk, or both.
The use of the alpha-generating strategies introduces an element of risk that few are willing to acknowledge. These absolute return strategies are highly susceptible to fat tails. And the leverage used on the strategies makes encountering the fat tail extremely dangerous., Just ask Long Term Capital Management.
I will continue to advocate a strategic asset allocation approach for individual investors. Creating the lowest risk portfolio that will achieve the goals and educating the client on the relationship between risk and return ultimately will provide the most successful relationship.
Sunday, July 17, 2011
Market Timing Made Easy
Mark Hulbert has been evaluating investment newsletters and trading systems for over thirty years. He takes a disciplined and realistic approach to evaluating the performance that can be produced by following the "expert's" advice. So when he endorses a newsletter or trading system, it is worth considering.
On the MarketWatch website, he published a column describing a timing scheme developed by Norman Fosback, formerly of the Institute for Econometric Research and currently the editor of Fosback's Fund Forecaster. The trading program, the Seasonality Timing System, is based on and consistent with academic research findings that there are significant excess returns associated with end of the month and holiday trading. The timing program invests in the market during those periods (about 1/3 of the trading days), and is invested in money market funds the rest of thee time. Hulbert has tracked a hypothetical portfolio since the early 1980s, and reports that the portfolio would have gained 1.4% annually. The index the hypothetical portfolio invested in returned 11.1% with a buy-and-hold strategy.
I am generally skeptical of timing systems. This one has a strong academic rationale, and has been verified in real time by an independent third party applying reasonable constraints. And the performance has been exceptional. It is certainly worth considering.
On the MarketWatch website, he published a column describing a timing scheme developed by Norman Fosback, formerly of the Institute for Econometric Research and currently the editor of Fosback's Fund Forecaster. The trading program, the Seasonality Timing System, is based on and consistent with academic research findings that there are significant excess returns associated with end of the month and holiday trading. The timing program invests in the market during those periods (about 1/3 of the trading days), and is invested in money market funds the rest of thee time. Hulbert has tracked a hypothetical portfolio since the early 1980s, and reports that the portfolio would have gained 1.4% annually. The index the hypothetical portfolio invested in returned 11.1% with a buy-and-hold strategy.
I am generally skeptical of timing systems. This one has a strong academic rationale, and has been verified in real time by an independent third party applying reasonable constraints. And the performance has been exceptional. It is certainly worth considering.
Friday, July 15, 2011
Frac Attack
Hydraulic fracturing, hydrofracking or fracking, is a drilling technique used for some fifty years to enhance the production of oil and natural gas wells. It involves shooting thousands of gallons of fluid under extremely high pressure into the well bore and ultimately into the production zone to loosen the rock and create channels through which the hydrocarbons can migrate back to the well. The fluid is primarily water, but also contains sand or pellets (to prop open the channels) and chemicals (to break down the rock and clean the well bore).
There has been a great deal of controversy stirred up over the environmental impact of fracking. Especially after the well has been treated, the fluids can be toxic and pose a threat of contamination of soils and surface water in the area. Companies have developed procedures to mitigate these risks, and state and federal regulations provide for guidelines and requirements for the recapture and disposal of the liquids.
There have been rapidly spreading stories of groundwater contamination related to oil and gas well fracking with incredible video and slick rap productions. This is all incredibly unfortunate because oil and gas drilling poses such a small risk to groundwater supplies that it detracts from legitimate concerns. John Stossel does a good job of unmasking the deceptions at Reason.com, and Jeff Schlegel writes an excellent balanced article about the industry.
There has been a great deal of controversy stirred up over the environmental impact of fracking. Especially after the well has been treated, the fluids can be toxic and pose a threat of contamination of soils and surface water in the area. Companies have developed procedures to mitigate these risks, and state and federal regulations provide for guidelines and requirements for the recapture and disposal of the liquids.
There have been rapidly spreading stories of groundwater contamination related to oil and gas well fracking with incredible video and slick rap productions. This is all incredibly unfortunate because oil and gas drilling poses such a small risk to groundwater supplies that it detracts from legitimate concerns. John Stossel does a good job of unmasking the deceptions at Reason.com, and Jeff Schlegel writes an excellent balanced article about the industry.
