I know next to nothing…You should listen to me. - December 2016
For those who don’t know me, I’m Bill Cumby, III and I recently joined W.S. Cumby Builders and Construction Managers to work alongside my father and brother after a 15 year career in real estate and finance. Because we have long-term plans to branch into real estate investment management and development (and because I’ll always be part finance nerd), I promised myself and others that I’d try my hand at some occasional writing about real estate and financial markets. The intent is merely to offer what I hope will be some thought-provoking ideas and commentary; take it for what you will.
Below is the first installment; I hope you enjoy it. And please feel free to offer feedback or forward to others who you think may be interested. Thanks for your time.
I know next to nothing…You should listen to me
I’d like to say I thought long and hard about the topic of this first piece, but it actually came to me pretty quickly. That clichéd saying “know what you don’t know” has never been too far from my lips, and it seemed a perfect self-serving introduction because I can confidently say everyone who knows me is impressed with how much I don’t know. And aside from it being easier than trying to find something I actually do know to write about, focusing on the unknown is the only way one can begin to see the whole picture. The scientific method (which I’d argue is largely responsible for human progress) is essentially a non-knowledge production machine. It disproves theories one by one, gradually growing the knowledge of a topic by expanding that which we know not to be true. It’s only in this way that we can begin to actually understand our world.
But enough of this metaphysical abstraction, let’s bring it back to the real world, and in particular the economic world, a place where non-knowledge abounds (and often goes by misleading names like “consensus”, “forecasts”, “projections” or “guidance”). The good news is that in economics this non-knowledge almost always has a signature tell that makes it easy to identify: it’s not actually observable. In other words, unless one can identify a source of said information, and that information will be the same regardless of who observes it, it’s non-knowledge. Earnings guidance, rent growth forecasts, economic projections…these are non-knowledge.
So what is observable? Just about anything that has already happened, and market prices. Of course this information needs to be distilled a bit to be informative, and the actual implications can be debated, but the information itself not up for debate. My favorite observable valuation metric is the risk premium; this can mean different things to different people, but I like to keep it as simple as possible: the current yield of an asset less the applicable risk free, or US Treasury, interest rate (which is not entirely risk free, but that discussion is for another day). This can then be observed over time and one can observe how current valuations look relative to history…all without making a single assumption, projection, forecast or any such nonsense!
For example, here is a historical chart of the risk premium of stocks (S&P 500), commercial real estate REITs (approximated by IYR, an ETF) and Investment Grade Corporate bonds, along with their 15-year averages:
For those interested, here is a technical description of what we’re looking at. For corporate bonds, I use the bond’s yield to maturity less the corresponding maturity US Treasury bond. For commercial real estate, I use the dividend yield less the 10yr inflation-indexed US Treasury (TIP), because real estate cashflows will change as inflation changes (in industry terms, real estate is a “real” asset, not a “nominal” one). For common equities, I take the earnings yield (or 1 divided by the PE) less the 10yr inflation-indexed US Treasury (because stocks are “real” as well). I use earnings for stocks and dividends for REITs is because REITs basically have to pay out all their earnings in dividends.
Now, none of this tells us what returns we should expect going forward; that is un-know-able. There is huge uncertainty in the future cashflows from all of these assets; the corporation may default on its bonds, the rent of the real estate could fall (or rise), and the businesses in the S&P 500 could become more or less profitable, or go bust entirely. We cannot know these things…we may have some views, we can debate and come to a conclusion, but nothing we conclude can possibly impact that chart. That chart is entirely observable. It tells us a few things, but most importantly that REITs in particular are offering elevated risk premiums relative to history, especially when compared to corporate bonds, while stocks are generally on top of their long term averages.
So, let’s bring this all back to Commercial Real Estate and investment opportunities… There’s a lot of chatter out there that valuations are stretched in real estate generally. However, if you objectively look at the risk premium in the sector, it’s pretty attractive relative to other financial assets, and relative to history (take a look at the ’05-’07 period for an illustration of stretched valuations). That doesn’t mean it’s without risk, or guaranteed to generate returns…those are debates for another day…but I do think we can add to our non-knowledge base the idea that Commercial Real Estate is uniquely overpriced.
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