Thursday, July 14, 2011
10-K Season: Cole
Financial reviews continue. I have run a basic financial statement analysis on the most recent Cole Capital offerings – Cole Credit Property Trust, Cole Credit Property Trust II, and Cole Credit Property Trust III.
| In Millions | Cole Credit Properties | Cole Credit Properties II | Cole Credit Properties III |
| Total Assets | $179,307 | $3,485,335 | $3,243,658 |
| Total Liabilities | $123,421 | $1,912,723 | $1,180,608 |
| Equity Raised | $100,331 | $2,200,000 | $2,500,000 |
| Net Real Estate | $172,410 | $3,154,692 | $2,987,707 |
| Direct Debt | $120,485 | $1,673,243 | $1,061,207 |
| Leverage Ratio | 70% | 53% | 36% |
| Revenue | $16,124 | $269,150 | $143,556 |
| Net Income | ($2,626) | $30,430 | ($6,603) |
| FFO | $2,851 | $117,939 | $33,968 |
| Mod Cash Flow[1] | $5,686 | $123,533 | $92,247 |
| Dividends | $5,408 | $129,497 | $121,748 |
| Yield ($10 share) | 5.5% | 6.2% | 7.0% |
Cole Credit Property Trust (CCPT) closed its offering in September 2005. At December 31, 2010, the REIT had $179 million of assets including $172 million of real estate owned directly. CCPT realized $16.1 million total revenue and a $2.6 million net loss. The shareholder 5.5% dividend is fully covered by Funds from Operations and Modified Cash Flow. The company recorded a $2.835 million impairment to a property whose tenant filed for bankruptcy protection during 2010. Property operations in 2010 capitalized at a 8.0% rate suggest net real estate value of $184 million, approximately 7% higher than the book value of the real estate. his estimate would suggest a share value of approximately $6.75, about 12% lower than management's estimate of $7.65 per share.
Cole Credit Property Trust II (CCPT2) closed its offering in January 2009. At December 31, 2010, CCPT2 had $3.5 billion total assets and $1.9 billion of liabilities. Net real estate owned was $3.2 billion. The REIT earned net income of $30.4 million on $269 million of revenues. CCPT2 paid a 6.2% dividend, amounting to $129.5 million which was 91% covered by FFO and 95% covered by Modified Cash Flow. On June 22, 2010, CCPT2 published an estimated value of $8.05 per share, which valuation remains in effect. On June 28, 2011, the REIT filed a Form 8-K with the SEC that included the disclosure:
"On June 28, 2011, Cole Real Estate Investments announced that it is actively exploring options to successfully exit CCPT II’s portfolio within the next 12 months, and that the potential exit strategies it is looking at include, but are not limited to, a sale of the portfolio or a listing of the portfolio on a public stock exchange."
Cole Credit Property Trust III (CCPT3) commenced its initial equity offering in October 2008, and opened a follow on offering in September 2010. As of December 31, 2010, CCPT3 had $3.2 billion of assets, including $3.0 billion of net real estate, and $1.2 billion of liabilities. The company reported a net loss of $6.2 million on $143.6 million of total revenues. The REIT generated $34 million of Funds From Operations and $92.2 million of Modified Cash Flow, which were 28% and 76% of dividends paid.
[1] AdvisorClarity measure equals (1) net income plus (2) depreciation and amortization, plus (3) acquisition fees and expenses, less (plus) (4) any realized or provisions for capital gains (losses) on the income statement, less (plus) (5) income from nonconsolidated entities, plus (6) distributions from unconsolidated entities.
Wednesday, July 13, 2011
Emerging Markets: Higher Returns With Lower Risks?
MarketWatch has a column extolling the virtues of investing in emerging markets and discussing some research by Renaissance Capital suggesting that certain emerging markets may not be as risky as common wisdom would have it.. Author Matthew Lynn opens with an assumption stated as a fact:
More interesting is the research that suggests that emerging markets may not be subject to the political risk that we all assume. Renaissance Capital studied 150 countries over the period 1950 - 2009 and found a relationship between per capita GDP and the risk of government overthrow. Among democracies the demarcation is at $10,000. No democracy with per capita income experienced an overthrow during the period studied. Among autocracies, the critical levels are $6,000 and $10,000, between which the risk of insurgency is high.
The study is not available, so I could not determine how the details were worked out, but the article includes a little hint of the biases working. The article notes that Renaissance Capital is an investment bank specializing in emerging markets, so it is likely to emphasize the positive of any findings there. Furthermore, government overthrow is not the only way that political risk can be manifest; there are also nationalization, currency debasement and regulatory overreach, among others.
The most glaring item though is this: "...Russia is now a stable democracy. There is little chance of it reverting to autocratic rule." Well, excuse me, bu the CIA disagrees: "Russia has shifted its post-Soviet democratic ambitions in favor of a centralized semi-authoritarian state whose legitimacy is buttressed, in part, by carefully managed national elections, former President PUTIN's genuine popularity, and the prudent management of Russia's windfall energy wealth." This makes me wonder how Renaissance Capital classified such democracies as Venezuela and Iran.
The expected returns to emerging markets should be higher than it is for developed markets because the risks there are greater. These increased risks include the political but also economic: emerging economies tend to be undiversified, reliant on the production of commodity inputs, and having very short histories with economic institutions that promote stability..
"If there is one thing that we know for sure about the global markets over the next few years, it is that the returns from all the developed countries are going to be pitiful.
This may be the case, but it is by no means certain. Developed economies have been delevering themselves over the past three years, with the private sector paying off more debt than governments are borrowing. In response corporate earnings, at least in the U.S., are growing nicely. Once the recovery takes a firm hold, the government borrowing issues will work themselves out. There is no reason to believe that return to the equity markets of developed countries necessarily will be "pitiful."The U.S., Europe and Japan are weighed down by massive government and consumer debts. They are going to struggle to get back on a sustained growth path. Emerging and frontier markets are the only places you are likely to get meaningful returns on your money"
More interesting is the research that suggests that emerging markets may not be subject to the political risk that we all assume. Renaissance Capital studied 150 countries over the period 1950 - 2009 and found a relationship between per capita GDP and the risk of government overthrow. Among democracies the demarcation is at $10,000. No democracy with per capita income experienced an overthrow during the period studied. Among autocracies, the critical levels are $6,000 and $10,000, between which the risk of insurgency is high.
The study is not available, so I could not determine how the details were worked out, but the article includes a little hint of the biases working. The article notes that Renaissance Capital is an investment bank specializing in emerging markets, so it is likely to emphasize the positive of any findings there. Furthermore, government overthrow is not the only way that political risk can be manifest; there are also nationalization, currency debasement and regulatory overreach, among others.
The most glaring item though is this: "...Russia is now a stable democracy. There is little chance of it reverting to autocratic rule." Well, excuse me, bu the CIA disagrees: "Russia has shifted its post-Soviet democratic ambitions in favor of a centralized semi-authoritarian state whose legitimacy is buttressed, in part, by carefully managed national elections, former President PUTIN's genuine popularity, and the prudent management of Russia's windfall energy wealth." This makes me wonder how Renaissance Capital classified such democracies as Venezuela and Iran.
The expected returns to emerging markets should be higher than it is for developed markets because the risks there are greater. These increased risks include the political but also economic: emerging economies tend to be undiversified, reliant on the production of commodity inputs, and having very short histories with economic institutions that promote stability..
Friday, July 8, 2011
Office and Apartrment Vacancies Are Declining, Retail Rising
Two articles from Bloomberg and one from The Wall Street Journal paint a picture of conditions for investment real estate. Apartment vacancies are falling and rents are increasing as a result of constrained supply and increasing demand. (See my last post as well.) There is some construction underway, but that supply is not expected to hit the market until 2012 or 2013.
Office vacancies in the Central Business District are falling as well. Corporate hiring is driving the absorption of space. Vacancies are about a full percentage point lower than a year ago, and are only 2/10ths of 1% higher than the recent low of nearly two years ago.
Meanwhile, the headline is that vacancies in shopping centers are increasing. The reality is that community shopping center vacancies increased only 1/10 of 1% over the past year. And while the article does not give earlier period comparisons, I suspect that regional mall vacancies are not changes significantly. I draw this conclusion from the firm rents for both property types.
These trends bode well for investment real estate over the next few years. With vacancies declining and rental rates firming or even rising, cash flows will improve and yields increase. Very positive developments for investors.
Office vacancies in the Central Business District are falling as well. Corporate hiring is driving the absorption of space. Vacancies are about a full percentage point lower than a year ago, and are only 2/10ths of 1% higher than the recent low of nearly two years ago.
Meanwhile, the headline is that vacancies in shopping centers are increasing. The reality is that community shopping center vacancies increased only 1/10 of 1% over the past year. And while the article does not give earlier period comparisons, I suspect that regional mall vacancies are not changes significantly. I draw this conclusion from the firm rents for both property types.
These trends bode well for investment real estate over the next few years. With vacancies declining and rental rates firming or even rising, cash flows will improve and yields increase. Very positive developments for investors.
Wednesday, July 6, 2011
Residential Rental Rates Rising
Smart Money quotes HotPads.com and a CNN.com story referencing Rent.com executives about tight rental supply and rents increasing. Vacancy rates of 6.2% are driving increases of 2% for one- and two-bedroom units to 12% for five-bedroom homes and 14% for studios. In addition, concessions to renters, from free rent to waived pet fees, are disappearing.
The article cites the breaking of roommates of convenience as one factor driving increasing occupancy rates. I suspect that the other reason, families moving from foreclosed homes, is a larger factor. There remains a large overhang (see my earlier comments), so vacancies could tighten more and rates push further upward.
The positive revenue news (from the landlord's perspective) bodes well for the economics of residential real estate for the next 18 - 24 months. The REIT market has anticipated the improvement with a 47% return in 2010 and an additional 14% for 2011 through April (source: REITWatch). RealtyRates.com is not showing any significant change in cap rates over the past five years. It looks like there are still opportunities in the private markets.
The article cites the breaking of roommates of convenience as one factor driving increasing occupancy rates. I suspect that the other reason, families moving from foreclosed homes, is a larger factor. There remains a large overhang (see my earlier comments), so vacancies could tighten more and rates push further upward.
The positive revenue news (from the landlord's perspective) bodes well for the economics of residential real estate for the next 18 - 24 months. The REIT market has anticipated the improvement with a 47% return in 2010 and an additional 14% for 2011 through April (source: REITWatch). RealtyRates.com is not showing any significant change in cap rates over the past five years. It looks like there are still opportunities in the private markets.
Tuesday, July 5, 2011
US Energy Production Increasing?
Contrary to convention wisdom, energy production in the US is increasing. Coal production exceeded 90 million tons in March, which was the highest production figure since the 1990s. Oil and gas production has reversed its long-term decline, and is expected to exceed "peak oil" of the early 70s sometime in the 2020s. All of this is based on analyses by Rystad Energy and reported in the Wall Street Journal.
It is easy to see the results of the increasing supply in the natural gas market. Prices are hovering around $4 per thousand cubic feet (MCF), compared to $8 per MCF four years ago.Less obvious are the gains in oil output, which are being dwarfed by growth in global demand. Oil is more easily transported and therefore US production is more exposed to global pricing factors. For the most part, natural gas is confined to the domestic market, where the sluggish economy has retarded natural gas demand.
These improvement in the energy sector, especially oil and gas, are attributable primarily to development and application of technology. 3-D seismic has improved the accuracy of finding and estimating hydrocarbon deposits. Horizontal drilling allows for better penetration of a productive zone. Hydraulic fracturing promotes more complete production of the oil and gas reservoir. Steam and CO2 injection techniques are responsible for extending the lives of wells that would have been uneconomical to produce at in the late 70s.
With the exception of natural gas, the increased supply is not keeping up with demand. Oil prices are just off their highs, and are still near the highs of three years ago. Coal prices are firming after a decline from 2008 price spike.
Domestic natural gas is developing a number of new markets. Operators of liquid pressurized gas (LPG) import terminals are considering building export terminals. The chemicals industry is revving up production, taking advantage of the cost advantage in products using natural gas as a feedstock. And the conversion of coal-fired electricity generation plants to gas-fired to improve environmental impact is aided by the economics.
The US is still a major energy producer. New fields are being discovered, and old fields are being revitalized by technologies developed since the last "peak oil." Oil pricing is still firm, and while new markets are being developed for natural gas.
It is easy to see the results of the increasing supply in the natural gas market. Prices are hovering around $4 per thousand cubic feet (MCF), compared to $8 per MCF four years ago.Less obvious are the gains in oil output, which are being dwarfed by growth in global demand. Oil is more easily transported and therefore US production is more exposed to global pricing factors. For the most part, natural gas is confined to the domestic market, where the sluggish economy has retarded natural gas demand.
These improvement in the energy sector, especially oil and gas, are attributable primarily to development and application of technology. 3-D seismic has improved the accuracy of finding and estimating hydrocarbon deposits. Horizontal drilling allows for better penetration of a productive zone. Hydraulic fracturing promotes more complete production of the oil and gas reservoir. Steam and CO2 injection techniques are responsible for extending the lives of wells that would have been uneconomical to produce at in the late 70s.
With the exception of natural gas, the increased supply is not keeping up with demand. Oil prices are just off their highs, and are still near the highs of three years ago. Coal prices are firming after a decline from 2008 price spike.
Domestic natural gas is developing a number of new markets. Operators of liquid pressurized gas (LPG) import terminals are considering building export terminals. The chemicals industry is revving up production, taking advantage of the cost advantage in products using natural gas as a feedstock. And the conversion of coal-fired electricity generation plants to gas-fired to improve environmental impact is aided by the economics.
The US is still a major energy producer. New fields are being discovered, and old fields are being revitalized by technologies developed since the last "peak oil." Oil pricing is still firm, and while new markets are being developed for natural gas.
Subscribe to:
Posts (Atom)